Finance Essay - Part I | MBA Term Papers

Introduction

The term capital structure denotes the mode of financing used by the corporation for financing its assets. This includes equity and debt. A firm with a capital base of $30 billion equity and $70 billion debt is said to have a leverage of 70%. Various studies explaining the impact of factors on the capital structure decisions have been conducted. However, no consensus has been reached in the mater till date (Barton, Gordon, 1987). But it has been seen that the firms with a high leverage are considered to be risky by the investors. As the financial risk of such firms is high the investors demand for higher returns thus raising the overall cost of capital of the firm. Various theories highlight the significance of capital structure on the value of the firm. The theories of capital structure include trade-off theory and pecking order theory. As per the trade-off theory the firms try to make a trade-off between the costs and benefits of raising debt. Pecking order theory advocates the use of internal financing and debt over equity. The issue of new equity is used as the last resort.

Capital structure theories

Miller and Modigliani-

Miller and Modigliani theorem is the basis of the modern approach on capital structure. This assumes that in an efficient market and a market characterized by the absence of bankruptcy costs and taxes, the firm?s value is independent of the capital mix. The mode of financing i.e. whether equity is issued or debt is raised has no impact on the firm?s financing strategy. The irrelevance proposition of Miller and Modigliani states that the firm?s market value does not depend on the composition of its capital and is obtained by capitalizing the anticipated net operating income by the return required on the firm?s assets. The value of the firm depends on the level of EBIT earned by the business irrespective of the allocation of the earnings to the shareholders in the case of an all-equity firm or the division of earnings between the equity and debt holders (Megginson, Smart, 2008, P496)
As per Miller and Modigliani Proposition II, if the cost of capital (Kc) and the rate of return required on debt (Kd) are kept constant then the rate of return required on equity (Ke) increases with the rise in the debt-equity ratio. This can be expressed as-

Ke = Kc + (Kc-Kd) D/E

As the debt-equity ratio increases the equity shareholders demand for higher returns to compensate for the high financial risk associated with debt funding. The validity of these propositions is based on the assumption of perfect market conditions. But in the real world the interest expense is tax deductible whereas the dividend on shares is not, thereby impacting the choice between debt and equity (Lucey et al, 2008, P409).

In the presence of taxes the value of the levered firm exceeds the value of the unlevered firm to the extent of tax advantage of debt. However, the incorporation of debt in the capital structure adds to the bankruptcy costs and adds to the agency conflicts. Beyond an optimum point the benefit of interest tax shield is off-set by the agency costs and the cost of expected bankruptcy.

Other theories

It has been observed that the established firms rely more on debt and retained earnings and equity is considered as the last resort in financing the investment requirements of the business. The pecking order theory has been motivated empirically but the lack of justification has restricted its acceptance in the mainstream of academics. Due to the presence of asymmetric information, the pecking order theory can be considered to be a rational response not just to transaction costs and taxes but also in terms of signaling. Various evidences now lend support to this theory.

to be continued?

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