Financial Management Chapter 15 Question 9
Describe why Capital Structure is relevant to the value of the firm?
Capital Structure is relevant and important to the value of a firm because its primary objective is to maximize the total value of a firm’s outstanding debt and equity, financial managers’ care a great deal about how the firms will be financed. Therefore if the firm is not financed properly it can have negative consequences on how the firms select its appropriate Capital Structure. If an inappropriate Capital structure is being chosen that can have harmful effects on the way in which the public value the firm and according to the two assumptions of M & M Capital Structure theory one may be violated. When any of the ...view middle of the document...
One under the US tax codes interest is a tax deductable expense, where as dividends paid to stockholders are not, thus after taxes firms have more money to distribute to their debt and equity holders if they use more debt financing. Two debt financing creates a fixed legal obligation if the firm defaults on its payment to creditors the firm can be forced into bankruptcy and incur all cost involved with that process. Three the treat of bankruptcy can influence the behavior of a firm executive as well as it employees and customers. Managerial attention can be focus on improving firms’ performance. Also too much debt can lead to changes that makes a firm less attractive and desirable for employers and suppliers.
Assumption two states that “Financial Markets are perfect” this assumption is clearly violated in reality. Transaction cost can be important and because of these cost the rate at which investors can borrow may be different at which the rate firms can borrow. When this occur firms values may depend on how they are financed because investors/individual cannot substitute individual borrowing for corporate borrowing to achieve a desired level of financial leverage. If firms can borrow cheaper than individual then firms should borrow for better financial leverage. This would increase both the risk and the return on their stock and have individual who want to take substantial risk on their own portfolio to do so without borrowing. Transaction cost that cause difference between the borrowing rates faced by corporation and the borrowing rates faced by individual tend to affect all firms equally.