The Traditional Approach to Capital Structure

885 Words2 Pages
bulb-icon

Recommended: What is the comparison of debt and equity finance

The traditional approach to capital structure
The traditional approach stresses the benefits of using the combination of cheaper debt and equity finance to find the optimal capital structure, so the total value of firms will be increased with the sensible debt. (Watson and Head, 2013) Of cause, the model was created which based on a certain assumption 1) There is no tax at a personal or a corporate level. 2) The perpetual debt finance and ordinary equity shares are the financial choices for firms. 3) The capital structure can be changed without incurring issue or redemption costs. 4) Any debt finance is up or down, which will lead to the same situation in equity finance. 5) All distributable earnings will be regarded as dividends by companies. 6) The relative business risks of companies keep existing over time. 7) The earnings and dividends of a company will not be increased over time.
To understand this traditional approach in depth, the theory model is illustrate in figure 1.

(Watson and Head, 2013)
As the figure showed, the cost of equity curve (k_e) is presenting a rising trend with the increasing gearing because of the growing level of financial risks of shareholders. The steeper rate of curve (k_e) at the higher level of gearing which embodies that the investment value of shareholders is being threatened by the risk of company bankruptcy. It can be seen that the cost of debt (K_d) is not increasing until at level of gearing. Hence the bankruptcy risks also threat to the debt holders. The point A stands for the company began to use the cheaper debt finance instead of the expensive equity, it will lead to the lower weight average cost of capital (WACC) initially. When t...

... middle of paper ...

...3)
Under the condition of asymmetry information, if the outsides investors obtaining the information about the enterprise asset value is less than the corporate managers’, the market value of rights and interests of the company won’t get an accurate pricing. When the company shares are undervalued, managers prefer to choose other financing ways to raise the money such as internal financial or issue bonds. In the case of stock value is overvalued. The Managers will try to secondary offerings to reduce the investment risks.

Reference:
Hiller.D. Ross.S and Jordan.B, (2013) Corporate Finance, (2nd edn), UK: McGraw-Hill Education.
Pike,R. Neale.B, and Linsley.P( 2012) Corporate Finance and Investment,(7 edn), London: Pearson Education Limited.
Watson.D and Head.A, (2013) Corporate Finance Principles and Practice, (6 edn), UK: Pearson Education Limited.

Show More
Related

  • Silicon Valley Medical Financial Analysis

    1403 Words  | 3 Pages

    In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.

    Read More

  • Dupont Case

    1919 Words  | 4 Pages

    DuPont is a very big company with a low debt policy designed to maximize financial flexibility and insulate operations from financial constraints. It is one of the few AAA rated manufacturing companies due its investments are primarily financed from internal sources. However, because prices fell in the 1960’s thus DuPont’s net income fell also. The adverse economic conditions in 1970’s escalated inflation: increase in oil prices increased required inventory investments of the company. 1975 recession negatively affected DuPont’s net income by 33% and returns on capital and earnings per share fell. The company cut dividends in 1974 and working capital investment removed. Proportion of debt increased from 7% in 1972 to 27% in 1975 and interest coverage falls from 38 to 4.6. The company perceived increase in debt temporary but moved quickly to reduce its debt ratio by decreasing capital expenditures. Debt proportion dropped to 20%, interest coverage increased to 11.5 by 1979.

    Read More

  • Du Pont de Nemours and Company Case Analysis

    1186 Words  | 3 Pages

    The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.

    Read More

  • Critically assess the Pecking Order Theory of Capital Structure

    1779 Words  | 4 Pages

    There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an optimal capital structure by using a mixture debt and equity known to act as an advantage leverage. Modigliani and Miller (1958) showed that the decisions firms make when choosing between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium.

    Read More

  • Modigliani And Miller's Theory: The Perfect Conditions Of The Market

    735 Words  | 2 Pages

    Modigliani & Miller applied their theories with two modules, one which doesn’t include the taxes and this is their first finding, and another one with taxes to make it more realistic. The First Proposition without taxes: In this part Modigliani & Miller stated that the firm’s value is not affected by the structure of the capital between Equity and Debt, They proved this by having an example of two firms that have got the same conditions in everything, same cash flow, same operational risks and same opportunity costs. One of the firm’s capital structure is all equity and the other firm’s capital structure is a mixture between equity and debt, since the form of financing (debt or equity) can neither change the firm’s net operating income nor its operating risk, the values of levered and unlevered firms will be the same. They have concluded that the value of the levered firm = the value of the unlevered firm, only if they have the same conditions, same risk levels, cash and opportunity cost.

    Read More

  • The Cost of Equity Capital and the Capital Asset Pricing Model

    1469 Words  | 3 Pages

    When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities

    Read More

  • Continental Carriers, Inc.

    923 Words  | 2 Pages

    Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering price are too low. Although long-term debt is a better financing choice, a few of the drawbacks are pointed out. Debt holders claim profit before equity. holders, so the chances that profits may be lower than expected. increases risk to equity, may reduce or impede stock value. However, the snares are still a bit snare.

    Read More

  • The Efficient Market Hypothesis

    1830 Words  | 4 Pages

    [16]. A Discussion with Burto Malkiel and Sendhil Mullainathan, 2005. Market Efficient versus Behavioural Finance, Journal of Applied Corporate Finance, Vol. 17, No. 3, A Morgan Stanley Publication, Summer 2005

    Read More

  • Portfolio Analysis and Investment

    987 Words  | 2 Pages

    William Sharpe, Gordon J. Alexander, Jeffrey W Bailey. Investments. Prentice Hall; 6 edition, October 20, 1998

    Read More

  • Home Depot & Capital Structure

    987 Words  | 2 Pages

    ...t the overall WACC. It will change the risk premium expected by equity holders. Less debt equates to a lower risk premium versus greater debt.

    Read More

  • Exhange Risk Faced by Multinational Corporations (MNCs)

    1553 Words  | 4 Pages

    Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.

    Read More

  • Nike: Company Financial Analysis

    1135 Words  | 3 Pages

    The final model used to compute the cost of capital was the earning capitalization model. The problem with this model is that it does not take into consideration the growth of the company. Therefore we chose to reject this calculation. The earnings capitalization model calculations were found this way:

    Read More

  • Advantages And Disadvantages Of Capital Structure

    1186 Words  | 3 Pages

    The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.

    Read More

  • Cash Management

    1080 Words  | 3 Pages

    Block, S. B., & Hirt, G. A. (2005). Foundations of financial management. (11th ed.). New York: McGraw-Hill.

    Read More

  • Banking and Finance

    1013 Words  | 3 Pages

    Studying Banking and Finance at University of St.Gallen will help me further increase my proficiency of corporate finance and financial markets. The in-depth research of specific topics, as well as a comprehensive curriculum, is a possibility for me to focus on my topic of interest ...

    Read More

More about The Traditional Approach to Capital Structure

Open Document