capital structure

capital structure

The term capital structure is used to refer the structure of the firm based on its capital mixture of the company’s equity, its debts and the companies financing in general. The most important point of studying or the application of the capital structure of the firm is to show the appropriate combinations that are crucial in the company’s equity and its debt. The primary purpose of this is to produce the best out of the measure of the market value of the firm and the capital of the company in general (De jong 2011, p1308). When it comes to pecking order theory, the explanations to the corporate finance show that every cost that is incurred in the firm is asymmetrically related to an inevitable increase in the financial information thereof.

Pecking order theory is based on the sources of the finance of any firm which are the equity, the company’s debts and the internal sources of funds (Brusov et al 2013, p99). The method is also referred to as the pecking order model and explains the necessity of a firm in adhering to the hierarchy of the sources of finance from the internal financing which should be the highest in terms of prevalence to the business’s debts and then the equity which is grouped to be an external finance tool and should be preferred the least according to the hierarchy (Leland 1994, p1238). The populists of the theory like Myers and Majluf even argue that equity, which investor oversee as a lower value when it comes to its issuance, should be overvalued in the sense that it can be used or else reflected in the firm choices of means of financing (Shyam-sunder & Myers 1999, p240).

When it comes to the tradeoff theory, is a capital structure that many companies use in determining or else in balancing the costs and the benefits of the debts and equity as a means of financing (Hovakimian et al 2002, p25). The classical hypothesis of this theory as done by Kraus and Lichtenberger shows that the theory is a way of considering the benefits that are saved on the firm’s debts and the bankruptcy that is associated with equity in general. Never the less it also shows that many companies prefer using the 50/50 way of financing their business that is through partly equity and slightly debts. Through the two theories, many scholars have been able to demonstrate how a firm can be able to create a safe structure in its capital especially one that does not have to affect the company’s capital (Frank & Goval 2003, p241). Through the literal light of evidence we can focus on the assumptions that the two theories have that shape the way firms make their capital structure the assumptions hereby include the overturn of risks I the industry, the absence of government influence especially through tax and subsidies, the asymmetric information provided on the company’s finance and the characteristics of the firm’s assets and their costs.

The two theories conceptualize the structure of the company’s capital and try to explain the importance of debt financing in a firm since there is no any risk-sharing when it comes to the servicing of the debts over equity which bears a lot of risks and which has a more residual claim in its servicing (Byoun & Rhim 2005, p14). Basically, the two theories provide firms with the necessary information to the structure of their finances for example, the pecking model shows that in the real world and light of empirical evidence from literature there should be a higher value in consideration of the debts and the issuance of equity should be the last option of capital structure (Rajan 1995, p1451). The capital structure depends on the management of all these choices about the market securities that are available in the industry market (Titman 1988, p17).

The theories explain the extent of how the financial decisions should be based on the managerial skills or knowledge that is applied for the supervision from the firms’ shareholders to be minimized.  According to much empirical research done by many researchers in the field, especially on the theories’ ability and their impacts on the capital decisions, the factors that affect capital structure have been made more understandable (Leland 1994, p1238). The principles help us in real life and enable every firm to determine their capacity of debts and the companies’ decision preference on the various methods of financing especially when they have a less significant level of borrowing.

In fact, the size of a firm is shown by the two theories as for the main variable which provides access to the company’s capital since it reflects on the various consequences for any sensible addition to the enterprise. Empirical support furnished by the many large corporations show that the investors who are a reflection of an increase in share prices have an impact on the levels of the accruals that are incurred by a firm (Baker 2002, p26).  However, in many businesses, the capital structure of the company is determined by the resolution that is foreseen in the company and its predominance in the existence of these two theories which is beneficial to the capital structure and the entire firm’s operational environment.