Capital Structure

Capital Structure - Introduction A situation can occur when...

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Introduction A situation can occur when one party in a transaction has more or superior information as compared to another. This is often the case in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation since one party can take advantage of the other party’s lack of knowledge. With increased advancements in technology, asymmetric information has been on the decline as a result of more and more people being able to easily access all types of information. (Berk/DeMarzo, 2011) “The firm`s shares and debt are priced according their true underling value. These assumptions may not always be accurate in practice. Manager`s information about the firm and its future cash flow is likely to be superior to that outside investors, There is asymmetric information between manager and investors” (Berk/DeMarzo, 2011, p 533). “Capital structure refers to the way a corporation finances its assets through some combination of equity , debt , or securities . A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage ”. (Capital Structure, 2011) Companies face the challenge of determining whether to issue debt or equity for financing needs. Issuance of debt or equity both has advantages and disadvantages. Advantages of Issuing Debt Issuance of debt has a tax benefit because of the debt tax shield. The interest payments to debt owners are expensed, causing a reduction taxable income. A company with a higher tax rate thus has a higher tax benefit from debt issuance.
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Some assert that debt adds discipline to management because interest expenses cause lower left over cash flows, which makes management more likely to be efficient and non- complacent. Also, future debt obligations can be easily forecasted and planned for. Disadvantages of Debt Debt issuance increases bankruptcy risk because debt owners can take control of the company if interest payments are not made. Debt owners have different wants than stockholders.
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Capital Structure - Introduction A situation can occur when...

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