CAPITAL STRUCTURE

Capital structure and corporate financing decisions



Capital Structure and Corporate Financing Decisions

Introduction

Modigliani and Miller's - 1958 publication of “Irrelevance theory of capital structure” has increased the interest of finance economists with respect to corporate capital structure theory. From past, there are three main theories of capital structure that has been emerged with the assumption Perfect Capital Markets on basis of which this model of Irrelevance has been working. First theory was Trade off Theory which state that firms Trade-Off the cost and benefits of equity and debt financing and discover an “Optimal” capital structure subsequent to market imperfections like bankruptcy, agency and Taxes cost.

Beside this, other is the Pecking Theory - Myers.1984, Myers and Majluf.1984 which suggest that firms should follow a Financing Hierarchy in order to reduce the information asymmetry problem between manager insiders of the firm and outsiders shareholders.

Currently, authors Baker and Wurgler 2002 have contributed their efforts for suggesting new theory for capital structure. This s theory is known as Market Timing Theory of Capital Structure. According to this theory, current capital structure of the firm is the cumulative results of the past attempt in order to time equity market. The term market timing entails company issue new shares when they perceive that their shares are over-valued and when company determines that their shares are under-valued they repurchase their own shares. This also has been stated by other authors as well, nevertheless, Baker and Wurgler have demonstrated that the market timing influence on capital structure is extremely importunate.

Hence, the focus of this paper will be on Pecking Theory with respect of how firms should finance their investment.

Discussion

The work of Modigliani and Miller's revolutionary work on capital structure has left with the query that is there such a thing as an optimal capital structure for companies or in the other way, is there a finest means to finance the company i.e. an optimal debt to equity ratios.

If we look and study Trade off Theory, the answer to this question is “YES”. This ratio is important which can minimize the cost of capital of the company and the value of the firm will be maximized. The company might experience a risk if they move beyond the optimal range. As company move beyond the optimal range, the cost of capital would increase (Fama & French, 2005, p. 550).

The Theory of Capital Structure

The issue of finding the optimal capital structure for a long time captures the minds of many economists. There are a number of theories, featuring a choice of an optimal capital structure. However, the first statement formulated by Modigliani and Miller caused a shock - the company's value does not depend on the method of financing (Frank &Goyal, 2009, p. 25).

In 1991, Harris and Raviv (Harris, Raviv) described a fairly large number of works, which at that time studied the theory of capital structure (Frank & Goyal, 2009, p. 1). The choice of capital structure was divided into four categories, indicating a ...