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.
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.
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 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
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…
It is always expected that the capital structures vary considerably across industries. And the optimal capital structure is also different for different industries. Many researchers and practitioners have come up a number theorise and some of them are explained in the following sections.
Capital Structure Decisions. Retrieved March 10, 2011, from Social Science Research Network: http://ssrn.com/abstract=396020 or doi:10.2139/ssrn.396020 This is the annotation of the above source, which is designed according to APA format and what this source says about Capital Structure Decisions is further discussed.
These sources are issuance of shares, debentures, long-term loans, plough-backs and short-term loans. Regardless of the source, the capital collected is invested in assets that differ in value and character. Even though capital needs to be viewed as whole, the concepts of “fund” and “assets” cannot be dismissed as they affect the valuation of the whole.
Investments are veiled with uncertainty of getting any returns or even retaining the initial investment capital. This is called risk. When choosing an investment, one must carefully evaluate changes in the risk factor.
Investors have to consider the amount of risk they can be ready to assume.
They also recommended that an ideal capital structure of a firm is with all debt with cheaper debt finance than higher cost & riskier equity but an optimal capital structure exists in which the terms of debt financing & such other real world problems of debt financing (like bankruptcy due to high debt) and tax savings of the debt financing are balancing factors (Modigliani and Miller.
The author states that evaluating the financial ratios of CVS shows that it has a debt-equity ratio of 28.4% which has impressively improved as compared to where it stood a year ago, i.e. 38.65% in 2005. This shows that CVS is not highly leveraged and comprises of a large proportion of equity in its capital structure.
The most important consideration is what form of capital structure would be most helpful in maximizing the firms value. This paper seeks to address the issue of what constitutes an optimal capital structure, and what
Respectively, I conjure that varied capital sources are typically based on different costs and thus, needed appropriate analysis for designing an optimal capital structure for raising required finance appropriately (Grundy, n.d.).
In businesses, sources of
A firm with more leverage may earn higher returns on average than a firm with less leverage, but the returns on the more leveraged firm will also be more volatile.
Breakeven analysis also known as cost-volume profit
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