Company Valuation and Capital Structure

Company valuation is the process of determining the current (or projected) worth of an asset or a company. The capital structure is the combination of debt and equity used by a company to finance its overall operations and growth. Do you know that the financial theory found a curved relation between company valuation and capital structure?

To illustrate the curved relationship between company valuation and capital structure, we can compare three firms. The first firm is a firm that has decided to finance the business through a little debt and a lot of equity. The second firm is a firm that has decided to finance the activity through some equity and some debt. The third firm is a firm that has decided to finance the operations through a lot of debt. When we compare the firms, we will find that the company's value is affected by the capital structure.

financial theory found a curved relation between company valuation and capital structure

Suppose the company's first shareholders are required to invest a million dollars in the company. Suppose also that a company with a similar risk yields a 10% return to shareholders. Therefore, they are willing to invest on the condition that the company will yield a return of 10% per year - that is, the company will pay them $ 100,000 annually. Assume also that the company will be able to invest the money in projects that yield a return of 15%. The company will earn $ 150,000 and pay its shareholders $ 100,000. The company will be left with $ 50,000 annually.

The second firm invests half a million dollars of shareholders and takes out a loan of half a million dollars, at an interest rate of 5%. It invests the money and earns 15% per annum. The profit will be $ 150,000 a year. The firm will pay the bank $ 25,000. She will pay shareholders $ 50,000. As a result, the firm will be left with $ 75,000. The conclusion is that the value of the second firm will be higher.

The third company decides to invest only $ 100,000 of the shareholders, and the balance to take a bank loan. It lends $ 900,000. Since the loan amount is relatively high, the bank will want to protect itself and will ask for a higher interest rate - 8% interest. The company will invest the money and receive $ 150,000 a year. It will pay the debtors - $ 72,000 (a multiplication of $ 900,000 at 8% interest) and the shareholders $ 15,000. Total - $ 89,000. The company will be left with a smaller profit, compared to the second company - $ 61,000. The conclusion is that the third company's value will be lower than the value of the second company.

So what can we learn about the relationship between company value and capital structure? Two things:

1. As long as the company does not have many loans - increasing the debt will increase the company's value (the case of the first and second firm).

2. When the company has many loans, it becomes risky because the receipts from the project are uncertain. Therefore - the creditors will ask for a higher interest rate. As a result, the value of the company will decrease.

This is the curved connection between the company value and capital structure.