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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.
While the valuation approach has some good benefits, it also has some disadvantages.
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.
