Capital Structure & Corporate Finance Techniques to Maximize Firm Value & Investor Returns

Abstract

A firm’s capital structure describes the way in which a company is financed and how its free cash flows or net profits are distributed to investors. In what follows we review how capital structure can be organized to maximize firm value and investor returns. Firstly we look at fundamental theory from corporate finance, namely the Modigliani and Miller propositions. The assumptions from this theory describe capital structure features that can be manipulated to benefit corporations and investors. Secondly we review trade-off theory and how corporations can exploit the tax advantages from issuing debt without exposing themselves excessively to bankruptcy risks. We discuss how firms use trade-off theory to optimize their capital structure to maximize firm value. This is a cyclical activity that is greatly influenced by the state of the economy, the company’s beta and financial health. Finally we present two case studies where we firstly create a replicating portfolio to demonstrate Modigliani and Miller capital structure irrelevance and secondly show how debt financing can increase firm value and equity beta.