FINANCIAL MANAGEMENT

Financial Management

Abstract

Capital Structure has become an important agenda of top management decision making process. Many theorists have recommended different composition of debt and equity in the company financial statements, but actual market conditions does not always appropriate for the suggested capital structure. The paper will try to access two fundamental questions related to capital structure that is the optimal capital structure ratio and different attributes affecting the capital structure. the aims to reach a meaningful conclusion after addressing both fundamental questions. 

Financial Management

Capital Structure

The fundamental finance resource for any company is the stream of cash flows that it's assets are generating. If the company is completely financed by equity, all money belongs to shareholders but that is not the case always. Most of the time, there is mix of debt and equity being employed to finance the company's assets and operations. Debt holders have senior rights to the company's cash flows while shareholders have residual claim which make their investment more risky. Capital structure is the composition of liabilities and equity to finance the company. It is the mix of securities and capital stock that have been used to fund the ongoing operations of the company or for capital expenditure. The proportion of debt and equity is not fixed in the capital structure. It varies across the different industries. Companies like Microsoft have completely financed it with equity until recently when it declared repurchase along with issuance of debt securities. On the contrary, oil and gas sector companies, airlines, utilities are on the other extreme i.e., relying completely on debt.

Capital structure decision making has taken on significant interest of all stakeholders. Shareholders want the management to choose optimal capital structure; a mix of debt and equity that maximize the company's value. But is there any optimal capital structure? The question of optimal capital structure has been there for a very long time. Many studies show that with certain assumptions about the market, there is no optimal structure; however, in real market activities, those assumptions are often not applicable. In recent years, a many theories came up addressing specifically optimal capital structure in the company. According to these theories, companies should select do cost and benefit analysis under different mix of debt and equity. The structure, costing lowest and benefiting the most, should be opted. As a matter of fact, empirical research in this field has been far behind the theoretical study, possibly because the relevant company attributes that have been used in reaching the conclusion are often expressed in fairly abstract concepts that are no directly observable. The contemporary theory of optimal capital structure is based on the distinguished paper of MM Model (Modigliani and Miller 1958, 261-97). MM indicated that direction that theories must take by showing under what conditions capital structure is irrelevant. After their paper, many economist and decision makers have followed the path they mapped out. Two famous Optimal Structure theories based on real market conditions are Trade off theory and Pecking theory. All of these theories tried to address only one ...