Capital Structure Theory

Capital Structure

The long-term financing of the company is funded through the capital structure owned by the company. It caters the whole company being a unique blend of financial sources, equity and debt. The capital developments mainly hang about a midway of equity and debt. Gearing is the only way to estimate debt in this context. The complications are obvious because other types of capitals also exists that are formed by the mixture of equity and debt. The economic effect of preference share is mot as closer to equity as debt as the returns are fixed but the debt is counted in terms of equity when it is convertible in future.

In short the company’s stability or internal and external threats and opportunities are revealed by ‘debt equity ratio’, which is capital structure. The highly levered firm is considered at low risk than the company that is in high debt. The total value of the company is that is combination of its debts and equity is not affected by the capital structure as explained by the financial theories. But some time it does affects and is regarded as capital structure irrelevance.

Modigliani Miller Theorem

The basis of modern concept of capital structure is described by the Farnco Modigliani and Merton Miller. Few decisions related to the capital structure that are considered important are often ignored in this theorem. The theme of this theory is that the value if the firm is not connected to its financing perspective or to the capital structure employed by it. These propositions that are made by Modigliani and Miller pave the path for consideration of the reasons of capital structure relevance information asymmetry, agency costs, bankruptcy costs, and taxes. This extends the analysis to check that whether or not capital structure enhances the company’s value positively or not.

Trade off Theory of Capital Structure

The bankruptcy costs exist according to the formula of Trade off Theory and the existence is beneficial because tax benefits and cost of financing is associated with the debts. The debt equity ratios are explained by the trade off theory, but the over all picture is enhanced rather than the particular or single entrepreneur or the company. The increase in debt is directly proportional to the marginal benefits with increased marginal costs. While considering this explanation of Trade off theory the company settles its debt and equity to consider financial approaches to optimize the company’s value.

Pecking Order Theory

The Pecking order theory of capital structure mainly emphasizes upon the methodology to raise the equity, while considering the costs related to asymmetric information. The companies following this theory are expected to raise the sources that are financial, that may be internal or external. This is made possible by following those laws that pose least resistance to uplift to equity. The cycle is followed to make this happen that starts from utilization of internal resources, allowing the debt in case of depleted internal resources and finally moving to equity issuance, however the external resources are not preferred over debt in any case.

On the whole it could be concluded that the capital structure of the company or the entrepreneur definitely makes the company dependable upon it and the value of the company is truly measured over the well constructed capital structure of the company.

References

• Lyandres, Evgeny and Zhdanov, Alexei. (2007) Investment Opportunities and Bankruptcy Prediction.SSRN.

• Myers, Stewart C.; Majluf, Nicholas S. (1984). "Corporate financing and investment decisions when firms have information that investors do not have". Journal of Financial Economics 13 (2): 187–221.