The goal of this chapter is to discuss the various theories that help to explain the determination of capital structure. Capital structure is commonly known as the debttoequity ratio. Capital structure theories the debate on optimal capital structure that leads to maximum market valuation and minimum cost of capital is perennial. Capital structure policy deals with the financing of firms activities, with debt, equity and intermediate securities. It is synonymously used as financial leverage or financing mix. The capital structure decisions of new firms nber working. The term capital structure refers to the percentage of capital money at work in a business by type. Capital structure planning free download as powerpoint presentation. Capital structure refers to the permanent financing of the company, represented by owned capital and loandebt capital i. We find both corporate and personal income taxes to be significant determinants of capital structure. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. All free term paper examples and essay samples you can find online are plagiarized. Chapter iii concepts and theories of capital structure and profitability. Therefore, a capital structure should give enough choice to.
In conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix. Impact of dividend policy on organizational capital structure. Capital structure financial definition of capital structure. Since modigliani and miller, 1958, modigliani and miller, 1963 a theoretical framework has been developed in which contributions that aim to explain the capital structure decisions of financial managers are embedded. As a rule of thumb, the higher the proportion of debt financing a company has, the higher its exposure to risk will be. Eventstudy methodology is a useful way to test the free cashflow hypothesis, because it focuses on the markets perception of how much information major policy changes offer about future firm. Capital structure policy for government businesses 1603 new south wales treasury page 4 appendix 1. Tpp1603 capital structure policy for government businesses. Capital structure commission authorizes the percentage of common equity, preferred stock and debt that utilities are estimated to hold based on a reasonable capital structure. Determining a companys optimal capital structure capital structure capital structure refers to the amount of debt andor equity employed by a firm to fund its operations and finance its assets. Jul 23, 20 in conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix.
The textile industry starting from yarn manufacturing industry spinning, cloth. Apr 18, 2017 next issues relevant to capital structure and costs of different types of capital or component costs of capital are discussed. The debt capital in a companys capital structure refers to borrowed money that is at work in the business. The traditional school, at one extreme, argues that there is an optimum capital structure at. In this chapter, we will assume that the rms investment decision is already made. Therefore, a capital structure should give enough choice to all kind of investors to invest. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. Lecture notes financial management sloan school of. Generally speaking, a company with a high level of debt compared to equity is thought to carry higher risk, though some analysts do not believe that. It is the employment of an asset source of finance for which. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. The cost depends on the health of the companys balance sheeta triple aaa rated firm can borrow at extremely low rates vs.
Since a number of factors influence the capital structure decision of a company, the judgment of the person making the capital structure decisions play a crucial part. Free sample term papers on capital structure written by the experts are the best help for every student who wants to complete a wellorganized original paper himself. A totally theoretical model cant adequately handle all those factors, which affects the capital structure decision in practice. Study the impact of growth, firm size, capital structure, and. Capital structure policy involves a tradeoff between risk and return 1 using more debt raises the riskiness of the firms earnings stream. Capital structure list of high impact articles ppts. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known. Capital structure a reading prepared by pamela peterson drake outline 1. Higher risk tends to lower a stock price, but a higher expected return raises it. A companys debt isnt always publicly traded bonds, which have a specified market value. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known empirical evidence. Capital structure planning capital structure dividend. This article studies the effect of growth, firm size, capital structure, and profitability on enterprise value ev in vietnam.
Cost of capital learn how cost of capital affect capital. Debt comes in the form of bond issues or longterm notes. Aswath damodaran 3 the objective in decision making n in traditional corporate finance, the objective in decision making is to maximize the value of the firm. Capital structure meaning and factors determining capital. Theories of capital structure explained with examples. Next issues relevant to capital structure and costs of different types of capital or component costs of capital are discussed. Capital structure, cost of capital, and voluntary disclosures. Financial leverage and capital structure policy a introduction the objective of the capital structure decision, like any corporate objective, should be to maximize the value of the rms equity.
