A firm can choose a mix of three modes of financing i.e. issuing shares, borrowing from the market and use of retained earnings. The ratio of this mix of funds purely depends on the firm and known as optimal capital structure of the firm. This leads to the different capital structure theories. These theories explain their
2. to avoid the company dwindling away assets and further reducing any return to creditors.
United States, the courts look at whether there was an identity of interest between creditors and shareholders and the timing of the advances during the corporation’s organization. They test for a debtor-creditor relationship based off a enforceable obligation to pay a fixed amount of money. They look at the motivation of the taxpayer to see if the advances were made for ulterior tax purposes. If repayment was contingent upon the success of the company advances were made toward, it would be more than likely considered equity than loans. This case also adds that because no promises were made to repay at a fixed interest rate or certain time, and did not pay interest and gave no security for the advances made, the case sees the taxpayers as the sole shareholders gaining equity in the
Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the
You work in the corporate finance division of The Home Depot and your boss has asked you to review the firm’s capital structure. Specifically, your boss is considering changing the firm’s debt level.Your boss remembers something from his MBA program about capital structure being irrelevant, but isn’t quite sure what that means. You know that capital structure is irrelevant under the conditions of perfect markets and will demonstrate this point for your boss by showing that the weighted average cost of capital remains constant under various levels of debt. So, for now, suppose that capital markets are perfect as you prepare
The cost of debt (kd) rate of 13% was used after we assessed the key industrial financial ratios and compared them with that of Wrigley’s (See Appendix 2) to conclude that it was in the range between the BB rate of
Tax rate of the company will influence in making capital structure decisions. The debt payments to the debtors are tax deductible. This would be the advantage for the company which has high tax rate. So, if the company has the high tax rate, they will tend to use debt capital structure to decrease their tax amount.
In above case there might be companies that are healthy and many go through period of financial distress. In particular is the threat of not being able to meet debt obligations.
A substitution of risks that investors may undergo in order to move from overpriced shares in highly levered firms to those in unlevered firms by borrowing in personal accounts; corporate leverage through purchasing and financing options;
The capitalization ratio compares the debt portion of the company’s capital structure and the equity part and is expressed in percentage terms. While evaluating company, keep in mind that a lower percentage means a healthy equity and is more desirable.
If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.
Now, the advantages of debt capital centre on its relative cost. Debt capital is usually cheaper than equity because, the pre-tax rate of interest is invariably lower than the return required by shareholders. This is due to the legal position of lenders who have a prior claim on the distribution of the company’s income and who in liquidation precede ordinary shareholders in the queue for the settlement of claims. Debt is usually secured on the firm’s assets, which can be sold to pay off lenders in the event of default, i.e. failure to pay interest and capital according to the pre-agreed schedule;
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
Bhaduri (2002) studied the capital structure choice in developing countries through a case study of Indian corporate sector, for the period 1989-90 to 1994-95, based on a sample of 363 firms across nine industries. The author has reported optimal capital structure choice is influenced by factors such as growth, cash flow size and product industry and characteristics.
Credit risk is the possibility that the actual return on an investment or loan extended will deviate from that, which was expected (Conford, 2000). Coyle (2000) defines credit risk as losses from the refusal or inability of credit customers to pay what is owed in full and on time. The main sources of credit risk include, limited institutional capacity, inappropriate credit policies, volatile interest rates, poor management, inappropriate laws, low capital and liquidity levels, directed lending, massive licensing of banks, poor loan underwriting, reckless lending, poor credit assessment., no non-executive directors, poor loan underwriting, laxity in credit assessment, poor lending practices, government interference and inadequate supervision by the central bank. To minimize these risks, it is necessary for the