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.

Answer 1

A)

Capital structure matters because it influences the cost of capital. Generally, when valuators use income-based valuation methods- such as discounted cash flow- they convert projected cash flows or other economic benefits to present value by applying a present value discount rate.

In accordance with the signalling model by Ross (1977) an increase in gearing represents, in term of a company's prospective cash flows, a positive signal to external investors. Beacuse, due to the higher risk of financial distress, companies with less optimistic market prospective tend to avoid additional financial obligations.

This implies that an increasing indebtness means a higher quality of business and therefore better valuation. This leads, in turn, to the assumption that the corporate managemnet can influence a firm's value by changing its capital structure.

If capital structure can effect value, how can firms identify an optimal capital structure what will it look like ? It is that mix of debt and equity that maximises the value of a firm and, at the same time, minimise overall cost of capital. In their seminal article, published in 1958 and 1963, Modigilani and Miller argue that under certain assumptionsthe valuse of a firm is independent of its capital structure , but with tax- deductible interest payments, they are positively related.