Blog 3

Capital structure is the topic for this week’s lecture. Coming into the lecture I expected that the idea of raising capital using different sources would be discussed, which is what it is all about anyway, at least that is what I presumed. Being a person who has a short attention span of about 20-30 minutes, I listen attentively during the first half of the lecture because I know that the remaining of that would be difficult for me to endure. True enough to what I have assumed, the introduction started with the lecturer stating the equity vs debt discussion, where raising capital through debt has lower risk and costs compared to raising capital through equity. However, it does not necessarily have to be only one way of raising the capital. A company can use a mixture of both debt and equity to raise capital. The weighted average cost of capital calculation is then introduced and it suggested the concept of an optimal capital structure. For me, the most significant aspect of this idea is that theoretically by increasing the gearing of the company, the weighted average cost of capital will be lowered. However, there are some risks of financial distress as the debt goes higher and higher. In 1958, Modigliani and Millar argued that a company’s capital structure has no impact on the weighted average cost of capital and that there is no optimal structure. This is questionable as they assumed that they is no taxation and that there are no costs of financial distress. In 1963, they revised the argument and included tax into the assumption. Having attended the lectures and reading the slides again when I went home, I have understood that as gearing increases, weighted average cost of capital decreases because of the tax benefit and in turn, this will increase the value of the company. The next thing that I would like to do is to read more about the effects of the costs of financial distress on the levels of debt which I will when I have the free time.