Basics of Capital Structure

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7 lessons0%

An Introduction to Capital Structure

Basic Differences in Capital Structure of Two Firms

Value of a Firm (Using Operating Free Cash Flows)

Does Capital Structure Matter?

Agency Costs of Equity and Debt

Why Issue of Additional Equity Leads to Share Price Fall?

What CFOs Consider While Making Capital Structure Decisions?

Lesson 3 of 7

Value of a Firm (Using Operating Free Cash Flows)

The value of the firm is measured as the sum of the value of the firm’s equity and the value of the debt. Any firm’s objective is to maximize its value for the shareholders. The value of the firm can be measured as the present value of the operating free cash flows over time.

The value of the firm can be expressed using the following formula:

$Firm Value (V) = \sum_{t=1}^{\infty }\frac{OFCF_{t}}{(1+WACC)^{t}}$

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Basic Differences in Capital Structure of Two Firms

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Does Capital Structure Matter?

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(1+WACC)tOFCFt

Where:

V is the Value of the firm
OFCF is the Operating Free Cash Flow After Tax
WACC is the Weighted Average Cost of Capital

The Operating Free Cash Flow (OFCF) is measured as:

OFCF = Revenue – Operating Expenses – Capital Expenditure

The Weighted Average Cost of Capital (WACC) is measured as:

$WACC = r_{e}\frac{E}{V}+r_{d}(1-t)\frac{D}{V}$

Where:

re = Cost of equity
rd = Cost of debt
E = Value of the firm's equity
D = Value of the firm's debt
V = E + D
E/V = Percentage of equity financing
D/V = Percentage of debt financing
t = Tax rate

The expected future cash flows of a firm can also be expressed as a perpetuity. In that case, the firm’s value can simply be expressed as:

$V = \frac{OFCF_{t}}{WACC}$