Capital Structure

The companies with the greatest growth prospects were under tremendous pressure on their need for funds and their ability to use funds productively.

The cost of developing the new products followed by the heavy marketing needed to introduce them to the customer was just the first heavy drain on capital needed to finance growth.

One of the fundamental questions in corporate finance is how a firm should choose the set of securities it will issue to raise capital from investors. This decision determines the firm’s capital structure, which is the total amount of debt, equity, and other securities that a firm has outstanding. The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. 

Consider the following investment opportunity. For an initial investment of $500 this year, a project will generate cash flows of either $1100 or $600 next year. The cash flows depend on whether the economy is strong or weak, respectively. Both scenarios are equally likely. Due to the project cash flows depend on the overall economy, they contain market risk. Suppose the current risk-free interest rate is 5%, and the market risk of the investment the appropriate risk premium is 10%.

The expected cash flow in one year is 1/2($1100)+1/2($600)=$850.

The net present value would be NPV = -500 + 850/(1 + 0.15) = 239.1
Thus, the investment has a positive net present value.

If this project is financed using equity alone, how much would investors be willing to pay for the firm’s shares? the market value of the firm’s equity today will be

PV (equity cash flow) = $850/ 1.15 = $ 739.1

The company can raise $739.1 by selling the equity in the firm. After paying the investment cost of $500, the entrepreneur can keep the remaining $239.1 as a profit.

Given equity’s initial value of $ 739.1 shareholders’ returns are either $ 360.9 or - $ 139.1.

The strong and weak economy outcomes are equally likely, so the expected return on the unlevered equity is 1/2($ 360.9 )+1/2 (- $ 139.1 )= 180.45 -69.55 = 110.9.

Financing the firm exclusively with equity is not the company’s only option. The company can
also raise part of the initial capital using debt. Suppose the company decides to borrow $500 initially, because the project’s cash flow will always be enough to repay the debt, the debt is risk free. Thus, the firm can borrow at the risk-free interest rate of 5%, and it will owe the debt holders 500 * 1.05 = $525 in one year.