CORPORATE FINANCE

Corporate Finance



Corporate Finance

Introduction

Capital structure is a way by which a firm finances its assets through a combination of debt and equity. It is considered as lifeblood for the organization as it is a composition of its liabilities. There are various theories for capital structure that has been emerged over the years such as trade off theory, pecking order theory and market timing theory.

Answer 1: Capital Structure Theories

Capital structure has an essential role in the firm since it has direct connection with firm performance and to maximize firm value. In accordance with the finance theory, capital structure engrosses decisions concerning the combination of various funds sources, since firm use these sources of fund to finance their assets, operation and capital investments. These sources of funds comprises of long-term and short term debt finance i.e. debt financing, beside this, company also finance their operation via common stock and preferred stock i.e. equity financing. Capital Structure has direct relation with the firm performance and this has been highlighted by many theories that are Trade-off theory, Pecking order theory, Agency Costs, Theory of information asymmetry and Signalling Theory (Baker, 2012, p. 129).

Trade-Off Theory

Trade-Off Theory is a capital structure theory which is related various costs and benefits of leverage plans. Main focus of this theory is on the tax effect and the financial cost distress when engaging in high leverages finance. Tradeoff theory considers tax code, bankruptcy costs and transaction costs.

The tax code is more multifaceted than it is assumed by the theory. Therefore, many objectives can be reached by using different features of the tax code. Secondly, rather than transferring the cost from one applicant to the other, bankruptcy costs must be deadweight costs. The nature of these costs is also very significant. Lastly, transactions costs should take septic form for the study. In order to adjust steadily rather than being swift, the marginal cost must increase when the adjustment is significant. The concept behind this theory is that company should go for borrowing till the marginal tax benefit of additional debt is off-set via rise in expect costs present value of financial distress.

There were various criticisms to this theory with respect to how it is related to capital structure decisions since there were numerous circumstances where business leveraging is greatly lower than what trade off theory states. The other reason to oppose this theory was due to companies that were operating for an extended period of time with lower debt ratios while they had high profit margins and they also accomplished solid credit ratings. Moreover, where trade off theory offers sensible approach, at the same time there are few things which are not properly explained by it (Brigham, Ehrhardt, 2012, p. 1019).

This theory has no explanation for scenarios like when leverage has steady trend in countries regardless of huge fluctuation in taxation system. Overall, Trade off theory suggests that whether companies should finance their operation with debt or with equity and it further states the benefits ...