Question

Hi, could you please assist with this question?

You are an investment banking consultant advising a mining company. The CEO of the company tells you that she believes that capital structure does not have an impact on firm value. On what basis might they make this comment? State whether you agree or not with this position and explain why. Does the nature of this firm’s business risk change your answer? Fully explain your reasoning.

Thanks kindly

Answer 1

This is not a correct statement which is made by chief executive officer because capital structure has a important role to play in the overall performance of a mining company because capital structure will define that how much equity or debt financing is used in the overall structure of the company in order to maximize the rate of return and minimise it's overall risk associated with the performance.

When a company is looking to finance a project,the capital structure will decide that how much equity or debt should be optimum used in order to finance effectively, so that overall cost of the project would be low and the return generated on the project should be higher, so it should always be selected after proper assessment.

It can be often seen that debt capital always has a interest tax shield associated with them as interest payable on the debt capital is tax deductible, so when the overall cost of capital is to be reduced, that capital is debt is be used when the corporator tax is high, so the overall cost of capital should be lower and it should be precisely lower than the rate of return, If a company want to maximize its earning in the long run. The interest tax benefit should always be traded with the cost of financial distress in case of debt financing.

So chief executive officer, should be having appropriate knowledge about the capital structure of the company, which is an important tool for making decisions for maximization of value.