Capital Structure Analysis (Pg-53)

5.5 Capital Structure Analysis (pg-53)

A firm’s capital structure primarily comprises of two components, the Debt and the equity. The overall valuation of the firm is a function of these two components of capital structure. The decision of how much a firm should be financed by debt or equities is very complex whereby an optimal choice depends upon many factors specific to the internal and external environment of the firm. The overall value of the firm is defined by Ross, as the sum of the overall market value of equities and the overall market value of debt. Most companies have maximum of shareholder wealth as one of their primary goals. To achieve this, the firm management tries to decide on the most appropriate debt to equity ratio such

From his perspective, a practical generalized model of optimal capital structure may not be feasible; however, existence of more equity may indicate more power to the managers as they tend to use debts more for contingencies during crisis situation to mitigate solvency risks. In a recent theory Brav (2009) added a new dimension to debt-equity optimization proving that the sensitivity of the controllers of the firm defines how much they allow equity finance compared to debt finance. Traditionally, debt financing has been considered to be safe but curtailing the growth of the firm. Brav (2009) argued that private companies tend to stay away from equity markets and prefer to be more debt financed than equity financed due to high sensitivity to fluctuations in performance. They also argued that the structure of management plays a major role in choosing debt versus

O’Brien (2003. Pp420) proved an empirical generalization that firms having higher emphasis on innovations (R & D investments) possess lower debt to equity ratios. This is because Research & Development creates substantial amount of intangible assets that cannot serve as an effective collateral in debt financing and hence do not support high levels of debt. Their research proved that all listed companies investing heavily in R & D tend to be more equity financed than debt financed.

In fact, companies having high initial costs of plant & machineries may also try to avoid debt due to large burden of long term interests. Typical examples may be telecommunications industry where global companies are heavily investing in large infrastructures in developing countries. The recent example of Vodafone taking over Essar in India proves this fact that such global giants are seriously interested in large capital investments in developing countries (Vodafone Annual Report.