Theories of Capital Structure Essay

1163 Words5 Pages
2. Literature Review: Capital structure is termed as an important area in financial decision making. It has relationship with other variables of financial decisions. Capital structure is composed of debt and equity capital that is used by the organizations to run its operations. The debate on capital structure has been started after provision of theory of Irrelevance by Modigliani and Miller. Modigliani and Miller (1958) concluded that financial leverage has no affect the market value of firm. However the theory is based some assumptions that do not exist in the actual world. The assumptions are perfect capital markets, no taxes, homogenous expectations and no transaction costs. But the results may be different in presence of bankruptcy…show more content…
According to Abor (2005) ratio of short-term debt has a positive relation with total assets & return on equity and the ratio of long-term debt has a negative relationship with total assets and return on equity. As per the relationship between total debt and return rates, he is of the view that the ratio of total debt has positive relationship with total assets and return on equity. Has further argued their findings and stated that as there is a low interest rate on short-term debt, therefore, it results in more profitability. On the other end, long-term debts are relatively more expensive than short-term, hence consuming more proportions of long-term debt may cause low profitability. In case of the said findings based on the firms registered at Ghana Stock Exchange, a high proportion (85%) of the debt is represented in short-term debt. Shubita and Alsawalhah (2012) have extended the research work done by Abor and have find out the effect of capital structure on profitability by taking industrial companies of Amman Stock Exchange into consideration. Their findings reveal that there is significant negative relation between debt and profitability. They suggests that equity financing is preferred by the profitable firms In contrary to Abor, Chen et al (2009) has found that capital structure has a negative effect on profitability. They further
Open Document