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Under the theory of cost of capital, explain how a company increase its total value by using a suitable amount of debt finance in capital structure.
based on my understanding,
1)the total value (enterprise value) of a firm is determined by its profitability and business model, and not its capital structure.2)a firm could choose an optimum weightage of debt:equity based on its risk profile, market condition and current earning potential.
i) a cyclical firm have more debt then equity in its capital structure. however, it should only have a certain amount of leverage to manage its financial leverage and maintains its cash liquidity in a stable position (protect value).ii) in a good market condition, a firm might undertake more debt due to having more sales (there is no issue on repaying debt obligation) by leverage recapitalization which could boost its EPS (a high EPS provide maximize shareholder value). in a bad market condition, it will not do so instead it will delever its capital structure to reduce financial risk.
a high weightage of debt will lead to a low weightage of equity.
a low cost of debt (tax shield) will offset the high cost of equity,(high cost of equity maximize shareholder value)
at the end, WACC still stays the same.this is my understanding, for this question. but i cant relate much to total value.
hope sir you can help me improve and correct my understanding. Tq sir.In theory the value of a firm is determined by its future expected earnings and by its cost of finance.
According to Modigliani and Miller, then if there is no tax the WACC will stay the same regardless of the capital structure and therefore there is no optimal level of gearing. However with tax, there is an extra benefit associated with debt borrowing and therefore with higher gearing the WACC will fall. A lower WACC will increase the market value of the firm.
All of this is explained in detail in my free lectures covering Chapter 19 of our free lecture notes.
The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.Hi Sir, in this case, we can apply
1) traditional theory
2) MM theory (with tax)
3) MM theory (without tax) right?If I use traditional theory, means the cost of debt for firm has reduce (tax saving), reducing the WACC, increasing its NPV in return.
what about the cost of equity , it will increase due to becoming a levered equity right ?
at the end, isnt WACC still the same? there is no “offset” of low debt to high levered equity right?
i am so confused sir T.T
I do understand, it will reduce cost of debt (increase its total value), but isn’t overall WACC stays the same (as prior to leverage recapitalization situation)?
You are not asked to ‘apply’ any of the theories in the exam. You are asked only to write about them.
The traditional theory does not assume that the cost of debt always reduces the WACC, because the cost of equity increases due to higher gearing. I assumes that there will be an optimal level of gearing which is when the WACC is at a minimum.
This is, again, all explained in my free lectures and you cannot expect me to type out all my lectures here 🙂
Based on the lecture I had just watch, is the optimal capital structure is
60 (equity) : 40 (debt) right?
Thank you Sir JohnI assume that you are referring to the first of the three examples which is on the traditional theory (the other two examples illustrate Modigliani and Millers’ theory). In which case yes – of the 5 levels of gearing considered then 60:40 would be the best.
However again appreciate that you cannot be asked calculations – only to discuss (only 50% of the exam involves calculations) – and these examples are only to illustrate the theories.
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