Question

1. What are some factors that affect capital structure decisions made by management? What are the arguments in support of using debt as part of the capital structure?

2. Does capital structure influence the value of a firm? Why or why not?

Answer 1

Answers-

Q 1)

The facors that affect capital structure decisions made by management are

Capacity of fim ( small of large), Revenue growth, Risk faced by the firm, The Debt payment ( Ability to service debt), Operating leverage of the firm, Consistent cash flow, Type of industry ( Sector) , Asset structure of the company, Lending pattern of company.

The usage of debt helps in maximizing the value of the firm. The debt in the capital structure is helpful as there is a tax shied that adds value to the company and decreases the overall cost of capital or WACC. The debt in the capital structure is good to certain extend as overusage of debt increases leverage and increases the cost of equity because the equity investors require higher rate of return or premium for taking more risk.

Q 2)

Yes, the value of the firm is influnced by the capital structure as per MM proposition I with taxes the value is maximized at 100 % debt and as per MM Proposition II the WACC is minimized at 100 % debt.
The value of the firm = market value of equity + market value of debt.
The debt financing provides a tax shield that adds value to the company. The tax shield is equal to the marginal tax rate multiplied by debt in capital struture.