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Determinants of a Company's Capital Structure

In: Business and Management

Submitted By aakankkha
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Financing and investment are two major decision areas in a firm. In the financing decision the manager is concerned with determining the best financing mix or capital structure for his firm. Capital structure could have two effects. First, firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier, being valued lower than less leveraged firms. If we consider that the manager of a firm has the shareholders' wealth maximisation as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximises the market price per share of the firm.

Capital structure has been a major issue in financial economics ever since Modigliani and Miller (henceforth referred to as MM) showed in 1958 that given frictionless markets, homogeneous expectations, etc., the capital structure decision of the firm is irrelevant. This conclusion depends entirely on the assumptions made. By relaxing the assumptions and analysing their effects, theory seeks to determine whether an optimal capital structure exists or not, and if so what could possibly be its determinants. If capital structure is not irrelevant, then there is also another thing to consider: the interaction between financing and investment. But in order to try to distinguish the effects of various determinants on capital structure, it is assumed in this paper that the investment decision is held constant.

II. TRADITIONAL VIEW OF CAPITAL STRUCTURE

In 1959, Durand listed the alternative approaches to valuation (Van Horne, 1990:321). Let kd represent the yield on debt, ke the yield on equity, and ko the WACC (weighted average cost of capital). Let kd be less than ke. Then, according to the traditional approach, ke constantly increases...

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