Capital structure management capital structure strategy. Capital structure that maximizes the value of company or stock prices is the best capital structure husnan and pudjiastuti, 1994. Systems vary from company to company, but may include policies such as weighting capital, financial leverage variability, sinking funds, financial structure design, and capital structure theory. Generally speaking, a company with a high level of debt compared to equity is thought to carry higher risk, though some analysts do not believe that capital structure matters to risk or profitability. When the stock is traded and markets are viewed to be efficient, the objective is.
The theory provides insight into a firms capital structure decision in a capital market free of taxes, transaction costs, and other frictions. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital wacc wacc wacc is a firms weighted average cost of capital and represents its blended cost of capital including equity and debt. Capital structure is still a puzzle among finance scholars. We combine elements of the pecking order and tradeoff theories of capital structure to develop a more powerful and empirically descriptive theory in which firms have low longrun leverage targets, debt issuances are temporary deviations from target to meet unanticipated capital needs, firms rebalance to target with a lag despite zero adjustment costs, and mature firms pay. To keep the cost of raising capital low, many businesses subscribe to a capital structure policy. Taxes and capital structure journal of financial and. The optimal capital structure for a company is one that offers a. What are the different types of capital structure policy.
The optimal dividend policy is the one that maximizes the firms value. If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. Debt comes in the form of bond issues or longterm notes payable, while equity is classified as common stock, preferred stock or retained earnings. An optimal capital structure is the best debttoequity ratio for a firm that maximizes its value. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the modiglianimiller theorem that has limited descriptive validity in real markets. A read is counted each time someone views a publication summary such as the title, abstract, and list of authors, clicks on a figure, or views or downloads the fulltext. The capital structure puzzle is unravelled and a clear. Capital structure is the proportion of all types of capital viz. Capital structure, cost of capital, and voluntary disclosures jeremy bertomeu, anne beyer, and ronald dye stanford university, northwestern university october 2009 abstract this paper develops a model of external nancing that jointly determines a rms capital structure, its voluntary disclosure policy, and its cost of capital. Capital structure describes the amount of debt a company uses as opposed to equity, and it is often measured with the ratio of debt to equity. It avoids the problem of computing the required rate of return for each investment proposal. Importance of capital structure planning mba knowledge base. Capital structure, payout policy, and financial flexibility.
Theoretical considerations a firm could use three methods to determine its capital structure. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm. Choice of investorsthe companys policy generally is to have different categories of investors for securities. Financial leverage and capital structure policy a introduction. The purpose of capital structure is to provide an overview of the level of the companys risk. A general free cash flow theory of capital structure. Capital structure usually refers to how much of each type of financing a company holds as a percentage of all its financing.
Application of the policy statutory state owned corporations listed in schedule 5 of the state owned corporations act 1989 are to apply the full aspects of the capital structure policy. Jun 25, 2019 the debt capital in a companys capital structure refers to borrowed money that is at work in the business. Modiglianimiller theorem financing decisions are irrelevant. Capital structure policy involves a tradeoff between risk and return. The theory and practice of corporate capital structure january 2006 2 liability strategies group executive summary this paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. The value of a firm is affected by its dividend policy.
Capital structure refers to the amount of debtmarket value of debtthe market value of debt refers to the market price investors would be willing to buy a companys debt at, which differs from the book value on the balance sheet. Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firms stock price. The more debt a company has, the more it has to pay creditors for the use of those funds. Lets say, for example, a company could raise between 40% and 60% of its needed funds with debt costing 8%. Unfortunately, there has been little consensus among researchers on what the optimal capital structure is. Apr 12, 2019 this article studies the effect of growth, firm size, capital structure, and profitability on enterprise value ev in vietnam. Based on ex post observed summary statistics, across organisation for economic cooperation and development oecd countries, taxes appear to be as important as other traditional variables in explaining capital structure choices.
The theory provides insight into a firms capital structure decision in a capital market free. A single, overall cost of capital is often used to evaluate projects because. Each type of capital has its benefits and drawbacks, and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure regarding riskreward payoff for shareholders. The alternative o ered by conventional wisdom is that informal capital dominates the capital. Capital structure and its 4 important theories ni, noi. Cost of capital is an important factor in determining the companys capital structure. Take an investor holding share s of firm 2, for a total of o 6.
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