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Optimal Capital Structure - Essay Example

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Optimal Capital Structure

3) The creditors are to be paid before the shareholders in the case of bankruptcy.
4) Small firms also face difficulty in raising debt since lenders seek security of their funds and look at the financial position and stability of the firm before issuing loans.
Since equity financing is done by issuing shares to the public, it also has some pros and cons. Below are some of the advantages and disadvantages of raising capital through equity.



Advantages:
1) Using more of equity financing raises the share price.
2) Small firms which struggle with cash flow initially use equity rather than debt because there is no obligation to repay the money.
3) Outside investors that become part owners of the company through the share issues, often prove to be a form of good advice and contact for small business owners.
Disadvantages:
1) The founders have to give some control of the business to the new shareholders who now also have a say in the business.
2) Some sales of the equity, such as Initial Public Offerings (IPOs) can be very difficult to administer.
3) If the investors have a different opinion as to how the business should be run or about the day-to-day operations, then this can create problems for the owners and conflicts can occur.
4) Dividends paid on stock are not tax deductible.
Following are some of the capital structure theories:
Modigliani and Miller's (MM) Theory: It states that there is no difference whether a firm raises capital through debt or equity and that it doesn't affect the value of the firm.
The Assumptions of this theory are:
No taxes
No cost of raising debt
No bankruptcy costs.
All investors have the same information as the management of the firm about future investment opportunities.
Trade-off Theory: Maximum debt can be raised when the...
If the firm needs to have the lowest WACC, it should design its capital structure in such a way that the debt equity ratio is high which would bring down the WACC.
The Optimal Capital Structure is that mix of debt and equity that maximizes the firm's value or minimizes the cost of capital. There is no standard mix of debt and equity that maximizes the firm's value, but each firm should strike a balance between risk and return thereby maximizing the share price, depending on its size and financial position.
1) If the firm size is small, it is difficult to make regular principal and interest payments in the event of shortages in generating substantial cash flow. Such firms face heavy fines and penalties by the creditors.
Trade-off Theory: Maximum debt can be raised when the share price is at its maximum. If the firm raises any more debt, the share price will decline. The point where share price is maximum, it is the trade-off point; risk and return are both at their peaks. Any change would cause a disbalance in the position of risk and return. The maximum risk involved is that of bankruptcy and the maximum return is the maximum value of the shares. Below is a graph that depicts the trade-off between risk and return.
Signaling Theory: This theory states that when the firm issues bonds fo ...Show more

Summary

Capital Structure is the mix of debt and equity that a firm uses to raise capital. Debt financing is done through obtaining loans and other forms of credit whereas equity financing is done by issuing shares. In debt financing, the creditors are to be paid before the shareholders in the event of bankruptcy whereas in equity financing, there is no direct obligation to repay the funds…
Author : zackerylynch
Optimal Capital Structure essay example
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