A Company’s Capital Structure refers to the mixture of equity and debt financing leveraged to finance its assets. Such mixture of equity and debt capital is consider as financing decision.
Such financing decision would have direct effect to the weighted average cost of capital (WACC). With that in mind, any changes to the financing decision, would undoubtedly effect WACC.
In any given organisation, the objective is surely to maximise shareholder wealth. To determine the wealth, is the measurement of future cash flows discounted at investors’ required return, ie WACC.
The Present Market Value of a Company = Future Cash Flows / WACC
Example:
100 / 0.15 = 667
100 / 0.10 = 1,000
Therefore, looking for higher shareholder wealth = searching for lowest WACC.
Questions: Which would be ideal blend between equity and debts?
Debts Financing
- Debt financing often the repayment amount is fixed in nature
- Repayment is obligation in nature
- In the event of liquidation, debt holders would receive their capital repayment before shareholders
- In Corporate tax treatment, Interest is prioritise given that interest is deducted before tax is calculated (Tax relief) Vs Dividend which is calculated after Tax deduction
Of course the higher Interest repayment (higher gearing) meaning lesser profit would be distributed to shareholders via dividends.
Given the volatility of Interest Rate Hike by the Feds, shareholders would require higher returns to hedge against such financial risk.
What would you consider an ideal balance mix of equity and debts financing for a company of your choice?
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