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47-457: Enterprise value is more comprehensive than market capitalization , which only reflects common equity . Importantly, EV reflects the opportunistic nature of business and may change substantially over time because of both external and internal conditions. Therefore, financial analysts often use a comfortable range of EV in their calculations. For detailed information on the valuation process see Valuation (finance) . A simplified way to understand

94-521: A dynamic structure that approximates reality. A similar type of research is performed under the guise of credit risk research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004). In addition to firm-specific characteristics, researchers find macroeconomic conditions have

141-845: A manner compatible with their growth types. As economic and market conditions improve, low growth type firms are keener to issue new debt than equity, whereas high growth type firms are least likely to issue debt and keenest to issue equity. Distinct growth types are persistent. Consistent with a generalized Myers–Majluf framework, growth type compatibility enables distinct growth types and hence specifications of market imperfection or informational environments to persist, generating capital structure persistence. A capital structure arbitrageur seeks to profit from differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds, and convertible bonds . The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of

188-616: A material impact on capital structure choice. Korajczyk, Lucas , and McDonald (1990) provide evidence of equity issues cluster following a run-up in the equity market. Korajczyk and Levy (2003) find that target leverage is counter-cyclical for unconstrained firms, but pro-cyclical for firms that are constrained; macroeconomic conditions are significant for issue choice for firms that can time their issue choice to coincide with periods of favorable macroeconomic conditions, while constrained firms cannot. Levy and Hennessy (2007) highlight that trade-offs between agency problems and risk sharing vary over

235-403: A recognition of how outsiders view the strength of the firm's financial position. Key considerations include maintaining the firm's credit rating at a level where it can attract new external funds on reasonable terms, and maintaining a stable dividend policy and good earnings record. Once management has decided how much debt should be used in the capital structure, decisions must be made as to

282-456: A simplified aggregation of company's financial situation. One unit of additional debt may not be of same importance as additional one unit of missing cash. It can be demonstrated that enterprise value depends on the probability of default (the rating) and works as a "negative growth rate" in the future. Unlike market capitalization, where both the market price and the outstanding number of shares in issue are readily available and easy to find, it

329-400: Is a negative relationship in the market between companies' relative price volatilities and their leverage. This contradicts Hamada who used the work of Modigliani and Miller to derive a positive relationship between these two variables. Three types of agency costs can help explain the relevance of capital structure. An active area of research in finance is that which tries to translate

376-429: Is an advantage to financing with debt, namely, the tax benefits of debt and that there is a cost of financing with debt the bankruptcy costs and the financial distress costs of debt. This theory also refers to the idea that a company chooses how much equity finance and how much debt finance to use by considering both costs and benefits. The marginal benefit of further increases in debt declines as debt increases, while

423-777: Is an important issue in setting rates charged to customers by regulated utilities in the United States. Ratemaking practice in the U.S. holds that rates paid by a utility's customers should be set at a level which assures that the company can provide reliable service at reasonable cost. The cost of capital is among the costs a utility must be allowed to recover from customers, and depends on the company's capital structure. The utility company may choose whatever capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes. The Modigliani–Miller theorem , proposed by Franco Modigliani and Merton Miller in 1958, forms

470-468: Is because the interest paid by the firm on the debt is tax-deductible. The reduction in taxes permits more of the company's operating income to flow through to investors. The related increase in earnings per share is called financial leverage or gearing in the United Kingdom and Australia. Financial leverage can be beneficial when the business is expanding and profitable, but it is detrimental when

517-461: Is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the Modigliani–Miller theorem. Trade-off theory of capital structure allows bankruptcy cost to exist as an offset to the benefit of using debt as tax shield. It states that there

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564-417: Is not normative i.e. and does not state that management should maximize EPS, it simply hypothesizes they do. The 1982 SEC rule 10b-18 allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure. This hypothesis leads to a larger number of testable predictions. First, it has been deducted that market average earnings yield will be in equilibrium with

611-461: Is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory has been popularized by Myers (1984) when he argued that equity is a less preferred means to raise capital, because when managers (who are assumed to know better about true condition of

658-576: Is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible. Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes. Various leverage or gearing ratios are closely watched by financial analysts to assess

705-478: Is sometimes heard. Large caps have a slow growth rate as compared to small caps. Different numbers are used by different indexes; there is no official definition of, or full consensus agreement about, the exact cutoff values. The cutoffs may be defined as percentiles rather than in nominal dollars . The definitions expressed in nominal dollars need to be adjusted over decades due to inflation , population change, and overall market valuation (for example, $ 1 billion

