Factors in Capital Structuring

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1. Introduction The structuring of corporate finance is an issue of vital importance for all companies engaged in business. These companies require capital to start and run their businesses and while they are primarily guided in their decisions by financial and profit objectives, they also remain constrained by the uncertain risks which arise from remaining in the marketplace. Companies are financed by three avenues, equity funds provided by shareholders, internal profit generation and debt funds provided by outside lenders.

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Funding by way of equity and debt consists of different alternatives, for example equity funding could come from the promoters, or from sale of authorised stock to the public, to individual large investors like Venture Capital companies, Mutual Funds or to other high net worth investors. Similarly debt can be raised in many ways, e.g. through loans, debentures, bonds and other debt instruments from various lending sources. In the case of funding through internal accruals, very obviously this avenue is not available at the commencement of business. For profitable companies it is dependent, apart from the quantum of accruals, upon their dividend payout and earning retention policies. Debt, being in the nature of outside funds that necessarily need repayment, carries with it, elements of risk of default, bankruptcy and asset seizure. These have to be accordingly weighed while deciding upon its quantum. On the other hand debt funds also have the attraction of availability, low interest costs and tax deductibility with consequent positive effects upon company profitability. Equity funds, while being limited in some cases are theoretically safe, do not have to be repaid and do not entail a compulsory interest load. In actual fact shareholders expect much higher returns than lenders.

They can also destabilise ownership patterns and effect changes in ownership and management. Furthermore, they need to be paid out of tax deducted residual profits, thus imposing a charge on corporate profits, which is much higher than the cost of servicing debt. This dilemma is further compounded by practical considerations like access to equity and debt fund as well as objectives of the shareholders, the corporate managements who are the agents of the shareholders, and the debt holders. As such, despite progress in theories of corporate finance during the last twenty odd years, our understanding of the issue remains largely incomplete and continues to be shaped by newer thought on various issues including the effect of various levels of gearing on corporate efficiency, information asymmetry and costs of agency. It is the objective of this essay to study the various theories of corporate finance that govern capital structuring, the interplay of corporate management objectives and the effect of various other factors that determine decision making in the area. 2. Commentary Four major theories, the Modigliani-Miller model, the trade-off theory, the pecking order approach and the effects of symmetric information and agency costs comprise current thought on capital structuring.

These theories are not mutually exclusive. Most companies are influenced by interplay of different facets of these theories resulting in a hybridised financing structure wherein different theories overlap and influence the final decision. The Modigliani-Miller approach is widely accepted as the theoretical base for the development of theories in capital structure. Developed in 1961 by Modigliani and Miller, it states that in a situation free of taxes, bankruptcy costs and asymmetric information, and in an environment of efficient markets, the value of a firm is independent of its mode of financing. It states that the market value of a firm is determined by its earning power and the risk of its underlying assets, and as such, is independent of the route chosen to finance investments or distribute dividends. The argument is uncomplicated.

The theorem states that if the total cash flows a company earns are the same regardless of its capital structure, changing of structure will not affect cash flows. The total value of assets that provide ownership to these cash flows will also not change. While it is obvious that the assumptions of the MM theory regarding taxes, bankruptcy costs and asymmetric information are not possible in actuality, the theory becomes all the more relevant by inferring that disturbance of assumptions will necessarily lead to situations where capital structuring will depend upon debt and equity components in financing companies. In the years that have passed since the emergence of MM theory, while research into the reasons behind capital structuring decisions have led to a great amount of literature, much of the questions still remain. According to the trade off theory, the decision to limit debt to a certain level of total capital employed is a simple function of the firm to trade off the risks of profiting from higher debt and the consequences of default and bankruptcy. Capital structuring, as per this theory is thus ruled by trade offs between the tax shield provided by debt and the financial distress costs of bankruptcy.

This will vary from firm to firm because while costs of financial distress will vary with the type of the asset, the benefit of the tax shield will change with the extent of profitability. At the optimal debt level the marginal benefit of the tax shield will equal the marginal cost of financial distress. The trade off theory does appear to provide some answers to the rationale behind capital structuring; its logic explains the differences in capital structure across industries with different profitability parameters and asset profiles. The trade-off theory, while logical, falls short of explaining the apparent unpredictability behind corporate financial structuring. It is unable, for example, to describe why profitable firms constantly underutilise debt. Some analysts have thought of this apparent shying away from debt, owing to fears of bankruptcy, to unnecessary conservatism that could cause harm to the company. The consensus view underlying this vast literature is that bankruptcy costs alone are too small to offset the value of tax shields and. thus, other factors, such as agency costs, must be introduced into the cost-benefit analysis to explain observed capital structures. Miller ((1977). p. 264) memorably characterizes the discrepancy by comparing the trade-off between tax gains and bankruptcy costs as “like the recipe for the fabled horse-and rabbit stew—one horse and one rabbit.” (Ju, Parrino, Poteshman and Weisbach, 2005) A significant number of firms follow a financing structure that is inconsistent with the trade off theory, and use significantly lower levels of debt than their target debt level.

