VALUE OF BUSINESS

Value of Business

Value of Business

Introduction

One of the central issues in both the theory and practice of financial management is the problem of determining the optimal capital structure of the firm. Given capital market conditions and the array of investment opportunities, is there some optimal composition of liabilities and equity at which the value of the firm will be maximized? (Hamada, 2006, 106-108)The criterion of maximization of the value of the firm is a function of two variables, the expected earnings stream from the assets and the rate at which that stream is capitalized by the market. Capital structure decisions must be evaluated in the context of the effect on both of these variables. (Booth, 2001, 3-4)

It is an accepted and obvious aspect of the problem that non-equity financing adds to the earnings stream as long as the explicit costs of financing are less than the returns from the capital invested. The controversy over the optimal capital structure question focuses on the effect of the addition of non-equity financing on the quality of the firm's earnings and, thus, on the rate at which the earnings are capitalized. (Booth, 2001, 3-4) Does the addition of a moderate amount of fixed commitment financing result in demands by shareholders for an increase in the risk premium component of equity yields sufficient to offset the incremental earnings derived from the new financing? (Hamada, 2006, 106-108)

If investors respond in this manner, the value of the firm remains unaffected by changes in financial structure and it may be concluded that financial structure is of no consequence in a firm's attempts to achieve the objective of wealth maximization for its stockholders. If, however, the increase in yield demanded by shareholders is either more or less than sufficient to offset the advantages of incremental earnings derived from additional non-equity financing, then financial structure will have an important effect on the value of the firm. In this latter case, financial structure decisions become important variables in pursuing the goal of maximization of shareholder wealth. (Booth, 2001, 3-4)

The capital structure problem has been the subject of much controversy in recent years, but the opposing views remain unresolved.^ The normative solutions presented in the literature are strongly dependent upon underlying assumptions regarding the form of investor response and the degree of market perfection. Empirical studies of capital costs and leverage have, thus far, yielded ambiguous results because of biases in both measurement and concept. (Booth, 2001, 3-4) This paper offers an alternative empirical approach to determining the relationships among risk, financial structure and capital costs for industrial firms. In section one, the empirical analysis is developed. (Hamada, 2006, 106-108)

1. Conceptual Problems Encountered in Empirical Studies of Leverage Effects

The Leverage Measure—One of the principal problems in empirical investigations of leverage effects is that of defining an unbiased measure of leverage. (Hamada, 2006, 106-108) Leverage has been defined in previous studies as either the ratio of debt to equity at book values or this same ratio at market ...