Capital Structure For A Business Organization Essay

1225 Words May 10th, 2015 null Page
To begin with, it is a vital role in determining the most appropriate capital structure for a business organization. One of the main reasons is to maximize shareholder wealth which has been the main priority. Besides that, the decision made on the type of capital structure to be applied can also impact the company itself in dealing with its competitive environment. Based on Modigliani and Miller (1958), optimal capital structure exists when risk of bankruptcy is balanced with the savings of debt. With this method, stockholder will be receiving greater returns compared to an all-equity firm.

The use of debt in a company to obtain financial gain which is considered as an ‘easy way out’ may lead to bankruptcy for the company itself. Modigliani and Miller (1963) stated that capital structure of a firm with entirely of debt is the most appropriate since there is tax deductibility of interest payments. However Brigham and Gapenski (1996) said that Miller and Modigliani (MM) is true in theory but in practice, bankruptcy cost does exist. Bankruptcy costs increase when more debt is taken into account. Hence, they argue on an optimal capital structure that is reached when the marginal cost of bankruptcy is equal to the marginal benefit from tax-sheltering provided by the increase in the debt ratio. The responsibility of the manager is to determine when OCS is obtained and to retain it. By doing so, the weighted average cost of capital (WACC) will be minimised together with the…

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