Under leveraging results in underutilization of tax shields and there does not appear to be a valid answer to the reasons “whether observed capital structures represent a value maximizing choice or whether firms throw away value by substantially under leveraging their assets.” (Perrino, Poteshman and Weisbach, 2005) The use of the Pecking Order theory, the impact of asymmetric information and that of agency costs possibly provide the answers to these apparent incongruities. The Pecking Order theory stipulates that asymmetry in information availability exists between internal management represented by CEOs and external shareholders, i.e. corporate managements generally hold significant information unavailable to external shareholders and are thus often able to take decisions affecting the choice of internal and external funds that are seemingly at odds with corporate objectives. In the Pecking Order, profitable companies first look for internal funds, obtained from retained earnings, to finance investments. Companies are reluctant to go to the market to look for borrowings even though their managements have full confidence in debt servicing ability, because of apprehensions of giving out wrong signals to the market and the possible undermining of their own position. This obviously has an effect on dividend policy and the tailoring of dividend payout to meet investment is common practice. In case of requirement of further funds, managements, who for all practical purposes are the agents of the stockholders, resort to debt instruments that send the least adverse signals to the stock market. The third and final choice for finance finally falls on the issue of further stock. In many cases, managements try to increase financial slack by increasing retained earnings, avoiding available debt, and smoothing dividend payouts.

Financial slack is valuable and Debt Equity ratios respond mainly to changes in imbalances between funds retained after dividend payouts and investment opportunities. The use of interest tax shields and raising debt to maximize value thus becomes secondary.

The Pecking Order theory implies that retained funds stay at the top of the preferred financing heap and external equity remains the last choice. The choice of debt comes up not in order to increase value but because of exhaustion of internal funds. 3. Conclusion Capital structuring depends upon a number of factors and is not as complex an issue as it appears to be. Modes of capital structuring primarily depend upon availability of capital. Start up corporations as well companies with weak profitability or irregular cash flows are often constrained by unavailability of external equity as well as of debt. These companies have to perforce manage with internal accruals and loans from the unorganized sector until their financial credibility becomes strong enough to attract external equity and debt. In the case of profitable companies that are able to access debt, maximization of firm value vis-A -vis capital structuring requires the incorporation of debt until the achievement of a target debt figure, which in turn represents the optimum balance between the financial benefit of the interest tax shield and the cost of financial distress, because of bankruptcy.

While this logic applies to capital structuring decisions in many companies, decision making in a number of firms also works on the Pecking Order theory, enabled by asymmetric information availability and the occurrence of agency costs. Managements of such companies, which are distinct from stockholders, tend to use their position to use funds from retained earnings for investment decisions due to their own considerations. Their desire not to create ripples in the outside market leads them to treat debt as a second choice. The benefits of the tax shield are not inducement enough to overrule their desire to create financial slack and keep buffers that would enable them to operate with some element of comfort. While this attitude is possibly inevitable to a certain extent, it becomes a matter of concern when it acts as a precursor to other decisions and becomes an indicator of the management’s decision to place their own interests before that of the stockholders. Bibliography Brown, C. M. 2005, Borrowing from Dad: Financing from Relatives and Friends Has Risks and Rewards. Black Enterprise, 35, 44. Chew, D. H. (Ed.). 1986,. Six Roundtable Discussions of Corporate Finance with Joel Stern.

New York: Quorum Books. Ju, N, Parrino, R, Poteshman, A, Weisbach, M, 2005, Horses and rabbits? Trade-off theory and optimal capital structure, Journal of Financial and Quantitative Analysis, Vol. 40, No.2, University of Washington Mansi, S. A., & Reeb, D. M.,2002, Corporate International Activity and Debt Financing. Journal of International Business Studies, 33(1), 129+. Read, L. 1998, The Financing of Small Business: A Comparative Study of Male and Female Business Owners. London: Routledge. Roe, M. J. ,1994, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance. Princeton, NJ: Princeton University Press.

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Factors in capital structuring. (2017, Jun 26). Retrieved January 30, 2023 , from

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