Question

For this week’s portfolio activity, please advise the instructor of the following: Utilizing the information provided in your course textbook(s) or other valid sources, briefly explain why company valuation is influenced by capital structure decisions. Please provide a brief update to the instructor on how you feel you are doing so far this term.

Answer 1

What is capital structure?

Combination of capital is called capital structure. The firm may use only equity, or only debt, or a combination of equity +debt, or a combination of equity + debt + preference shares or may use other similar combinations.

A company make use of its business assets to generate a stream of operating cash flows. firm makes distributions to the providers of its capital and retains the balance for use in its business after paying taxes to the government. For example If company is entirely financed by equity then the entire after-tax operating cash flow each period accrues to the benefit of its shareholders, may in the form of dividend or retained earnings, on the other hand If company uses debt funds as a portion of capital instead of entire equity then it must dedicate a portion of the cash flow stream to service this debt. Moreover, debt holders have the senior claim to a company’s cash flow; shareholders are only entitled to the residual. The company’s choice of capital structure determines the allocation of its operating cash flow each period between debt holders and shareholders.

Example of Capital Structure:

Let's consider two different examples of capital structure:

Company X, for our purposes, has $150,000 in assets and $50,000 in liabilities.
This means Company A's equity is $100,000.The company's capital structure is therefore such that for every 50 cents of debt, the company makes $1 of equity.
This, then, would be an example of a low-leverage, or even low-risk, equity capital-structured company.

Now, take its cross-town rival,
Company B. Company B has $120,000 in assets, $100,000 in debt and therefore $20,000 in equity.
Company B is "highly leveraged." For every $5 of debt, the company has $1 in equity.
This means not only the company needs to increase its returns to be able to finance its debt, eventually, but the company also will be viewed as a greater risk to future lenders