Why Capital Structure Matters: Cost of Capital, Debt/Equity Balance are Key to Successful Appraisal. —TimesFreePress

Relative Levels of Equity and Debt Affect Risk and Cash Flow.   This Has Substantial Impact on Amount Investors Will Pay.    

Matt Stelzman notes in the Chattanooga News TimesFreePress that the question that often arises in connection with a business valuation is whether the valuator should use the company’s actual capital structure or its anticipated future capital structure. A valuator might also use a prospective buyer’s capital structure or the company’s “optimal” capital structure. Which method is best depends on several factors, including the type of interest being valued and the valuation’s purpose. More: 

What’s the cost of capital?

Capital structure matters because it influences the “cost of capital.”

Generally, when valuators use income-based valuation methods — such as discounted cash flow — they convert projected cash flows or other economic benefits to present value by applying a discount rate.

That rate, which generally reflects the return that a hypothetical investor would require, is derived from the cost of capital, which is commonly based on the weighted average cost of capital. WACC is a company’s average cost of equity and debt, weighted according to the relative proportion of each in the company’s capital structure.

What’s the optimal capital structure?

Many business owners strive to be debt-free, but a reasonable amount of debt can provide significant financial benefits. Debt is almost always cheaper than equity, and interest payments are tax-deductible. So, as the level of debt increases, returns to equity owners also increase — enhancing the value of the company.

If risk wasn’t a factor, then the more debt a business has, the greater its value would be. But at a certain level of debt, risk associated with higher leverage begins to outweigh its financial advantages.

When debt reaches this point, for instance, investors may demand higher returns as compensation for taking on greater risk, which has a negative impact on business value. The optimal capital structure, therefore, comprises a sufficient level of debt to maximize investor returns without incurring excessive risk.

Identifying a company’s optimal structure is a combination of art and science. Valuators may:

• Use industry averages.

• Examine the capital structures of guideline companies.

• Refer to financial institutions’ debt-to-equity lending criteria.

• Apply sophisticated financial models to estimate a subject company’s optimal structure.

The full article is  here. 

Wikipedia Graphically Illustrates The Tradeoffs of Debt/Equity Capital Structure