Determinants of Capital Structure in Pakistan”
“DETERMINANTS OF CAPITAL STRUCTURE IN PAKISTAN”
Capital structure refers to the combination of asset financing from different available sources. Normally the companies have two choices, either to finance the assets from internal source that is termed as retained earnings or from external source that splits into debt and equity. A firm’s capital structure is than the composition of its liabilities. In reality, capital structure of firms may be highly complex and consist of number of sources. These sources start from the retained earnings and ends in hybrid securities. The source of funding a capital is also diversified into short term and long term financing.
Modigliani-Miller theorem
The thinking of capital structure was initiated by the Modigliani-Miller theorem, proposed by Franco Modigliani and Merton miller. They made two findings under perfect market conditions. Their first proposition was that the value of a firm is independent of its capital structure and the second proposition stated that the cost of equity for a leverage firm is equal to the cost of equity for an un-leveraged firm with addition of premium for financial risk. They extended their analysis by including the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable. It means the increase in proportion of debt in capital decreases the cost of capital. And eventually the optimal structure would have no equity at all.
Later on it was revealed that the imperfections of real world must be the cause of capital structure relevance to firm value. The trade-off and pecking order theory try to address some of these imperfections, by relaxing the M&M assumptions.
Trade-off theory
Trade-off theory adds another variable called financial distress in the previous studies and explains that although there is an advantage of debt financing and that reaps from the tax benefit shield. But a time come when the high debt give birth to
Capital structure refers to the combination of asset financing from different available sources. Normally the companies have two choices, either to finance the assets from internal source that is termed as retained earnings or from external source that splits into debt and equity. A firm’s capital structure is than the composition of its liabilities. In reality, capital structure of firms may be highly complex and consist of number of sources. These sources start from the retained earnings and ends in hybrid securities. The source of funding a capital is also diversified into short term and long term financing.
Modigliani-Miller theorem
The thinking of capital structure was initiated by the Modigliani-Miller theorem, proposed by Franco Modigliani and Merton miller. They made two findings under perfect market conditions. Their first proposition was that the value of a firm is independent of its capital structure and the second proposition stated that the cost of equity for a leverage firm is equal to the cost of equity for an un-leveraged firm with addition of premium for financial risk. They extended their analysis by including the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable. It means the increase in proportion of debt in capital decreases the cost of capital. And eventually the optimal structure would have no equity at all.
Later on it was revealed that the imperfections of real world must be the cause of capital structure relevance to firm value. The trade-off and pecking order theory try to address some of these imperfections, by relaxing the M&M assumptions.
Trade-off theory
Trade-off theory adds another variable called financial distress in the previous studies and explains that although there is an advantage of debt financing and that reaps from the tax benefit shield. But a time come when the high debt give birth to