Capital Structure and Performance of UK Financial Institutions - Dissertation Example

Download file to see previous pages In firm debt holders and equity holders are the two types of investors who invest in equity and debt issued by the firm. Equity and Debt differ from each other in their level of risk, return and control associated with each investment. Debt holders earn affixed rates of return, are protected by the contractual obligations made with respect to their investment, are less exposed to risk, but do not enjoy control over the company. Whereas equity holders are more exposed to risk, their returns fluctuate as per profits earned, are not protected, but enjoy control over the firm. Thus, an investor before making an investment must be conscious of the choice of appropriate financing streams and examine strategy and strategic outcomes.

Thus, the theory of capital structure addresses those sources of finance, that a business organization avails to raise funds required for continuing operations. Capital Structure includes a line of credit, equity sales, accounts payable, retained earnings, bank loans, bonds, and some other interest-bearing debts. The theory of capital structure originated from the research of Miller and Modigliani (1958), where it was examined that in certain situations the choice of debt or equity does not affect the value of the firm, thus the capital structure is not affected, but with tax-deductible interest payment capital, structure and firm value are positively related. Thus this theory pointed to the direction which the capital structure must take in relevance to the situation. Titman in 2001 found fundamental conditions which hold the M&M proposal as the perfect market assumption with no transaction cost, no taxes, and no bankruptcy cost. Thus, the M&M proposal became a subject of considerable debate both for theoretical and empirical research.

The agency cost theory is premised on the idea that the concern of the company’s manager and its shareholders is not perfectly associated. Meckling and Jensen (1976) emphasized the significance of agency cost of equity in corporate finance arising as a result of the separation of control and ownership of firms, whereby managers aim to maximize their own benefit rather than the value of the firm. Agency costs can also result from the conflicts between debt and equity investors which arise due to the risk of default. The default risk may also arise due to debt overhang or underinvestment issues, which might adversely affect the value of the firm. This effect on the firm’s performance due to a change in its value affects the choice of capital structure.

Bonaccorsi di Patti and Berger (2006) specified that efficient firms earn higher returns from their capital structure; the higher returns earned act as a cushion against portfolio risk so that the firms acquire a better position where they can substitute equity for debt in the capital structure.

After the publication of M&M proposals, many scholars have made their contributions so as to establish their theory, and in doing so have resolved basic financing decision problems regarding the effect of appropriate financing mix on a firm’s performance, optimal capital structure for an individual firm, and conditions relevant to the choice of capital. Miller in 1997 added personal tax to the analysis and found that usage of optimal debt occurs on a macro level but not on a firm level and deductibility of interest at the firm level is offset at the investors level. ...Download file to see next pages Read More