An overview kennedy prince modugu department of accounting faculty of management sciences university of benin nigeria abstract capital structure decision poses a lot of challenges to firms. It is very important for the financial manager to determine the proper mix of debt and equity for his firm. The major contending theories of capital structure as well as their predictions are considered. Moreover, most of the empirical research in this area has been largely confined to developed economies. The capital structure must be so simple to manage and easily understandable to the interested parties. Debt comes in the form of bond issues or longterm notes. Capital structure theories the debate on optimal capital structure that leads to maximum market valuation and minimum cost of capital is perennial. Capital structure meaning and factors determining capital structure. In addition to this, the firm should employ debt to such a level that does not harm the firms solvency. Shareholders equity is provided as a discrete line item on the balance sheet. Use of financial leverage in corporate capital structure. Capital structure planning, which aims at the maximisation of profits and the wealth of the shareholders, ensures the maximum value of a firm or the minimum cost of capital.
The traditional school, at one extreme, argues that there is an optimum capital structure at. Therefore, it is hypothesized that such firms are likely to have a preference for equity in their capital structure. Pdf factors determining capital structure and corporate. We summarize how well the traditional tradeoff and pecking order approaches explain these sources of variation and highlight their empirical shortcomings. How to find capital structure using the balance sheet. Chapter iii concepts and theories of capital structure and profitability. Pdf capital structure is still a puzzle among finance scholars. This study focuses on the factors that determine the capital structure for dutch companies.
Factors affecting the capital structure of a company. Meaning and definition of optimal capital structure. A companys capital structure refers to how it finances its operations and growth with different sources of funds, such as bond issues, longterm. This method incorporates a risk premium for variability in a companys return stocks with greater variability in return have higher risk premiums. Factors affecting capital structure of a firm capital. Empirical evidence from kuwait ahmad mohammad obeid gharaibeh assistant professor, dept. Capital structure decisions are affected by many factors and as youll see determining optimal capital structure is not an exact science. In section 1 the most prominent theoretical and empirical findings are surveyed. Important factors in determining the capital structure of. Second, the theory has identified a relatively small number of general principles. In this article you can find complete details for capital structure like meaning of capital structure, capital structure gearing, details for highly geared companies, low geared companies, size of a company, condition of economy, condition of sales, legal provisions etc.
Determining an appropriate mix of equity and debt is one of the most strategic decisions public interest entities are confronted. Theoretical considerations a firm could use three methods to determine its capital structure. The determinants of the capital structure of listed on stock. Making capital structure support strategy the issue is more nuanced than some pundits suggest. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to finance its core operations through equity. The optimal capital structure indicates the best debttoequity ratio for a firm that maximizes its value. However, determining an optimal capital structure, which in turn, is. So, even companies in the same industry can have significantly different structures of capital. Calculate the effect on firm value and stock price. The vast majority of previous empirical works analyses the capital structure of firms in economies with highly developed stock markets. Obligation to pay interest and principal lien against the assets of the company right to force bankruptcy preferred stock hybrid equitydebt. We begin by documenting three dimensions of capital structure variation.
Optimum capital structure and cost of capital n if the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized. Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity financing to use for operations and expansions. Based on this article, researchers have tried to investigate how different capital market imperfections affect the capital structure of a company. The study of capital structure attempts to explain how listed firms utilise the mix of various forms of securities in order to finance investment.
Accordingly, it is aimed to test the factors that determine the capital structure in lowcost airlines in the context of capital structure. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debttoequity ranges thus minimizing the firms cost of capital. To truly understand the idea of capital structure, the dupont model provides insight into how capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Capital structure, as its name itself signifies, is the composition of the capital employed by the firm from various sources of finance. Factors affecting the capital structure the dependent variable are. The data was taken from secondary data source named as industry.
A practical contemporary approach 1 introduction astute financial managers agree that investment in assets and managing operations create the greatest opportunities for profitseeking companies to maximize shareholders wealth. Important factors in determining the capital structure of a company. The capital structure involves decisions like type. Making capital structure support strategy mckinsey. Does corporate performance determine capital structure and. Capital structure meaning, gearing, factors for determining. Determinants of capital structure mba knowledge base. The theory of capital structure 299 tion of the relationships among similar models. Several properties of the debt contract have important implications for determining capital structure. The final method for determining the cost of internal equity is the capitalassetpricing method.
This article throws light upon the top seventeen factors determining the capital structure. Use of debt vs equity how much of each as sources of financial capital. Firms with more liquid stocks benefit from lower costs of equity issuance. The capital structure claims on a companys assets and income bonds and loans debt. An optimal capital structure is the best debttoequity ratio for a firm that maximizes its value. A read is counted each time someone views a publication summary such as the title, abstract, and list of authors, clicks on a figure, or views or downloads the fulltext. The optimal capital structure should ensure companies retain sufficient capital levels. The study extends empirical work on capital structure theory in three ways. Type of securities to be issued are equity shares, preference shares and long term borrowings debentures. Expressed as a formula, capital structure equals debt. The optimal capital structure for a company is one that offers a. Exhibit 2 different capital structures for different. The final method for determining the cost of internal equity is the capital assetpricing method. In section 2 the potential determinants of capital structure are summarized and theoretical and empirical evidence concerning these determinants is provided.
