Optimal Capital Structure

Topics: Finance, Corporate finance, Modigliani-Miller theorem Pages: 6 (1496 words) Published: March 20, 2010

This report tries to visualize “OPTIMAL CAPITAL STRUCTURE” and represent the facts that include features of capital structure, determinants of capital structure, and patterns of capital structure, types and theories of capital structure, theory of optimal capital structure, risk associated with capital structure, external assessment of capital structure and some assumption related to capital structure.

To determine features of capital structure
To know about determinants of capital structure
To evaluate pattern and form of capital structure
To identify the types and theories of capital structure
To analyze the theories of optimal capital structure
To determine the risk associated with capital structure
To have an overview about external assessment of capital structure •To know the assumptions related to capital structure

Books on financial management
Articles published on capital structure
Search out different websites for data collection related to capital structure decisions.

Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables. Poor capital decision can result in a high cost of capital thereby lowering the NPVs of projects and making more of them unacceptable. In practical sense, a firm can probably more readily increase its value by improving quality and reducing costs than fine tuning its capital structure. Effective capital structure can lower the cost of capital, resulting in higher NPVs and more acceptable projects, and thereby increasing the value of the firm. A firm’s major decision is its financing decisions which are analysied in the theory of corporate capital structure and based on the model developed by Dodd (1986), capital structure is determined mainly by three agency costs variables- agency equity, agency debt and bankruptcy risk and other potential variables such as growth rate, profitability and operating leverage. The firm’s capital structure should result from balancing the costs of certain relationships between firm related groups. Somtime agent does nat act in line with the set objectives of the principal. •Shareholders are the owner of the firm. If shareholders value increases they will be benefited and vice-versa. shareholders value maximization depends on managers activities. But as a rational being, managers try to maximizes their own interest. As a result agency and equity cost arises which tend to discourage the use of equity. •Debt holders have no voice on management issue. Managers are accountable only to the firm. So, they are trying to maximize the wealth of shareholders not debt holders. There is an agency-debt cost which discourages the issuance of debt. •There is a possibility of bankruptcy if the firm taking more debt capital. Because the greater the firms debt capital, higher the possibility of default on interest and capital repayment. •Three other potential determinants of capital structure are also included in the model developed by Dodd. Firms growing at higher rates should have higher debt ratios than firms with lower growth rates. The relationship between debt ratios and growth rate is expected to be positive. Firms with higher profitability ratio may be expected to have more equity than firms with lower ratios. Management of companies with high operating leverage may use lower levels of financial leverage i.e. debt.

Capital structure is the manner in which a firm’s assets are financed; that is, the right-hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm-debt, preferred stock, and common equity. Combination of capital is called capital structure. The firm may use only equity. Or only debt, or a combination of equity and debt, or a...
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