Such sustainable growth requires increasing investment in long term assets, which in turn needs to be financed by long term funds. The two conventional long term sources of fund are debt and equity. The proportion of such debt and equity determines the capital structure of the firm.
There are benefits and shortcomings of both the funding options. While debt funds are considered to be less costly owing to the interest tax shield that they provide, equity funds are considered to be more expensive owing to its inherent risk profile. Though debt funds reduce an organization's weighted average cost of capital (WACC), such funding increases the risk profile of the organization owing to long term commitments secured by asset collaterals, which could seriously increase the bankruptcy risk of the organization during an economic downturn.
The modern thinking on capital structure is primarily based on the seminal work done by Franco Modigliani and Merton Miller. The Modigliani-Miller theorem (1958) states that in an ideal world, the value of a firm is independent of its capital structure. When a firm increases its gearing ratio, the overall risk to the equity holders increase thus increasing the cost of equity, thereby having no net effect on the value of the firm. ...Show more