Capital Structure Decisions: Evaluating Risk and Uncertainty

Chapter Four

Maximising Value with Capital Structure Decisions

VALUATION RELATIONSHIPS ARE THE foundation of all financial decisions. They are the first concepts introduced in most corporate finance books. The relationship between capital structure and firm value has long been debated since the works of Durand (1958) and Modigliani and Miller (1958 and 1963) were published. The existence of an optimal capital structure and its effect on the value of a firm are so fundamental to the logic of financing that this relationship goes without saying.

Given the very fundamental nature of financing, as discussed in Chapter 2, the cost of capital gives the basis for valuation of each and every action of a firm. Values in a business are created by investing in fixed assets that generate cash flow in the form of revenue and income and that grow with time. One way to create value is to generate capital from the firm’s operations. Value creation is a slow process of investing and reinvesting free cash flows into profitable and high-return ventures. Borrowing is necessary when equity contributions and earnings are insufficient to support an investment. The mix and cost of debt and equity can make an investment viable or unviable. The question for firms is: How to decide this mix? In this chapter, we discuss some traditional tenets that created the relationship between firm value and capital structure. Firm value can be magnified by the use of different sources of financing.

The method of magnifying ...