The Impact of Capital Structured Decision to Company Valuation
According to Finance for Managers (2012), company valuation or business valuation is the process of evaluating a company’s fair market worth. This is a complicated procedure that involves calculating several variables such as the company’s financial performance, assets, liabilities, industry trends, competitive environment, and other aspects. Capital structure considerations, such as the types and quantities of debt and equity employed by a firm, are critical components of the company valuation process.
For shareholders and potential investors, a company’s value is critical. The capital structure decisions of a company have a significant impact on its value, since they affect the cost of capital and how the firm will finance its operations. This study will explain why capital structure decisions impact firm valuation (Sloan, R., 1997).
Why Company Valuation Is Influenced By Capital Structure Decisions?
Berk, J., DeMarzo, P., & Harford, J. (2018) stated that capital structure decisions are those made by a firm about the mix of debt and equity used to fund its business operations. The best capital structure for a company will be determined by its individual conditions, such as available resources, competitive environment, and goals. In general, capital structure decisions seek to optimize the firm’s value by lowering its cost of capital.
When a company decides on its capital structure, it is aiming to establish the best combination of debt and equity to finance its operations. The capital structure selection influences the cost of capital since the cost of debt is often lower than the cost of equity. By adopting a bigger share of debt to finance operations, the firm can lower its cost of capital, increasing the company’s value (Dauderis, H., Annand, D., & Jensen, T., 2021).
Furthermore, according to Finance for Managers (2012), the risk connected with a company’s capital structure might affect its value. Companies with a larger debt-to-equity ratio are regarded riskier, as debt must be serviced regardless of the company’s success. This increased risk might reduce the firm’s value since potential investors are less willing to participate in a riskier company.
Moreover, the tax consequences of a company’s capital structure decision might have an impact on its valuation. Companies that utilize a larger amount of debt might profit from the tax advantages of debt financing. Debt interest payments are tax-deductible, which can lower the company’s tax burden and, as a result, boost its value (Kieso, D. E., Weygandt, J. J., & Warfield, T. D., 2016)
Conclusion
The capital structure decisions can have a substantial influence on the valuation of a company. A company may minimize its cost of capital, reduce its risk profile, and take advantage of the tax benefits associated with debt financing by optimizing the mix of debt and equity used to finance its operations (Finance for Managers, 2012). Therefore, I think, while establishing a company’s worth, it is critical that it carefully analyze its capital structure decisions.
References
Berk, J., DeMarzo, P., & Harford, J. (2018). Corporate finance (4th ed.). Upper Saddle River, NJ: Pearson.
Dauderis, H., Annand, D., & Jensen, T. (2021). Introduction to financial Accounting. Lyryx Learning Inc. Licensed under Creative Commons BY-NC-SA 3.0. Retrieved December 13, 2022, from https://lyryx.com/introduction-financial-accounting/
Finance for Managers. (2012). Licensed under Creative Commons by-nc-sa 3.0. Retrieved December 13, 2022, from https://my.uopeople.edu/pluginfile.php/546007/mod_page/content/17
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2016). Intermediate accounting (17th ed.). Hoboken, NJ: Wiley.
Sloan, R. (1997). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 72(3), 289–315. https://doi.org/10.2308/accr.1997.72.3.289
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in December 2022
