Does capital structure play a role in valuation?
Which side of the balance sheet creates Value? This is an interesting question. While valuing a company, one always tends to focus on equity or debt side. However we forget the fundamental fact that the value of any business always emanates from the idea/ asset. It’s the idea or the asset that has the potential to generate cash flows though the idea needs to be funded by either debt or equity or a mix of both.
Now the next question is – Does equity or debt affect the value of the company? Should we change the mix of debt and equity to maximize the value of the firm? Before we delve into this, let us understand the work by Nobel laureates Miller-Modigliani. The Miller-Modigliani theorem (1950s), stated that the value of the business depends only on the type of projects and capital structure does not impact on the value creation.
Of course, the assumptions were based on a hypothetical world, where there are no taxes, default risks, bankruptcy costs and transaction costs and where the investors and companies have the same information.
Welcome to the real world!! We do have to pay taxes, we face the risks of default- even governments are facing the risks of default these days. In this real world, finding the right financial mix does play a role in maximizing the value of the firm.
There are many ways on finding the right financial mix or the right optimal debt ratio. We will go through that in my next blog post.
– Saurabh Mishra