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    Optimum Capital Structure Maximizes The Market Value of The Firm Determination of The Optimum Capital Structure

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    vaeshnavikanukuntla
    1) The financial manager should plan an optimal capital structure that maximizes the firm's market value. This involves balancing the tax advantages of debt against maintaining flexibility and reasonable risk. 2) Debt provides a tax shield since interest is tax deductible, but high debt reduces flexibility and increases bankruptcy risk. The optimal structure preserves some reserve borrowing capacity to respond to changes. 3) Both business risk, from demand, price and input variability, and financial risk should be considered. Too much risk could increase costs and hurt the firm's strategy and shareholders.

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    Optimum Capital Structure Maximizes The Market Value of The Firm Determination of The Optimum Capital Structure

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    vaeshnavikanukuntla
    32 views2 pages
    1) The financial manager should plan an optimal capital structure that maximizes the firm's market value. This involves balancing the tax advantages of debt against maintaining flexibility and reasonable risk. 2) Debt provides a tax shield since interest is tax deductible, but high debt reduces flexibility and increases bankruptcy risk. The optimal structure preserves some reserve borrowing capacity to respond to changes. 3) Both business risk, from demand, price and input variability, and financial risk should be considered. Too much risk could increase costs and hurt the firm's strategy and shareholders.

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    notes of strategic fm

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    1) The financial manager should plan an optimal capital structure that maximizes the firm's market value. This involves balancing the tax advantages of debt against maintaining flexibility and reasonable risk. 2) Debt provides a tax shield since interest is tax deductible, but high debt reduces flexibility and increases bankruptcy risk. The optimal structure preserves some reserve borrowing capacity to respond to changes. 3) Both business risk, from demand, price and input variability, and financial risk should be considered. Too much risk could increase costs and hurt the firm's strategy and shareholders.

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    © All Rights Reserved
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    Download as doc, pdf, or txt
    32 views2 pages

    Optimum Capital Structure Maximizes The Market Value of The Firm Determination of The Optimum Capital Structure

    Uploaded by

    vaeshnavikanukuntla
    1) The financial manager should plan an optimal capital structure that maximizes the firm's market value. This involves balancing the tax advantages of debt against maintaining flexibility and reasonable risk. 2) Debt provides a tax shield since interest is tax deductible, but high debt reduces flexibility and increases bankruptcy risk. The optimal structure preserves some reserve borrowing capacity to respond to changes. 3) Both business risk, from demand, price and input variability, and financial risk should be considered. Too much risk could increase costs and hurt the firm's strategy and shareholders.

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    © All Rights Reserved
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    Download as doc, pdf, or txt
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    [Type text]

    For the real growth of the company the financial manager of the company should plan an
    optimum capital structure for the company. The optimum capital structure is one that maximizes
    the market value of the firm. In practice the determination of the optimum capital structure is a
    formidable task and the manager has to perform this task properly, so that the ultimate objective
    of the firm can be achieved.
    Guidelines for Capital Structure Planning
    The following are the guidelines of capital structure planning:
    1) Avail or Tax advantage of Debt
    Interest on debt finance is a tax-deductible expense. Hence, finance scholars and practitioners
    agree that debt financing gives rise to tax shelter which enhances the value of the firm. What is
    the impact of this tax shelter on the value of the firm? In this 1963 paperModigilani and
    Miller argued that the present value of the interest tax shield is t cD where, tc = corporate tax
    rate on a unit of marginal earnings and D = Debt financing.
    2) Preserve Flexibility
    The tax advantage of debt should not persuade one to believe that a company should exploit its
    debt capacity fully. By doing so, it loses flexibility. And loss of flexibility can erode shareholder
    value. Flexibility implies that the firm maintains reserve borrowing power to enable it to raise
    debt capital to respond to unforeseen changes in government policies, recessionary conditions in
    the market place, disruption in supplies, decline in production caused by power shortage or labor
    market, intensification in competition, and, perhaps most importantly, emergence of profitable
    investment opportunities. Flexibility is a powerful defense against financial distress and its
    consequences which may include bankruptcy.
    3) Ensure that the Total Risk Exposure is Reasonable
    While examining risk from the point of view of the investor, a distinction is made between
    systematic risk (also referred to as the market risk or non-diversifiable risk) and unsystematic
    risk (also referred to as the non-market risk or diversifiable risk).
    Business Risk refers to the variability of earnings before interest and taxes. It is influenced by the
    following factors:

    Demand Variability- Other things being equal, the higher the variability of demand for
    the products manufactured by the firm, the higher is its business risk.

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    Price Variability- A firm which is exposed to a higher degree of volatility in the prices of
    its products is, in general, characterized by a higher degree of business risk in comparison
    with similar firms which are exposed to a lesser degree of volatility in the prices of their
    products.

    Variability in Input Prices- When input prices are highly variable, business risk tends to
    be high.

    4) Subordinate Financial Policy to Corporate Strategy


    Financial Policy and Corporate Strategy are often not integrated well. This may be because
    financial policy originates in the capital market and corporate strategy in the product market.
    5) Mitigate Potential agency Costs
    Due to separation of ownership and control in modern corporations, agency problems arise.
    Shareholders scattered and dispersed as they are not able to organize themselves effectively.
    Since agency costs are borne by shareholders and the management, the financial strategy of a
    firm should seek to minimize these costs. One way to minimize agency costs is to employ an
    external agent who specializes in low cost monitoring. Such an agent may be a lending
    organization like a commercial bank (or a term-lending institution).

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