Capital Structure

Paper Summary:

This paper presents an overview of several different theories of corporate capital structure, focusing particularly on the differences between the traditionalist view of capital structure and the Modigliani-Miller view. The paper points out that there are two major differences between the traditionalist view of corporate capital structure and the Modigliani-Miller view, explaining that the first difference lay in the traditional view's contention that the value and cost of capital of a firm is interrelated to its capital structure, whereas the Modigliani-Miller view contends that they are independent of each other. The paper next explains that the second major difference is that the Modigliani-Miller view indicates a linear relationship between shareholder rate of return and firm leverage, which means that at low levels of debt the cost of equity increases faster under the Modigliani-Miller theorem than it does under the traditional View. The paper also takes a look at several other modern theories of corporate capital structure and investigates how these theories differ from the Modigliani-Miller view.

From the Paper:

"Generally the capital structure of a company is much influenced by the practical influences like managerial shareholdings, corporate strategy and taxation. The investment strategy by firms necessitates managers to explore the methods of financing new investment. The managers practice three main preferences: utilization of retained earnings, borrowing through debt instruments or issue of new shares. Thus the retained earnings, debt and equity constitute the three primary ingredients of the capital structure of the firm. The first two ingredients show ownership by shareholders and the second ingredient shows ownership by means of debt holders. The financing policy, capital structure and firms ownership are inextricably linked in representing the ways the economic agents form and alter their asset acquisition behavior via firms and capital markets and impact their income levels and returns to asset holdings in the form of capital gains, dividends or direct remuneration,. (Company Financing, Capital Structure, and Ownership: A Survey and Implications for Developing Economies)"

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