Essay on Business

4066 Words Nov 27th, 2010 17 Pages
How a company is finance its growing business, operations by using multi types of funds is called capital structure, both short & long term loan need to be counted when explaining a company capital structure. Company can chose whatever percentage of debt and equity they like to have is their business.

Four primary factors influence capital structure decisions-

1. Business risk- the higher the company business risk, the lower the proportion of debt is good 2. Tax proposition- a significant reason for using debt is the interest on debt is tax deductible which effect lower cost of debt 3. Financial flexibility- the capability to increase fund under crucial condition on reasonable terms 4. Manager attitude- how much to
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M&M proposition I- imply that the value of the firm does not relay on its capital structure, let’s say 2 company have same business and assets and below the pie chart look identical the only thing different between the 2 companies are the debt and how they finance their business.

In first diagram, equity is 70% and debt is 30% of the capital structure where as in second diagram it is exactly the reverse, therefore M&M says that how the debt and equity is structure in a company is not relevant.

M&M proposition II- Their seminal paper in 1958 proposed that, for a given operating or business risk, the WACC remains unchanged at all levels of gearing, implying that no optimal capital structure exists and how a company was financed was irrelevant.

Cost of capital

Ke WACC

Kd

Gearing level

Debt (Kd) remains same as the level of gearing rises. The WACC is same as gearing levels change. As the gearing increases, the cost of equity (Ke) increase in a way as to exactly offset the greater proportion of cheaper debt capital. As the WACC remains same, this implies the method of financing projects is not relevant

Their starting point was that if two companies had same

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