Internal

Many factors determine how much debt a firm takes on. Chief among them ought to be the impact of the debt on the value of the firm. How should a firm go about choosing its debt-to-equity ratio? We assume that companies choose the course of action that maximizes the value of a share of stock. Making a decision on changing the capital structure is essentially the same thing as maximizing the value of the whole firm. Companies prefer a capital structure that minimum WACC (weighted average cost of capital). There is a particular debt-to-equity ratio which represents the optimal capital structure if it results in the lowest possible WACC. In addition, one of the most important theories in finance is developed by Modigliani and Miller (M&M). The M&M theory indicates that the value of assets is equal to value of debt plus value of equity. The value of asset is also equal to the sum of value of unlevered firm and debt tax shields. According to M&M Proposition I with considering the effect of taxes: the value of the firm levered is equal to the value of the firm unlevered plus the present value of the interest tax shield. Implication with this theory is that debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100% debt. A firm’s WACC, decreases as the firm relies more on debt financing. In the case relevering firm, total value will not be good proxy for what is happening to the price per share, so the repurchasing stock will affect the total value of equity and price per share under a constant EBIT. As the firm borrows and repurchases shares, the total value of equity may decline, but the price per share may rise. As well as we will examine that valuation effects of the recapitalization. Hence, we will have a detailed explanation for each part and give strong evidence for the theories that we stated above.