Question

In your opinion, does capital structure matter (e.g. does it affect firm valuation)? Detail your reasoning with concrete examples (using real data) of your firm (the firm you pick to work on throughout the term).

Answer 1

The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A valuater might also use a prospective buyer's capital structure or the company's "optimal" capital structure. ... So, as the level of debt increases, returns to equity owners also increase enhancing the value of the company. If risk wasn't a factor, then the more debt a business has, the greater its value would be.

Equity financing – raising money by selling new shares of stock – has no impact on a firm's profitability, but it can dilute existing shareholders' holdings, because the company's net income is divided among a larger number of shares. When a company raises funds through equity financing, there is a positive item in the cash flows from financing activities section and an increase of common stock at par value on the balance sheet.

If a firm raises funds through debt financing, there is a positive item in the financing section of the cash flow statement as well as an increase in liabilities on the balance sheet. Debt financing includes principal, which must be repaid to lenders or bondholders, and interest. While debt does not dilute ownership, interest payments on debt reduce net income and cash flow. This reduction in net income also represents a tax benefit through the lower taxable income. Increasing debt causes leverage ratios such as debt-to-equity and debt-to-total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet cer0tain interest coverage and debt-level requirements. In the event of a company's liquidation, debt holders are senior to equity holders.