Evaluating The Risks Involved in Equity and Debt Financing

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Firms around the world rise funds in the capital markets to finance their expansion, acquisitions and other operations. This is usually done through equity and/or debt financing. Equity financing is the process in which a firm raises capital through the sale of shares. Debt financing involves the firm borrowing through, for example by issuing bonds.
The firm‘s decision on how to rise capital influences its capital structure and as a result may affect the value of the firm. It is therefore important that the firm must take into account the risks involved in both equity and debt financing. In order to be able to make an optimal decision, a firm that uses the combination of both equity and debt must ensure an optimal debt-equity ratio, i.e. the one that minimizes the costs and risks and maximizes the overall value of the firm.
The traditional view of capital structure is that changes in the debt-equity ratio would affect the value of the firm because it would change the risk shareholders bear. Therefore, for the firm to determine their optimal capital structure they must consider the cost of capital to the firm in line with the Capital Assets Pricing Model which says that individual investors require a higher return in compensation of an increase in the risk they bear.
Modigliani and Miller (1958), argued that under certain assumptions a firm‘s debt-equity ratio does not affect the cost of capital. According to them there is no optimal debt-equity ratio and the amount of debt issued by the firm is irrelevant and does not matter how much or how little it borrowers. They also argued that changes in the debt-equity ratio will not affect the value of a firm. This means that the value of the firm is independent of its capital structure....

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...is no longer demanded or consumed, if company X require more machinery it might its self with high quantity of redundant assets. Machinery has maximum production levels, i.e. a limit at which it can produce in a certain point of time. If the demand of the product increases significantly the machine may be unable to produce to a level that will meet the demand.

As the capital- labor increase the amount of labour will be reduced. Even though Company X has a flexible work workforce that can be easily be fired, letting go of some of the workforce will come at a cost. This cost includes compliance costs relating to retirement, and payout retrenchment packages.
My advice to Company X on the change to operational structure is that, it can increase the capital-labour ratio as long as the cost of the acquisition is equals to or less than the cost of retaining the workforce.

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