The equity finance is an expensive and exclusive method for raising capital in the business and it comprises of ordinary and preference shareholdings, bonds and floating market shares. It also includes a listing cost and legal paper work, potential shareholders and raises wider opportunity for pool of finance (Slee, 2011).
The difference in usage of appropriate financial capital structure is the selection of Leverage the business can be adhered to. It signifies the impact of debt in the company’s capital structure e.g. long-term bonds for 5 to 8 years and their impact on company’s profitability and earning stream (Khan et al., 2005). If the debt ratio is higher in good economic terms than it will also improve the required rate of return and return on equity of the business, similarly, if the debt ratio is higher in terms of recession than it creates a significance risk to the business operations and its sustainable future (Slee, 2011).
According to the conventional theory of Modigliani and Miller (1985), in a perfect world the mix of debt and equity does not matter when economic terms and corporate taxes are assumed to be constant. It also suggested that value of the firm is independent of the financial capital structures and overall operating cost (Cox, 2011). It further argued that if the benefit is obtained due to low cost debt then it could be offset against the cost of equity borrowing that will be considerably higher than the debt finance.
It also suggested that the cost of capital remains the same irrespective of the appropriate mix between debt and equity. It can be argued that value of the business and cost of capital will remain constant in a tax-free world e.g. United Arab Emirates (Slee, 2011). Debt financing is bind by obligations to pay interest and principal amounts and failure to meet the payment may result in serious risk to the business and in further case negative impact on the value of firm such as Bankruptcy (Khan et al., 2005). It can also be argued that as compared to the conventional theory if the business’s debt structure is higher than the equity portion, it might result in increased risk of higher interest payments and probable bankruptcy as well. It will also increase the cost of capital for the bondholders thus also indicating a highly geared business. It is suggested that to create an optimal mix of debt and equity structure, the margin level of gearing should be equal or does not outweigh the probability of bankruptcy cost to the business (Ross et al., 2004). There are various debts to equity and debt ratio for industries and their risk level incorporating their business. The volatile industries like steel, cement, energy might adhere to higher debt ratio as compared