Capital Structure and Firm Value

Firm Value and Capital Structure

• Definition of Firm Value (V):

  • The total value of a firm, including equity and debt.

• Maximum Firm Value:

  • The point at which the firm’s value reaches its peak due to optimal capital structure.

• PV of Tax Shield on Debt:

  • The present value of the tax benefits a firm receives by using debt financing.
  • Debt financing allows firms to deduct interest payments from taxable income, effectively lowering tax liabilities.

• Optimal Amount of Debt (D*):

  • The level of debt that maximizes the firm's overall value.
  • Involves balancing the tax shield benefits against potential costs of financial distress.

• PV of Financial Distress Costs:

  • Present value of the costs associated with the potential for bankruptcy or financial instability due to excessive debt.
  • As debt increases, the risk of financial distress also increases, which reduces firm value.

• Value of the Firm with Debt:

  • Expressed by the formula:
    V1 = V{11} + tD
  • Where:
  • $V_1$: Value of the firm with debt
  • $V_{11}$: Value of the firm without debt
  • $t$: Corporate tax rate
  • $D$: Amount of debt

• Actual Firm Value (V):

  • The true value of the firm, incorporating all factors including debt and equity.

• Debt Variable (D):

  • Refers to the total amount of debt a firm has which impacts its overall financial strategy and value.