Capital Structure Decision for Firm X: Finance for Decision Making

FINANCE FOR DECISION MAKING
FIRM X-CAPITAL STRUCTURE DECISION

Table Of Contents
Analysis..................................................................................................................................................3
Computation of Capital Structure under different scenario..................................................................5
Case 1: Risk Free Debt without tax....................................................................................................5
Case 1: Risk Free Debt with tax..........................................................................................................7
Case 2: Risky Debt without tax..........................................................................................................9
Case 2: Risky Debt with tax..............................................................................................................10
Problems under Capital Financing.......................................................................................................12
Conclusion...........................................................................................................................................14
References...........................................................................................................................................14

Introduction
The report has been written to explore proposed business decision making for raising finance
via equity or debt. X Company is trying to explore different venues of procuring funds and
has surveyed and collected data regarding the cost of capital of the company under different
structure and different level of risk.
X company has an investment opportunity of $100,000 and for the purpose of the same the
company has listed various funding options and trying to explore an optimal combination of
debt and equity to fund the project at low cost of capital while emphasizing on the qualitative
aspects of loan procurement like agency effect and signalling effect of capital structure. The
report in detail deals with the same.
It shall also be pertinent to note that Net Present Value of the project is positive at 15% rate
of discount. Thus, the ideal financing shall have ideal combination of debt and equity under
which the cost of capital shall be lower than 15%.
Analysis
The report contains two case: case 1 and case 2 with different range of combination of debt
and equity. Under case 1 there is risk free debt while under case 2 there is risky debt. Further,
the corporate rate of taxation is 40% and the tax saving in account if interest shall be
available. The report also assumes that the pre and post cost of equity remains the same and
thus there is no impact of corporate tax.
The analysis starts with explaining the proposition of Modigliani Miller under which it has
been stated that the market capitalisation of the company is not dependent on the capital
structure of the company rather the same is dependent on the net operating cash flows.
Further, the model assumes that there is no transaction cost and taxes. However, under the
present scenario, there is corporation tax of 40%, thus the proposition 1 does not hold good.
Under the second proposition it has been stated that the market value of the firm shall
increase by the present value of tax savings on account of interest on debt. Further, the above
proposition states that the ideal debt equity combination is 100% and 0% symbolising fully
funded by debt which is not a good idea. The proposition is set back by many drawbacks and

limitation and cannot be wholly trusted upon. Further, it shall be in appropriate to assume that
cost of capital of the company remains consistent irrespective of capital structure as it with
increase in debt in the capital mix, the cost of debt initially decreased however the same
increase after a certain level of combination on account of cost of distress to equity
shareholders.
Further, the computation of Net Present value for an indefinite cash flow at specified discount
rate has been presented here-in-below:
Sl No Particulars Briefs
1 Investment 100000
2 Net Cash flow 40000
3 Cost of Capital 15%
4 Present Value of Cash flows(2/3) 266666.7
5 Net Present Value (4-1) 166666.7