Q1

Content type

User Generated

Subject

Finance

School

University of Aberdeen

Course

BU 5034

Type

Homework

Uploaded By

583pncrcc

Pages

Rating

The analysis of capital structure

Introduction

Capital structure refers to the mix of all kinds of debt and equity used to finance a

firm’s business. In many instances, the term is constantly utilized as financial control

or financing mix. Also, capital structure is looked at as several debts in the capital or

the financing of a business company. In this case, financial control refers to how

corporate organizations utilize loan, cash, and debts. Financial control is a

fundamental term and a significant decision based on financial administration. Two

main components in capital structure are debt that is regarded as a cheaper source of

finance, and equity that is more expensive than the cost of debt. Based on the

structure of capital, there are a lot of theories. I will illustrate some theories in this

essay.

Theories

Net income approach

The Net Income Approach suggests that the value of the firm can be increased by

decreasing the overall cost of capital (WACC) through a higher debt

proportion(Finance management,2021). Comparing with equity, this is a cheaper

method to get fund. The WACC can be used when the firm raise fund by more than

one type of security.

In addition, the Net Income Approach refers that the change of financial leverage will

impact on WACC and firm value. The value of the firm increases with the financial

leverage increases and WACC decreases. In the contrary, the value of the firm

decreases with the financial leverage decreases and WACC increases.

However, there are some assumptions. 1) Increasing debt does not affect the level of

investor confidence. 2) There are two sources of funding: debt and equity. 3) There

are no listing costs, transaction costs, or corporate dividend taxes. 4) the market is

prefect, and thus the investors will get all information. 5) All sources of funding are

unlimited.

Net Operating Income Approach.

Net Operating Income Approach suggests that the value of a company is not impacted

by the amount debt change. However, this approach assumes that the importance of

the organization through debt infusion is counteracted by the rapid growth of the

required rate of return by shareholders. Therefore, the increase of debt will increase

the threat of risk that is bankrupt risk.

Durand formulated the Net Operating Income Approach. Having been developed by

the same person as the Net Income Approach, these two approaches significantly

differ. Ideally, the theory is famous, just like any other traditional approach.

The value of the firm will be not impact by how financial leverage changed and the

change of debt. Therefore, the WACC and the value of a firm are sovereign of the

firm's the choice of capital structure or financial control.

Moreover, NOI approach indicates that the firm’s market value is depend on the

existing income and linked commerce risk of the company. All related factors cannot

be influenced by financial control. As a result, the change of D/E ratio cannot alter the

Company's value. Additionally, it holds that with an increase in the debt element of an

organization, an organization is threatened with more significant risks. To compensate

for this aspect, the equity investors anticipate more returns. Eventually, a raise in

financial control will grow the equity cost. There are assumptions in NOI approach. 1)

The overall capitalization rate has nothing to do with leverage. 2）the value of equity

is equal to the total value of firm mins the value of debt. 3) WACC stays unchanged,

and the equity price rises with the risers in debt. Increasing debt in the capital

structure outcomes ingrown threat for investors. As reimbursement of investing in the

End of Preview - Want to read all 7 pages?

Access Now

Unformatted Attachment Preview

The analysis of capital structure Introduction Capital structure refers to the mix of all kinds of debt and equity used to finance a firm’s business. In many instances, the term is constantly utilized as financial control or financing mix. Also, capital structure is looked at as several debts in the capital or the financing of a business company. In this case, financial control refers to how corporate organizations utilize loan, cash, and debts. Financial control is a fundamental term and a significant decision based on financial administration. Two main components in capital structure are debt that is regarded as a cheaper source of finance, and equity that is more expensive than the cost of debt. Based on the structure of capital, there are a lot of theories. I will illustrate some theories in this essay. Theories Net income approach The Net Income Approach suggests that the value of the firm can be increased by decreasing the overall cost of capital (WACC) through a higher debt proportion(Finance management,2021). Comparing with equity, this is a cheaper method to get fund. The WACC can be used when the firm raise fund by more than one type of security. In addition, the Net Income Approach refers that the change of financial leverage will impact on WACC and firm value. The value of the firm increases with the financial leverage increases and WACC decreases. In the contrary, the value of the firm decreases with the financial leverage decreases and WACC increases. Howeve ...
Purchase document to see full attachment

Tags: finance capital structure mergers