5.5 Capital Structure Analysis (pg-53)
A firm’s capital structure primarily comprises of two components, the Debt and the equity.
Debt: A sum of money that is owed or due. Whatever a company has on its own, money, goods, services & other liabilities of the company which are due all comes in this heading Debts.
Equity: The value of Share issued by a company. It is commonly referred as the ordinary share, partial ownership, maximum entrepreneurial risk associated with the company. These shareholders have voting rights.
The company’s capital structure- It is the blend of equity & debt financing, it’s a significant factor to valuate business.
The overall valuation of the firm is a function of these two components of capital structure. The decision…show more content… According to the arguments of Modigliani & Miller, valuation of a company can be improved if they are able to maximize their debt & borrow at lower rates of interest than the dividend payouts of their investors in the equities.
(pg. 54)
Given that interest rates on debt financing are tax deductible, from their perspective the optimum Capital Structure is the one having debt only. However, Stiglitz proved that if debt is traded in separate market where investors are more pessimistic about the firm that the equity holder and the imply their own terms of lending than the overall value of firm decreases on increase of debt.
Kocher (1996) related agency theory to capital structure and argued that agency costs keep a control on the capital structure. If a firm is completely financed by debt and controlled by shareholders, they will tend to take higher risks given lower liabilities for maximization of their wealth and hence even may risk the net present value becoming…show more content… O’Brien (2003. Pp420) proved an empirical generalization that firms having higher emphasis on innovations (R & D investments) possess lower debt to equity ratios. This is because Research & Development creates substantial amount of intangible assets that cannot serve as an effective collateral in debt financing and hence do not support high levels of debt. Their research proved that all listed companies investing heavily in R & D tend to be more equity financed than debt