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 tax structure and financial distress plus agency costs. Therefore, a firm should take a debt to an extent that keeps its position up and above the default line. Using debt to create value is at the core of the valuation approach.
Proper valuation of the debt structure can provide businesses with some good rewards.
Firstly, when the point of optimum debt accumulation is known, the companies can be aware of the susceptibilities of the danger ahead. So, they can stop accumulating more debt that can cause financial distress. This saves the firm from potential bankruptcy.
The valuation approach also lets the businesses operate within limited resources. So, the management must be efficient to handle the debt the company has taken from the capital markets. This helps the companies to be efficient and act in a competitive manner which is a good sign of operating under limited resources.
While the valuation approach has some good benefits, it also has some disadvantages.
The first disadvantage of the valuation approach is that it is not possible to apply it completely in practical needs. It is impossible to accurately find the actual break-even point where debt is maximum and optimum for the business ventures. Therefore, although it is known that the limiting point of debt is good, managers can hardly find the exact point while running the operations of the company.
The nature of capital markets is complex and it can be difficult for investors and managers to predict what will happen next. Therefore, while it is known that debt is a better option, companies cannot identify the limit of debt that should be taken from the market.
The fluctuations of the debt market add more complexity to the process, as market swings make it harder to get the optimum amount of debt from the market.
Although a good capital structure is one that creates the maximum value for the business, it is easier said than done. As the nature of debt in the capital markets is dynamic, it is hard to find a balancing point to base the capital structure with confidence by the management.