The cost of capital concept is widely used in business decision-making. The theory and estimates for measurement of cost of capital are derived from the seminal Modigliani-Miller analyses. This book . is founded are: (1) utility theory, (2) state-preference theory, (3) mean-variance theory and the capital asset pricing model, (4) arbitrage pricing theory, (5) option pricing theory, and (6) the Modigliani-Miller theorems. They are discussed in Chapters 4 through 8 and . firms track traditional trade-off theory while others the pecking order theory but none of them can be rejected. Another theory of capital structure is market timing theory of capital structure which has been suggested by Baker and Wurgler 5. According to this theory, current capital structure is based on past equity market timing. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity).

The Theory of Capital Structure tion of the relationships among similar models. We have identified four categories of determinants of capital structure. These are the desire to. ameliorate conflicts of interest among various groups with claims to the firm's resources, including managers (the . Capital Structure I Finance Theory II () – Spring – Dirk Jenter * Debt Ratio = Ratio of book value of debt to the sum of the book value of debt plus the market value of equity. 8 If Firm A were to adopt Firm B’s capital structure, its total value would not be affected (and vice versa). The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their cost of capital. [This minimizes the risk that the increase in EVA is less than what the market expected it to be, leading to a drop in the market price.]. The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

nominal growth if the cost of capital is in nominal terms, or real growth if the cost of capital is a real cost of capital. Second, the characteristics of the firm have to be consistent with assumptions of stable growth. In particular, the reinvestment rate used to estimate free cash flows to the firm should be consistent with the stable growth. 3 Determination of the Cost of Capital Parameters WACC Overview 27 Risk-free Rate 31 Market Risk Premium 33 Beta Factor 36 Cost of Equity 40 Other Risk Premiums 41 Consideration of Risk in the Cost of Capital 44 Cost of Debt and Debt Ratio 47 Sustainable Growth Rate 4 Impairment Test Figure 2: The Cost of Capital as Swiss Army Knife For investors in companies, the cost of capital is an opportunity cost in the sense that it is the rate of return that they would expect to make in other investments of equivalent risk. For the companies themselves, it becomes a cost of financing, since they have to deliver returns that.