Discuss the traditional argument that the firm can lower its cost of capital and increase market...

Discuss the traditional argument that the firm can lower its cost of capital and increase market value of the firm using leverage and the non-traditional argument that leverage is irrelevant. Based on the understanding of the two sides, which approach will you use if you have to make a decision on capital structure in your firm.

Expert Solution

Traditional argument states that market value of the firm depends on the capital structure and cost of capital of the firm, cost of capital is also known as WACC (weighted average cost of capital which is an average of cost of equity, cost of debt and cost of preference shares). According to the traditional argument a decrease in WACC leads to the increase in the market value of a firm. WACC is decreases due to the use of more debts in the capital structure. But it also states that value of a firm increases due to a decrease in WACC or using debt (leverage) in its capital structure up to a certain level after that level any further increase of debts in capital structure will decrease the market value of the firm.

Therefore, it suggests that equity and debt should be used in a optimum ratio. use of 100% equity or 100% debt can't be a optimal capital structure whereas a combination of both will be result in an optimum capital structure, there is no pre-fixed ratio of debt and equity for a optimum capital structure it depends on the needs of companies.

Untraditional argument is given by Modigliani-Miller Model

MM proposition I states that it is completely irrelevant how a firm arranges its capital funds.

It argues that if two firms are same in all aspects except that they differ in resect of their financial pattern and their market value, then the investors will develop a tendency to sell the shares of overvalued firms to buy the shares of the under valued firms. This, buying and selling pressures will continue till the two firms have attained same market values. Therefore, due to this arbitrage process capital structure of the firm and cost of capital of the firm are irrelevant to the market value of a firm.

I will go with the traditional approach as it sounds more useful because debt is definitely a cheaper source of finance that reduces the cost of capital. I will try to find the optimal capital structure in order to increase the market value of the firm.

jeff jeffy answered 3 months ago

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