Capital Structure is a mix of debt and equity capital maintained by a firm

Capital Structure is a mix of debt and equity capital maintained by a firm

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Mini Case in Chapter 15 on pages 637-638 Mitchell Jones Devry University Capital Structure is a combination of debt and equity capital sustained by a firm. Capital structure is also referred as financial structure of a firm. The capital structure of a firm is very important since it’s interrelated to the capability of the firm to meet the needs of its stakeholders. Modigliani and Miller were the paramount ones to landmark the subject of capital structure and they debated that capital structure was irrelevant in defining the firm’s worth and its future performance. Alternatively, many other readings have demonstrated that there exists a connection between capital structure and firm value. Modigliani and Miller demonstrated that their model is no more of use if tax was taken into thought since tax subsidies on debt interest payments will affect a rise in firm value once equity is traded for debt.
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In other latest literatures, authors have exposed that there are fewer alarmed on how capital structure setback the firm value. As an alternative they place more importance on how capital structure influences on the ownership/governance structure, thereby, impelling top management of the firms to make strategic decisions. Their choices will in turn influence the overall performance of the firm. In this day and age, the main issue for capital structure is how to resolve the conflict on the firms’ resources between managers and owners. This paper is review of literature on the various theories related to capital structure and ownership structure of firms cash flow. Capital structure is a very strategic decision for firms, therefore they can maximize returns to their various stakeholders. Furthermore, a suitable capital structure is also essential to a firm as it will benefit in dealing with the competitive environment within which the firm operates. Modigliani and Miller debated that an ‘optimal’ capital structure occurs when the risks of going bankrupt is offset by the tax savings of debt. As soon as this optimal capital structure is established, a firm would be able to maximize returns to its stakeholders and these returns would be higher than returns obtained from a firm whose capital is made up of equity only. It can be argued that leverage is used to discipline mangers but it can lead to the demise of the firm. Modigliani and Miller argued that the capital structure of a firm should compose entirely of debt due to tax deductions on interest payments. However, Brigham and Gapenski (1996) said that, in theory, the Modigliani-Miller (MM) model is valid. But, in practice, bankruptcy costs exist and these costs are directly proportional to the debt level of the firm. Hence, an increase in debt level causes an increase in bankruptcy costs. Therefore, they argue that that an optimal
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This note was uploaded on 10/27/2011 for the course ECON 102 taught by Professor J.hester during the Spring '11 term at DeVry Austin.

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Capital Structure is a mix of debt and equity capital maintained by a firm

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