FINANCIAL MANAGEMENT

Financial Management

Financial Management

Part A: Critically evaluate the need to manage capital structure effectively in maximizing the wealth of business organizations.

When a company expands, it needs capital, depending on what kind of company funding distinguish debt capital or equity. Borrowings are two significant advantages. First, the interest paid is deducted when calculating the tax, which lowers the actual cost of borrowing. Secondly, those who provide the loan receive a fixed income, and shareholders should not share with them the profit, if the enterprise is successful.

However, borrowing has its drawbacks. Firstly, the higher the debt ratio, the riskier the company, and consequently higher costs for firms and debt and equity. Secondly, if the company is experiencing hard times and its operating profit is not enough to cover interest costs, the shareholders themselves will have to compensate for a deficiency, and if they cannot do this, the company is declared bankrupt. (Mittoo, 2004, pp. 103-32)

Therefore, companies whose earnings and operating cash flows are unstable and should limit the attraction of borrowed capital. On the other hand, those companies whose cash flows are more stable are free to raise debt financing. However, the question arises: Is the debt financing is better to "own"? If yes, should the company be fully financed through borrowing or still to some extent? If the best solution is a combination of debt and equity, what is the best of their relationship?

The cost of any firm is the present value of future free cash flows discounted at the weighted average cost of capital (Weighted Average Cost of Capital, WACC). Changes in capital structure change the percentage of its components will have an impact on the risk and cost of each type of capital, as well as the WACC as a whole. Changes in capital structure can also affect the free cash flow, influencing the decisions of managers associated with the formation of budget capital investments, as well as determining the costs associated with bankruptcy and financial collapse. Thus, capital structure affects both the free cash flows, and at the WACC, and therefore stock prices.

In addition, many firms pay dividends, which reduce retained earnings, and thus increase the amount that these firms should seek further to provide funding for their business. Consequently, decisions on capital structure are interrelated with the policy of paying dividends. In this section of the site, we will focus on the choice of capital structure. (Yermack, 2007, pp. 1411-38)

Decisions on capital structure is influenced by many factors, as you'll see the definition of optimal capital structure - is not an exact science. Therefore, even firms that belong to the same industry often have significantly different capital structure. Here, we first consider the impact of capital structure on the risk of its components, and then we use these data to determine the optimum ratio of debt to equity. (Rosen, 2005, pp. 701-715)

Optimization of Capital Structure

The company's activity is subject to certain life cycles. To assess the structure of the equity of the enterprise and the decision to optimize it is necessary to understand what stage of development the company is experiencing at the ...