Importance Of Capital Structure

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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
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Nevertheless in practice, many studies found that optimal capital structure is not achievable in many firms (Simerly and Mingfang, 2000). The reason being is because manager does not have the incentive to maximise their company’s performance. Plus managers do not share firm’s profits with …show more content…
There are two potential costs when firms are choosing external markets to raise capital. They are information asymmetry costs and transaction costs. These two costs are the reason why external capital cost more than internal capital which make the firm choose internal over the external.

Information asymmetry occurs when there is a split-up between ownership and management. Meaning managers know more about the firm value and at the same time would try to issue equity when the market value is high (Myers and Majluf, 1984). As a result from the information asymmetry between the managers and investors, equity might be under-priced. This will make equity as an expensive source of finance. However, retained earnings are not affected by any problems. Also, debt is less sensitive with this problem as it requires fixed payment of interest.

Transaction costs can resemble a firm’s sources of finance in a similar way. Baskin (1989) proved that costs for borrowing can be as low as 1% of the amount raised whereas the costs for issuing equity are anywhere between 4% and 15% of the total amount. Referring to this evidence, it clearly shows that debt is a preferred source of external financing over

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