CAPITAL STRUCTURE AND DIVIDEND POLICY

Analysis of Corporate Accounts: Capital Structure and Dividend Policy



Analysis of Corporate Accounts and Capital Structure and Dividend Policy

Introduction

Corporate officers, analysts and professional investors usually talk about the capital structure of the company. Majority of the people does not know and neither are they concern regarding the capital structure. Nevertheless, the concept is very important as it has a direct impact on the return for share-holders and most importantly the survival of company. This paper will focus on “Is there such thing as an optimal capital structure for a company and does the payment of a dividend matter in the 21st century?”

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.

Corporate Finance Theories in the Context of Real Life Experience

Theoretical models of capital structure are built around the concept of optimal level of debt. If managers are concerned with maximizing firm value, they will seek to achieve the level of debt which is the optimal compromise between costs and benefits associated with debt. Some characteristics of debt affect the value of the firm when there are market imperfections. Time schedules of charges for loan increases the probability of bankruptcy, which imposes real costs to shareholders. At high levels of debt firms may have to pass up valuable investment opportunities (underinvestment: Myers, 1977) or to invest in overly risky projects (asset substitution: Jensen and Meckling, 1976) (Baker K, English P., 2011, pp. 172).

Indeed, the debt also has advantages on equity. It enjoys a favorable tax treatment on dividends and capital gains, whose importance is nonetheless tempered by the volume of non-cash charges tax deductible. Given the difficulty of writing contracts that perfectly align the utility functions of managers and shareholders, debt can be seen as a mode of conflict resolution since it requires agency managers to distribute the free cash flows. It is generally referred to current literature under the term Trade off Theory.

The trade-off theory is to explain how to achieve an optimal capital structure that maximizes the value of the company. She argues that the optimal level of debt is reached when the marginal benefit of tax attributable to the indentation is canceled by the corresponding increase of the potential costs of agency and bankruptcy. One problem to be solved to test this theory lies in estimating the target ratio. In models of compromise and more precisely (STOT), the approach ...