752-536: Is the number of common shares outstanding, and P is the market price per common share. For example, if a company has 4 million common shares outstanding and the closing price per share is $ 20, its market capitalization is then $ 80 million. If the closing price per share rises to $ 21, the market cap becomes $ 84 million. If it drops to $ 19 per share, the market cap falls to $ 76 million. This is in contrast to mercantile pricing where purchase price, average price and sale price may differ due to transaction costs. Not all of

799-462: Is the total value of a publicly traded company 's outstanding common shares owned by stockholders. Market capitalization is equal to the market price per common share multiplied by the number of common shares outstanding. Market capitalization is sometimes used to rank the size of companies. It measures only the equity component of a company's capital structure , and does not reflect management's decision as to how much debt (or leverage )

846-550: Is used to finance the firm. A more comprehensive measure of a firm's size is enterprise value (EV), which gives effect to outstanding debt, preferred stock, and other factors. For insurance firms, a value called the embedded value (EV) has been used. It is also used in ranking the relative size of stock exchanges , being a measure of the sum of the market capitalizations of all companies listed on each stock exchange. The total capitalization of stock markets or economic regions may be compared with other economic indicators (e.g.

893-428: Is virtually impossible to calculate an EV without making a number of adjustments to published data, including often subjective estimations of value: In practice, EV calculations rely on reasonable estimates of the market value of these components. For example, in many professional valuations: When using valuation multiples such as EV/EBITDA and EV/EBIT, the numerator should correspond to the denominator. In other words,

940-464: The Buffett indicator ). The total market capitalization of all publicly traded companies in 2023 was approximately US$ 111 trillion. Total market capitalization of all publicly traded companies in the world from 1975 to 2020. Market cap is given by the formula MC = N × P {\textstyle {\text{MC}}=N\times P} , where MC is the market capitalization, N

987-515: The marginal cost increases, so that a firm optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in debt-to-equity ratios between industries, but it doesn't explain differences within the same industry. Pecking order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to

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1034-566: The EV concept is to envision purchasing an entire business. If you settle with all the security holders, you pay EV. Counterintuitively, increases or decreases in enterprise value do not necessarily correspond to "value creation" or "value destruction". Any acquisition of assets (whether paid for in cash or through share issues) will increase EV, whether or not those assets are productive. Similarly, reductions in capital intensity (for example by reducing working capital) will reduce EV. EV can be negative if

1081-465: The amount of debt in a company's capital structure. The Miller and Modigliani theorem argues that the market value of a firm is unaffected by a change in its capital structure. This school of thought is generally viewed as a purely theoretical result, since it assumes a perfect market and disregards factors such as fluctuations and uncertain situations that may arise in financing a firm. In academia, much attention has been given to debating and relaxing

1128-463: The appropriate mix of short-term debt and long-term debt. Increasing the percentage of short-term debt can enhance a firm's financial flexibility, since the borrower's commitment to pay interest is for a shorter period of time. But short-term debt also exposes the firm to greater refinancing risk . Therefore, as the percentage of short-term debt in a firm's capital structure increases, equity holders will expect greater returns on equity to compensate for

1175-413: The assumptions made by Miller and Modigliani to explain why a firm's capital structure is relevant to its value in the real world. Up to a certain point, the use of debt (such as bonds or bank loans) in a company's capital structure is beneficial. When debt is a portion of a firm's capital structure, it permits the company to achieve greater earnings per share than would be possible by issuing equity. This

1222-401: The base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs , agency costs , taxes , and information asymmetry . This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of

1269-409: The basis for modern academic thinking on capital structure. It is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like fluctuations and uncertain situations that may occur in the course of financing a firm. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides

1316-462: The business cycle and can result in the observed patterns. Others have related these patterns with asset pricing puzzles. Corporate leverage ratios are initially determined. Low relative to high leverage ratios are largely persistent despite time variation. Variation in capital structures is primarily determined by factors that remain stable for long periods of time. These stable factors are unobservable. Firms rationally invest and seek financing in

1363-423: The business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company's operating income, or bankruptcy may be the result. If the firm does not prosper and profits do not meet management's expectations, too much debt (i.e., too much leverage) increases the risk that the firm may not be able to pay its creditors. At some point this makes investors apprehensive and increases

1410-472: The company's balance sheet . The larger the debt component is in relation to the other sources of capital, the greater financial leverage (or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital . Company management

1457-411: The company, for example, holds abnormally high amounts of cash that are not reflected in the market value of the stock and total capitalization. All the components are relevant in liquidation analysis, since using absolute priority in bankruptcy all securities senior to the equity have par claims. Generally, also, debt is less liquid than equity, so the "market price" may be significantly different from

