Capital Structure of Firms
Introduction Gist of major theories on capital structure:
By way of a conventional start, perhaps it would be worth our while to look at what "capital structure" actually means. In broad terms, it is essentially the firms ' mix of debt and equity but it would be wrong to assume that this is all there is to it. These two terms belie the complexity that lies beneath, from the viewpoint of the decisions that any firm must take - that is to say, what kind of debt and which type of equity. Capital structuring would then, deal with how a concern splits its cash flows into the relatively safe stream that goes to the debt holders, and the riskier stream that goes to the stock holders. The aim of any exercise within the purview of this is simple: find the combination that maximizes the firms ' market value.
It could first be argued that the firms ' value is not altered by the method by which it is split because the value is determined by its real assets, and not by the securities issued. This total separation of investment and financing implies that given a firm which uses a mix of debt-equity financing, its value will be exactly the same as it would have been had it opted for all equity financing. The aforesaid is the essence of what Modigliani and Miller showed as their Proposition I '. Thus, Modigliani and Miller, in their seminal work, espoused that in a perfect market the combinations of debt and equity are all at par in essence, the market value of any firm is capital structure independent. Here, the law of value conservation operates, wherein an asset value is preserved irrespective of the claims that might arise on it. This is precisely where the question of practicality presents itself, for if debt policy was of no consequence, then this fact cannot adequately explain actual debt ratios varying significantly across the board in various industries, be it airlines or banks.
Modigliani and Miller went on to say, as Proposition II ' that the value of
By way of a conventional start, perhaps it would be worth our while to look at what "capital structure" actually means. In broad terms, it is essentially the firms ' mix of debt and equity but it would be wrong to assume that this is all there is to it. These two terms belie the complexity that lies beneath, from the viewpoint of the decisions that any firm must take - that is to say, what kind of debt and which type of equity. Capital structuring would then, deal with how a concern splits its cash flows into the relatively safe stream that goes to the debt holders, and the riskier stream that goes to the stock holders. The aim of any exercise within the purview of this is simple: find the combination that maximizes the firms ' market value.
It could first be argued that the firms ' value is not altered by the method by which it is split because the value is determined by its real assets, and not by the securities issued. This total separation of investment and financing implies that given a firm which uses a mix of debt-equity financing, its value will be exactly the same as it would have been had it opted for all equity financing. The aforesaid is the essence of what Modigliani and Miller showed as their Proposition I '. Thus, Modigliani and Miller, in their seminal work, espoused that in a perfect market the combinations of debt and equity are all at par in essence, the market value of any firm is capital structure independent. Here, the law of value conservation operates, wherein an asset value is preserved irrespective of the claims that might arise on it. This is precisely where the question of practicality presents itself, for if debt policy was of no consequence, then this fact cannot adequately explain actual debt ratios varying significantly across the board in various industries, be it airlines or banks.
Modigliani and Miller went on to say, as Proposition II ' that the value of
References: 1. http://www.mmtclimited.org/management.html 2. http://www.capitaline.com 3. http:// www.reachouthyderabad.com 4. The online edition of the Hindu Business Line for the month of February 2004