Utilities, transportation and capital intense manufacturing firms have gearing then service companies. Modigliani and Miller developed the very first capital structure theory by asking a Articles relating to capital structure essay question: Therefore, costs in terms of legal and administrational costs, however, there are also liquidation costs of below market value sells of fixed assets.
There are no homogeneous products and investors are rational risk adverse utility maximises. Such restrictions are referred to as agency costs. However, they found a strong link between firm leverage and amount of non-debt tax shield. Given the existence of a semi-strong form efficient financial markets, investors will be aware of the management thought processes and will see the issue of new equity as a signal that management believe the shares to be overvalued.
The second observation is that capital structure is dependent on the industry the firm operates. Thirdly, profitability is inversely linked to leverage. Several regularities have been observed in terms of capital structure in various countries.
The issue of debt will signal that the shares are undervalued and investors will buy and push up the prices. The second is the Pecking order theory is build on the observation that in the real world companies have all sort of capital structure, some percent debt financed, others per cent equity based and some have a mixture of both.
The disadvantages are in terms of increase financial risks.
Interest costs by their very nature are fixed; however, future cash flows are uncertain. At relatively low levels of gearing the advantages outweigh the disadvantages and the market value of the business rises at first, but the relationship reverses and the disadvantages start to outweigh the advantages.
There are three main capital structure theories, the first of which is the trade-off model. The evidence from and their leverage ratio over a period of 20 years was consistent with the trade off model. The suppliers of debt finance are concerned that the management are responsible with their money.
The cost of bankruptcy is borne by shareholders as well as the management to an extent; in terms of lose of employment. The main advantage of gearing is that debt interest is allowable against taxation. The restrictions could be in terms of dividend payments, sell of tangible fixed assets or the introduction of more debt into the capital structure.
The traditional view of capital structure is that there are both advantages and disadvantages in maximising shareholders value trough corporate gearing. The proportion of debt and equity has implications for the overall cost of capital WACC and thereby, an effect on shareholder-required return from cost of equity.
However, the cost of bankruptcy is sizeable in reality. Firstly, capital structures varies significantly cross nations, for example German and Canadian firms have a lower book value debt than Japanese and Italian companies Rajan, R.
As a company increases its level of gearing, an increasing proportion of its cash flow each year will be paid out as interest cost.
This contradicts the tax based capital structure theory. This will cause the investors to sell their shares and prices will fall. There is a single rate of interest for borrowing and lending.
Critically evaluate with some evidence of empirical research what is the trade off model, the signaling model? Therefore, as the debt servicing costs increase the future uncertain cash flows could be insufficient to meet the interest payment obligations.
Agency costs arise out of what is kwon as the principal-agent problem. The third model is that of market signals. Such default of payment could cause the lender to recall the capital and in turn send the company into bankruptcy and incursion of its associated costs.
And finally, no personal or corporate taxations exist. Other observations made regarding capital structure are that taxation does not affect it, despite various tax rule changes in US; the capital structure decisions of firs have remained the same. The theory states that the capital structure choice of the firm is dependent upon its trade off between tax benefits and increase financial risk associated with high leverage.
A further cost that could result as debt capital increase and is often views as part of the agency costs is that of bankruptcy. This is a problem of external control of management by shareholders. The greater the level of gearing, the greater would be the tax subsidy on debt financing.
The empirical evidence for trade-off model is inconclusive. One such cost is that of agency costs.Articles Relating to Capital Structure: There have been lots and lots of study, researches, arguments, and articles written on capital structures as it is one of the wide topics to discuss upon.
For an Example, If a company sells £40bn pounds in equity and. Does capital structure affect firm value? Hypothesis: H0: There is no a significant relationship between capital structure and their total Fair Use Policy ‘The Cost of Capital, Corporation Finance and the Theory of Investment’.
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Capital Structure Essay a) Capital structure, what are the observed regularities? Critically evaluate with some evidence of empirical research what is. The optimal capital structure can be obtained by the trade off between tax benefits and the cost of distress. The present value of the tax shield.
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