Capital Structure and Agency Theory

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1.0 Introduction
The maximization of the company’s value has long been the objective of financial management. In order to create more value for business organizations, how to comprehensively make the most effective investment, financing and operating decisions becomes more crucial. Among these decisions, the optimization of capital structure has a great influence on the performance of the companies, for a reasonable capital structure can decrease the financing cost, take advantage of the financial leverage and play an important role in corporation governance. Given the importance of capital structure, this essay will firstly discuss the ways that capital structure affects corporation value, then it will introduce the influencing factors of capital structure and how to effectively manage it. Due to the conflicts among the debtors, managers and shareholders etc, this essay will also illustrate the agency problems that are existed in the companies and evaluate the role of effective financial management in addressing these problems.

2.0 The ways that capital structure affects corporation value The capital structure is refered to the allocation between the long-term debt and equity, which determines the solvency and refinancing ability of the company to a large extent. While the optimum capital structure is the capital structure that can maximize the wealth of shareholders or bring about the least capital cost. It is necessary to manage the capital structure effectively, for a reasonable capital structure can maximize the value of a company through a series of approach. According to a series of capital structure theories, the way that capital structure affects corporation value can be described from different perspectives (Margaritis, D. & Psillaki, M. 2010).

2.1 Form the perspective of capital cost
The traditional Net Income Theory holds the view that due to the lower debt cost compared to the equity cost, the increase of debt ratio in the capital structure can decrease the weighted average cost of capital (WACC), thus a 100% percent of debt can maximize the value of the corporation. Although the Net Operating Income Approach suggests that the financing decision has no relationship with the corporation value, the traditional theory thinks that although the increase of debt ratio or financial leverage will increase the risk of the corporation and the equity cost, the increase of equity cost can not offset the advantage that is brought about by the relatively lower debt cost. When the marginal cost of debt is equal to the marginal cost of equity, the optimum capital structure with the least capital cost emerges. Therefore, reasonably arrange the debt ratio in the capital structure can greatly decrease the WACC, thus increase the value of the corporation.

2.2 From the perspective of the benefit on financial leverage Due to the often costant debt interest, the fixed interest that is born by every pound profit will decrease correspondingly when the earnings before tax and interest (EBIT) increase, which will finally increase the profit after tax (Luoma, G. A. & Spiller, E. A. 2002). Therefore, reasonably make use of the debt capital within a limit can bring about the function of financial leverage, which will bring the benefit on financial leverage to the shareholders and increase the corporation value.

2.3 From the perspective of tax shield returns
While the classic MM theory holds the view that capital structure has no relationship with the corporation value, the tax MM theory lay an emphasis on the tax shield returns form debt. Due to the debt interest can be paid before tax, the debt can bring about the tax shield returns. Therefore, in the management of capital structure, a higher debt ratio can create more value for the corporation.

2.4 From the perspective of the costs that are brought about by debt financing Although the MM theory had taken account for various benefits that can be brought about by the debt,...
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