Capital Structure Decisions: Evaluating Risk and Uncertainty

Chapter Five

Risk Dimensions to Capital Choices

SINCE 1958, MODIGLIANI AND MILLER’S “irrelevance” propositions have led most finance students to believe that neither a company’s capital structure nor its dividend policy affects the value of a firm. Furthermore, to this Modigliani and Miller proposed that the use of debt in capital structure does not reduce the total risk of a firm but only divides the risk between equity and debt holders. Both the dividend and the capital structure policies are merely a source of financing for a firm and do not influence its future earnings stream. Hence, valuations are a simple function of cash flow streams and their stability and growth. Capital and cost of capital are merely means to generate such earnings and not a way to safeguard such earnings. Shortfalls in expectations or earnings may lead to a magnified impact for long periods.* Evaluations of investment outlay and cash streams have been subject to the benchmark rate or cost of capital, but emphasis was not placed on how this rate was determined in order to make a project viable or not viable. A CFO’s prime responsibility is to protect and safeguard any reduction in cash flow earnings. Protection against disastrous outcomes forced CFOs to place a premium on insurance covers till the 1980s. Firms needed to hedge any sharp downturns in earnings or cash flow. Arrangements of high-cost funding or withdrawal from a promising investment called for an appropriate strategy of capital management. ...