Theory on Capital Structure Finance Essay

Theory on capital structure: Capital structure is the combination of debt and equity. Asymmetric information, tax benefits associated with debt use, bankruptcy cost and agency cost are some important theories that are used to explain the capital structure decisions. Bankruptcy costs are the cost obtained when the theoretical probability that the firm will default on funding is greater than zero. Bankruptcy cost could be both direct and indirect. Examples of direct bankruptcy costs are the approved and administrative costs in the bankruptcy process which are bankruptcy filing fees and court charges, accounting and other professional costs. Haugen and Senbet (1978) argued that if one assumes that capital market prices are competitively determined by reasonable investors then bankruptcy costs must be insignificant or unreal. Examples of indirect bankruptcy costs are the loss in earnings acquired by the firm as an outcome of the refusal of interested party to do business with them. Customer reliance on a firm's goods and services and the solvency of firms are affected by high probability of bankruptcy (Titman, 1984). Customers may be less willing to buy its goods and services from a firm that has financial difficulties due to the risk that the firm may not be able to meet its obligations. Bankruptcy is simply the transfer of ownership from one security holder to another. The theory is that bondholders are no less sensible than stockholders. For suppliers and customers it is inappropriate to assume that firm has disappeared as an entity if bondholders are in control. It is stress-free to terminate of firms that are or have been in agony and estimation that impending bankruptcy led to a reduction in product demand. Capital structure of the firm can also be explained in rapports of the tax benefits linked with the use of debt. Green, Murinde and Suppakitjarak (2002) identified that tax policy has a crucial effect on the capital structure decisions of firms. Corporate taxes accept firms to deduct interest on debt in computing taxable profits. This recommends that tax is imitative from debt would lead firms to be totally financed through debt. Capital structure is also known as the financial structure of a firm. Modigliani and Miller (1958) were among the first ones to meaningful the problem of capital structure and they claimed that capital structure was separated in determining the firm's value and its future performance. The value of the firm can be improved by the use of debt as interest expenses can be subtracted from taxable corporate income. But increase in debt results in an increased chance of bankruptcy. Hence, the finest capital structure signifies a level of leverage that stabilize bankruptcy costs and remunerations of debt finance. The bigger the probability of bankruptcy a firm outside as the outcome of increase in the cost of debt, the less debt they use in the issuance of new capital (Pettit and Singer, 1985). On the other hand, Lubatkin and Chatterjee (1994) as well as many other studies have proved that there exists a connection between capital structure and firm value. Modigliani and miller (1958) claimed that an 'optimal' capital structure occurs when the risk of going bankrupt is offset by the tax savings of debt. However, Brigham and Gapenski (1996) said that, in scheme the MM model is valid, but in practice, bankruptcy costs exist and these costs are directly comparative to the debt level of the firm. Capital structure increases the probabilities of financial distress and bankruptcy. Firms face costs of financial distress when they are incapable to pay debt. They will have high debt relations if these budgets are zero or minor (Scott, 1976; Kim, 1978). Since costs of financial distress are non-trivial, firm can actually go bankrupt, firms with high prospect of bankruptcy will have low debt ratio. The likelihoods of bankruptcy for firms with large reserve resources will be moderately less, but unlevered firms with high profitability and huge reserve funds would have great competitive advantage.

Model of bankruptcy

Bankruptcy and liquidation

Theoretically, a rise in debt level causes an increase in bankruptcy costs. Therefore, they argue that an optimal capital structure can merely be conquered if the tax sheltering welfares convey that an increase in debt level is equal to the bankruptcy costs. In this case, managers of the firms should be able to sort when this optimal capital structure is achieved and try to maintain it at the same level. Awareness about capital structures has frequently been derived from data from developed economies that have many institutional likenesses (Booth et al., 2001). It is essential to note that different countries have different institutional arrangements, principally with respect to their tax and bankruptcy codes, the present market for corporate control, and the roles banks and securities markets play. A similar argument can be made with respect to the tie between capital structure and liquidation recommended in a recent paper by Allen (1986). In his model, bankruptcy is exposed to bring a delay in investment by the firm that sets the firm at a strategic weakness that it likely to lead to liquidation in the end. Allen, however, openly assumes that stockholders are for some cause prohibited from repurchasing the debt at its current market value to avoid bankruptcy.

Bankruptcy and Asymmetric Information

Liquidation and bankruptcy decisions are made separable, however Webb claims that asymmetric information may, under positive circumstances, cause in the frequency of bankruptcy costs as a drain away from the firm. He considers two kinds of asymmetric information. First, indecision about the formal bankruptcy court settlement may lead to circumstances in which bankruptcy costs would not be concealed through informal settlement. Second, stockholders are expected to know the true going apprehension value of the firm qualified to its liquidation value, but bondholders are undefined unless a certification cost to a third party is incurred. The cost of verification is principally the bankruptcy cost, and it may be acquired depending on the bondholder's estimated gain from formal settlement would not eagerly liquidate the firm even if the liquidating value exceeds the going concern value. Therefore a debate has been put forward that the two asymmetric information cases reflected not to prime to the frequency of bankruptcy costs as a drain away from the parties to the firm.

Market solution to the problem of bankruptcy costs

Scientists begin by repeating their original market result to the bankruptcy cost problem. The bankruptcy cost can be escaped by amending the firm's capital structure to an ideal prior to the frequency of bankruptcy. This familiar reorganization of the capital structure can be accomplished in a number ways. The stockholders can repurchase the debt at its present market value. Alternatively, the bondholders can purchase the stock. Then strangers can purchase both the debt and equity the entire market value. With rational performance and unrestricted arbitrage, the charges of bankruptcy must be inadequate to the inferior of transaction costs earned through financial markets and the cost incurred through the court system. Once debt has been wholly eliminated, a new debt can be issued that takes advantage of the corporate tax subsidy

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