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Target Capital Structure is IdealTarget capital structure is the capital structure that is the most advantageous way for funding a company. There may be a number of optimum capital structures of a company, but the target capital structure is the only one that is considered to be ideal.Capital structure decisions are usually taken in two levels.In the first level, the financial managers prefer to identify the resources of the company to build optimum capital structures.In the second level, the board of directors and the chief financial officer chose a target capital structure for the company from the given options.Target Capital ... Read More
It has often been a matter of managerial decision-making to state the link between strategy and capital budgeting. As capital budgeting is one of the most important decisions organizations make, the effect of strategy on them is a matter of interest for all stakeholders. The strategy may not be the only requirement that drives the capital budgeting process, but there is a very solid link between the two.In fact, the strategy offers a higher level of screening and integration of resources in a capital budgeting procedure. It may not be accounted for in the regular accounting or DCF method, but ... Read More
Risk preference is the attitude of taking financial risks by an investor. An individual investor, while making an investment decision, would take risks according to his or her risk preferences. Depending upon the risk preference, the investor will classify the risks associated with an investment and thereby find the investments that match his/her preferences.There are two major factors that affect the decisions of decision-makers. These are the expected values and the measures of standard deviation. It is however impossible to realize whether investors will go for high expected values and high standard deviations or they will stick to low expected ... Read More
Sequential analysis deals with the sequence of events an investment process follows instead of just accept or reject a process. Sequential analysis is more relevant in practice because it shows all the probable events in terms of a decisions tree that constitutes the probability of an outcome generated in the process.Decisions trees are not a perfect measure of a future event, but they represent quite a close approach to the original outcome in general. However, some steps must be followed while constructing a decision tree which are explained below.Defining the InvestmentsThe investment for which the sequential investment has to be ... Read More
As financial planning and policymaking are of top priority for firms, they must use proper scrutiny and analysis of the following elements of capital structure −Capital MixMaturity and PriorityTerms and ConditionsCurrencyFinancial InnovationsLet's check the importance of each of these important elements of capital structure in detail.Capital MixFirms often need to take a decision on how much debt and equity must be sourced for the operation of the business.Debt can be acquired from a variety of sources. The firm must realize what is the debt-equity ratio to keep a track of the financial mix that is optimum for it.The firm should ... Read More
Capital rationing is a strategy opted by companies that restrict the company’s investment in only one project at a given point of time. When several investments are available, the business needs to invest in the most profitable one.Companies that rely on capital rationing usually have higher return on investment. This is simply because the company chooses the option where profitability is guaranteed and at its maximum.Benefits of Capital RationingCapital rationing often leads to the most successful projects and hence it often guarantees the highest return on investment. Investors are interested in capital rationing because this gives them the idea of ... Read More
The theory of the net income approach suggests increasing the value of a firm by decreasing the overall cost of capital. The cost of capital in the theory is measured in terms of Weighted Average Cost of Capital (WACC). It can be done by incurring and collecting a higher proportion of debt because it is a cheaper source of finance in comparison to equity finance.WACC is the weighted average costs of equity and debts, and the weights are the units of capital collected from each source.According to the Net Income Approach theory, changes in the financial leverage of a firm ... Read More
Qualitative factors play an important role in capital budgeting decisions. Although capital budgeting relies more on quantitative measures, there are abrupt influences of qualitative factors on capital budgeting decisions. Qualitative factors are not expressed in capital budgeting decisions (unlike quantitative factors), however, in terms of context, qualitative factors are equally important.Qualitative Factors Vary According to DemongraphyQualitative factors usually change according to markets and demography where a project has to be implemented. For example, in India, the three qualitative factors that guide projects are urgency, strategy, and environment. Each of these three factors needs to be considered in the case of ... Read More
The valuation approach of capital structure is one of the ways capital structures are formed with debt and equity. In fact, shareholders have more risk than debt holders because the cost of equity is higher than the cost of debt. In such situations, owning debt is cheaper than owning equity. A firm will therefore be tempted to go for debt instead of equity when both the options are available.Higher debt, however, increases the risk of default. It increases financial distress and agency costs. The tax deductibility, however, decreases the amount of payback amount. So, there is a constant tradeoff between ... Read More
The decision tree analysis process is an extremely useful tool to calculate sequential investments. As we determine the branches of the decision tree, we can work backward, from future to present to cancel the unprofitable alternatives. By doing so, we can keep only the profitable investment options in our hands.Therefore, the decision tree analysis offers a unique approach to get a bigger picture of the original alternatives and thereby lets the investors choose an optimum profitability project.The utility of decision tree analysis can be broadly divided into the following categories −Presents a Clear PictureThe decision tree analysis shows all implicit ... Read More