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1504-441: The firm in question. Value of associate companies is subtracted because it reflects the claim on assets consolidated into other firms. EV should also include such special components as unfunded pension liabilities, employee stock options , environmental provisions, abandonment provisions, and so on since they also reflect claims on the company. There are certain limitations and traps in using enterprise value. One of which can be

1551-437: The firm than investors) issue new equity, investors believe that managers think the firm is overvalued, and managers are taking advantage of the assumed over-valuation. As a result, investors may place a lower value to the new equity issuance. The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share (EPS) are maximized. The model

1598-487: The firm's cost of borrowing or issuing new equity. It is important that a company's management recognizes the risk inherent in taking on debt, and maintains an optimal capital structure with an appropriate balance between debt and equity. An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm. Internal policy decisions with respect to capital structure and debt ratios must be tempered by

1645-445: The firm. Consider a perfect capital market (no transaction or bankruptcy costs; perfect information ); firms and individuals can borrow at the same interest rate; no taxes ; and investment returns are not affected by financial uncertainty. Assuming perfections in the capital is a mirage and unattainable as suggested by Modigliani and Miller. Modigliani and Miller made two findings under these conditions. Their first 'proposition'

1692-472: The increased risk, according to a 2022 article in The Journal of Finance . In the event of bankruptcy, the seniority of the capital structure comes into play. A typical company has the following seniority structure listed from most senior to least: In practice, the capital structure may be complex and include other sources of capital. Financial analysts use some form of leverage ratio to quantify

1739-407: The law of least effort, or of least resistance, preferring to raise equity as a financing means "of last resort". Hence, internal financing is used first; when that is depleted, debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt

1786-473: The market average interest rate on corporate bonds after corporate taxes, which is a reformulation of the ' Fed model '. The second prediction has been that companies with a high valuation ratio, or low earnings yield, will have little or no debt, whereas companies with low valuation ratios will be more leveraged. When companies have a dynamic debt-equity target, this explains why some companies use dividends and others do not. A fourth prediction has been that there

1833-441: The models above as well as others into a structured theoretical setup that is time-consistent and that has a dynamic set up similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in

1880-513: The outstanding shares trade on the open market. The number of shares trading on the open market is called the float. It is equal to or less than N because N includes shares that are restricted from trading. The free-float market cap uses just the floating number of shares in the calculation, generally resulting in a smaller number. Traditionally, companies were divided into large-cap, mid-cap, and small-cap . The terms mega-cap and micro-cap have since come into common use, and nano-cap

1927-406: The price at which an entire debt issue could be purchased. In valuing equities, this approach is more conservative than using the "market price". Cash is subtracted because it reduces the net cost to a potential purchaser. The effect applies whether the cash is used to issue dividends or to pay down debt. Value of minority interest is added because it reflects the claim on assets consolidated into

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1974-537: The profitability metric in the denominator should be available to all stakeholders represented in the numerator. The EV should, therefore, correspond to the market value of the assets that were used to generate the profits in question, excluding assets acquired (and including assets disposed) during a different financial reporting period. This requires restating EV for any mergers and acquisitions (whether paid in cash or equity), significant capital investments or significant changes in working capital occurring after or during

2021-625: The proportion of debt and equity in a company's capital structure, and to make comparisons between companies. Using figures from the balance sheet, the debt-to-capital ratio can be calculated as shown below. The debt-to-equity ratio and capital gearing ratio are widely used for the same purpose. Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate). Capital not bearing risk includes equity. Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds) Capital structure

2068-503: The reporting period being examined. Ideally, multiples should be calculated using the market value of the weighted average capital employed of the company during the comparable financial period. When calculating multiples over different time periods (e.g. historic multiples vs forward multiples), EV should be adjusted to reflect the weighted average invested capital of the company in each period. Market capitalization Market capitalization , sometimes referred to as market cap ,

2115-407: Was a large market cap in 1950, but it is not very large now), and market caps are likely to be different country to country. Capital structure In corporate finance , capital structure refers to the mix of various forms of external funds, known as capital , used to finance a business. It consists of shareholders' equity , debt (borrowed funds), and preferred stock , and is detailed in

2162-401: Was extended to include the effect of taxes and risky debt. Under a classical tax system , the tax-deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt. If capital structure

2209-426: Was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk . That is, as leverage increases, risk is shifted between different investor classes, while the total firm risk is constant, and hence no extra value created. Their analysis

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