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Nov 24, 2024

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Assignment 10 Ahmed Abdelhamed University of the Cumberlands Corp Fin: Fiscal Mngmnt GloCul (BADM-734-M40) - Full Term Dr. Adu Bonna November 5 th , 2023

Capital Structure Theory: An overview. Abstract This article provides an overview of capital structure theory, which is the decision- making process that determines the mix of debt and equity financing used by firms. The article starts by discussing the capital structure irrelevance theory proposed by Modigliani and Miller in 1958. This theory argues that the value of a firm is independent of its debt-to-equity ratio in a perfect capital market without taxes or transaction costs. However, the article acknowledges that this theory is based on unrealistic assumptions and has led to further research on capital structure. The article then explores three major theories that have emerged from the capital structure irrelevance theory. The first is the trade-off theory, which suggests that firms have an optimal debt ratio where the marginal benefit of debt financing is equal to its marginal cost. The trade-off theory considers the tax advantages of debt and the costs of financial distress. The article explains that the optimal debt ratio balances the tax shield benefit with the potential costs of bankruptcy and agency conflicts. The second theory discussed is the pecking order theory, which states that firms prefer internal financing over debt and debt over equity. This theory is based on the idea that firms have a hierarchy of financing preferences and that they will use internal funds first, then debt, and finally equity as a last resort. The pecking order theory is rooted in the concept of information asymmetry and the avoidance of capital markets. The third theory explored is the market timing theory, which suggests that firms issue new equity when their share price is overrated and buy back shares when the price is underrated. This theory explains that capital structure decisions are influenced by the timing of the equity market and

that they are long-lasting. However, the article notes that the market timing theory does not provide an optimal capital structure and that its impact on capital structure may fade over time. (Yapa Abeywardhana, Dilrukshi,2017) Problem Statement The article is addressing the problem of understanding the capital structure decision of firms in corporate finance. It explores various theories and factors that influence a firm's capital structure, such as the trade-off theory, pecking order theory, and market timing theory. The article aims to provide clarification and insights into the determinants of capital structure and the optimal debt to equity mix for firms. Significance & Purpose of the study The significant findings and ideas of the study on capital structure theory are as follows , The study reviews various capital structure theories proposed in the finance literature to provide clarification on firms' capital structure decisions. The capital structure irrelevance theory of Modigliani and Miller (1958) is considered the starting point of modern capital structure theory. It argues that, in a perfect capital market without taxes or transaction costs, the value of a firm is unaffected by its capital structure. The trade-off theory suggests that firms have an optimal debt ratio where the marginal benefit of debt financing is equal to its marginal cost. This theory considers the tax advantages of debt and the costs of financial distress. The pecking order theory proposes that firms prefer internal financing over debt and debt over equity. It is based on the idea that firms have a financing hierarchy and minimize information asymmetry. The market timing theory explains that firms issue new equity when their share price is overrated and buy

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back shares when the price is underrated. This theory suggests that capital structure decisions are influenced by the timing of the equity market. The study highlights that none of these theories provide a complete explanation for why some firms prefer debt and others prefer equity financing under different circumstances. The study acknowledges the limitations of these theories and the ongoing puzzle of how firms choose their capital structure. It suggests that there is no single theory that incorporates all the important factors, and the capital structure puzzle remains unresolved. Overall, the study provides an overview of different capital structure theories and their implications, emphasizing the need for a more comprehensive understanding of firms' capital structure decisions. Research Method The article does not explicitly mention the specific method of study (qualitative, quantitative, or mixed study) used by the authors to address the problem of understanding capital structure. The article primarily focuses on reviewing and discussing various capital structure theories proposed in the finance literature. It provides an overview of these theories and their implications, but it does not mention any specific research methodology or data analysis techniques used by the authors.

Critical analysis The strengths of the study include providing an overview of various capital structure theories and their implications, as well as discussing the limitations and ongoing challenges in understanding capital structure decisions. The study also references relevant empirical studies and provides a comprehensive list of references for further reading.However, the study does not present any original research or empirical analysis. It primarily focuses on reviewing existing theories and does not provide a comprehensive analysis of the empirical evidence supporting or refuting these theories. Additionally, the study does not propose any new theories or frameworks to address the capital structure puzzle. Conclusion The conclusion of the study is that understanding the capital structure decision of firms is the focus of the various theories discussed. The capital structure irrelevance theory of Modigliani and Miller paved the way for other theories, such as the trade-off theory and the pecking order theory. These theories provide insights into the factors influencing capital structure decisions, such as the tax advantages of debt, financial distress costs, and information asymmetry. However, none of these theories provide a complete explanation for why firms choose their capital structure, and the capital structure puzzle remains unresolved.The findings of the study support the conclusion that there is no single theory that incorporates all the important factors and accurately predicts firms' capital structure decisions. The study highlights the limitations of the theories discussed, such as unrealistic assumptions and the inability to explain the actual

gearing level adopted by firms. It also acknowledges that the market timing theory does not provide an optimal capital structure and its impact may fade over time. Future work For future research, it would be valuable to conduct empirical studies that test the predictions of different capital structure theories using large datasets and rigorous methodologies. This could involve examining the capital structure decisions of firms across different industries and countries, considering the impact of various factors such as firm size, profitability, growth opportunities, and market conditions. Additionally, further research could explore the role of behavioral factors and managerial preferences in shaping capital structure decisions. References Yapa Abeywardhana, Dilrukshi. (2017). Capital Structure Theory: An Overview. Accounting and Finance Research. 6. 133. 10.5430/afr.v6n1p133.

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