Market Value of the Firm, Market Value of Equity, Return Rate on Capital and the Optimal Capital Structure

Chao Chiung Ting

doi:10.5430/ijfr.v3n4p1

Abstract

The firm should pursue both maximum return rate on capital and maximum return rate on equity simultaneously. Maximum return rate on capital is the primary goal for firms because maximum return rate on capital guarantees efficiency. Therefore, maximum profit, maximum market value of the firm, maximum value of equity and maximum return rate on equity are inappropriate to be the primary goal. Since gross profit is independent of capital structure, capital structure just distributes return on capital into equity and debt (i.e., maximum return rate on equity determines capital structure). The maximum return rate on equity is the secondary goal that the firm pursues. Leverage makes the return rate on equity be higher than interest rate. Leverage explains the puzzle of equity premium.

Highlights

What is the primary goal for a business? There are many answers for this question
Maximum return rate on capital is the primary goal for firms because maximum return rate on capital guarantees efficiency
Microeconomics takes maximum profit as an axiom to allocate resource while finance applies value maximization to be a fundamental principle for business performance evaluation

Summary

Introduction

What is the primary goal for a business? There are many answers for this question. For examples, maximum profit, maximum market value of the firm, maximum market value of equity, maximum return rate on equity, optimal capital structure and ...etc. Microeconomics takes maximum profit as an axiom to allocate resource while finance applies value maximization to be a fundamental principle for business performance evaluation. It is no doubt that both microeconomics and finance intend to investigate the same object as firms Why do they use different goals to study firms? The answer is: economists usually advocate new hypothesis (e.g., natural rate of unemployment) to solve economic puzzles and financial expert are accustomed to introduce new criteria to analyze business performance They ignore the possibility that these “new things” may not be independent of “old things”. For the purpose of analysis, it is the first priority that we are necessary to ask following questions, which have never been asked by both economists and experts of finance Should management authority pay no attention to capital structure? Does the optimal capital structure of the firm exist? Is the optimal capital structure a goal of business? Is capital structure just a tool to realize these goals?

Published by Sciedu Press

Conclusions