Factors determining capital structure and corporate performance in india. Capital structure how investment asset ownership is financed. Capital structure chapter 15 and chapter 16 contents i. The results revealed that the use of debt financing by sri lankan firm is significantly low and this is largely due to the use of less long term debt. Capital structure and its 4 important theories ni, noi. Normally, a firm raises long term capital through the issues of common shares, sometimes accompanied by preference shares.
Introduction capital is a critical resource for all firms, the supply of which is uncertain. Meaning of capital structure capital structure represents the relationship among different kinds of long term capital. Important factors in determining the capital structure of a. This article empirically investigates the relationship between liquidity and capital structure decisions on a sample of indian firms. This article empirically investigates the factors determining capital structure of textile industry in indian context. Molina 1 argue that differences in technology lead to different capital structures. Therefore, once you have obtained total debt, you can easily calculate debttoequity or debttoinvested capital. Capital structure meaning and factors determining capital. Capital structure while deciding the capital structure of the company the promoters will have to decide the proportion of capital to be raised by issue of shares and debentures. The theory of trade off was developed by kraus and litzenberger 1973 arguing that the companies choose their optimal capital structure by by evaluating the revenue and costs, debt. Capital structure ratios tend to fall within a narrow range within industries. Working capital reveals a great deal about the financial condition. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm.
The capital structure is how a firm finances its overall operations and growth by using different sources of funds. How to calculate working capital on the balance sheet. Traditionally this question has focused on publiclytraded corporations, but much real estate investment is made more directly, not through publiclytraded companies. The theory of capital structure harris 1991 the journal. The structure is typically expressed as a debttoequity or debttocapital ratio. Analysis of capital structure is relevant to understanding the level of risk which a business has. Lets take a look on how capital structure influences the risk of its components and briefly explain factors.
Until now a lot of research has been conducted in different countries to find the determinants of the capital structure for a company. The theory and practice of corporate capital structure january 2006 2 liability strategies group executive summary this paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. Capital structure refers to the mix of debt and equity financing a company uses to fund its operations. Having said this, the dilemma in capital structure theory has been to determine to what extent debt can be employed in order to offset tax implications to the extent that the 29 risk of excessive debt is avoided. Capital structure is a permanent type of funding that supports a companys growth and related assets.
One of the major reasons behind an investors desire to analyze a companys balance sheet is that doing so lets them discover the companys working capital or current position. Find capital structure definition and factors to be considered in its formulation process. Capital structure is referred to as the ratio of different kinds of securities raised by a firm as longterm finance. It is synonymously used as financial leverage or financing mix. The capital structure involves two decisionstype of securities to be issued are equity shares, preference shares and long term borrowings debentures. It is demonstrated that there are reliably important firm level attributes that determine the. Whether you own a donut shop or are considering investing in publiclytraded stocks, its the knowledge you simply musthave if you want to. Factors determining capital structure and corporate. Analyzing a companys capital structure investopedia.
Pdf determinants of capital structure of indian textile. The two dominant capital structure theories are the static tradeoff theory and the pecking order theory. Given these dynamics, it can be hypothesized that inflation causes firms to modify their capital structures. The empirical results shows that the variables of size, growth. The empirical work so far has not, however, sorted out which of these are important in various contexts. We have identified four categories of determinants of capital structure. Panel data regression is employed to determine the effect of capital structure on. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per. It should be noted that shareholders are paid dividend out of profit so they bear the risk involved in carrying out the business activities. Capital structure is the proportion of all types of capital viz. It is the employment of an asset source of finance for which. The capital structure is how a firm finances its operations and growth by using. Capital structure, a reading prepared by pamela peterson drake 4. Capital structure is still a puzzle among finance scholars.
The cost of capital approach value of a firm present value of cash flows to the firm, discounted back at the cost of capital. The extant literature on capital structure and corporate performance investigates the two in the absence of change in the macroeconomic environment and changing macroeconomic policies set by the regulator. The capital structure of the firm represents its investment and financing strategy. We can measure the risk associated with each alternative by calculating the standard deviation of the possible. Capital structure refers to the amount of debt andor equity employed by a firm to fund its operations and finance its assets. Capital structure is a statement of the way in which a companys assets are financed. Debt and equity capital are used to fund a business operations, capital expenditures, acquisitions. The determinants of capital structure choice sheridan titman and roberto wessels abstract this paper analyzes the explanatory power of some of the recent theories of optimal capital structure. Watch this short video to quickly understand the main concepts covered in this guide, including the definition of capital structure, what is the optimal capital structure, and the calculation of the weighted average cost of capital wacc.
Hence, it should be borrowed as per the firms potential to pay. Managers, therefore, use industry capital structure ratios as a guide for optimizing their own companys capital structures. The purpose of this study is to identify the factors that determine the capital structure of lowcost airlines. Pdf corporate capital structure remains a controversial issue in modern corporate finance. Bahadur institute of management sciences, university of mysore, india available online at. Factors that determine the capital structure among micro. Modigliani and miller proposed that capital structure is irrelevant when there are no taxes and that 100% debt is the optimal capital structure when there are taxes. May 09, 2019 view 3a1 capital structure meaning and factors determining capital structure. The capital structure decision aswath damodaran stern school of business. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to.
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