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Capital Structure and Valuation

There is big relationship between current capital structure and valuation of company. At the different capital structure, Value of company will be different because new company will buy after checking its mixture of share capital and debt liabilities. Value of company will be decided after analysis of controlling power, risk and dividend and interest cost. These factors are also related with capital structure.

So, today, we will discuss the relationship between capital structure and valuation of a company.

1. Risk and Return 

Both capital structure and valuation of company is decided on the basis of risk and return theory. Optimal capital structure will be there where risk will be minimum but return of shareholder will be highest.

When a buyer company wants to buy any other company, it will see its risk and return level. Now, for checking risk and return level, we will use optimal capital structure. If buyer thinks that capital structure of company is not optimal and there is high risk and low return. Value of company will be low. If buyer thinks that capital structure of company is optimal, there is low risk and high return, buyer will buy company at higher value.

2. WACC

Both capital structure and valuation of company is decided on the basis of cost of Capital. But in normal cost of capital, both cost of debt and cost of share capital will include. So, for getting best answer, we will calculate weighted average cost of capital. We will decide capital structure (Debt/Equity Ratio ) where is WACC will be lowest.

When buyer will buy any comapny, he will also try to best WACC. If he will see in the Graph, company's capital structure is on highest level of WACC, buyer will buy company at low value. When buyer will see WACC is at its lowest level, he will buy company at highest value. See following graph.



3. Net Present Value 

When we buy anything, we remember the time value of money. NPV is one of important measurment, if there is higher NPV, we will interested to buy that asset. For buyer company or buying any other asset is same thing. For valuation, he check the capital structure, total value of capital and debt, he has to buy because with this, all the assets of company will become the asset of buyer. He will check market value of shares and market value of debt. He will also study the current earning. Both cash outflow (investment for buyig) and cash inflow (income from buying of company) will be counted  at present value. Then we will compare it and calculate the value of NPV. We will compare it with other company's NPV. If this company's NPV is higher, then we will buy this company at higher price. If NPV is low, we will buy this company at low price.

 Related : Valuation of a Firm 

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Accounting Education: Capital Structure and Valuation
Capital Structure and Valuation
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Accounting Education
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