CAPITAL STRUCTURE Essay Example

CAPITAL STRUCTURE

Abstract

A capital structure refers to the mode of capital generation utilized by business in sourcing resources for profit generation. It is an activity that is not new to business administration. Since time immemorial, business leaders have advanced the practice in the generation of assets. Even though the mode of quantification of the resource varies, the goal has always been increasing revenue generation by enhancing capital stability and such is the case for the article. In the study, the researcher employs a qualitative approach in the review of materials from various sources exploring the subject. After which, the research utilizes the concepts as the guide for exploring the significance of capital structure constituents of equity, securities, and debts.1 The objective is to enable audiences who include business managers and regulators among many other people in the business sphere plan on ways of leveraging capital with other business resources in ensuring accomplishment of the goal of profit making.

Given that several factors influence the outcome of success in the utilization of capital, the calculation of risk is a mandatory process upon the identification of sources of funding, yet such is only possible with the mastery of capital structure concepts. As explored in the article, the knowledge facilitates balancing of debts and equity among many other constituents of business capital. Another significance of the comprehension of the concept as explored in the literature selected for the study is that the identification of the sources of financial distress which lead to more risks is easier when equipped with the knowledge of capital financing. With the knowledge the enhancement of objectivity in financial management becomes feasible.

Capital Structure

Introduction

Businesspersons have no obligation but to acknowledge that the advancement of any venture requires enough capital and such is only possible with the comprehension of a myriad of concepts of corporate financing. For that reason, one has to acquaint themselves with the basis of capital structure leveraging before advancing any business mission and such is the case of the paper. The objective is to acquaint audiences with the fundamentals of capital generation in order to facilitate amicable decision-making in business.2 As noted, having in place sound structure for capital generation demands a reliable source of equity for many businesses. However, while advancing the activity, it is critical noting that shares and debts equally form an integral part of capital structure.3 This explains why a balance of the components is fundamental to the success of any operations.

Capital structure is the pillar of performance in every organization. As such, the chosen capital structure should be able to optimize the profit margin of the organization. Usually, capital of a firm depends on the both the external and the internal sources. In this regard, most managers use the most efficient structure in relation to the sources of capital. Most of the manager employs different theories to determine an efficient capital structure as far as the profit maximization is concerned. Some of the theories used include the pecking order theory, Modigliani and Miller approach, and net income approach among other theories. The value of every firm depends on the type of the capital structure hence coercing the managers to adopt a capital structure with high return on capital.

Notably capital structure is described as the form by which a firm funds its operations either through debt or equity. Two kinds of capital exist: equity and debt capital. The two has merits and demerits, thereby necessitating the management to determine the one that suits its need and will yield optimum structure. They achieve this by balancing the two types4. The capital structures in the banking institutions differ from those in other organizations. Their equity capital is only made up of issued share capital alone. Contrarily, the other firms’ equity capital is comprised of authorized, called up share capital, paid up share capital, calls in arrears as well as calls in advance. Importantly, “authorized share capital is defined as the capital that a firm can issue as described in the firm’s Articles of Association.” The equity part of the firm’s capital structure shows it but it is not in the banking institutions. The shareholders do not have to pay up entirely for their shares in the case of the called up share capital. In its place, they may be required to pay a given amount initially and pay the rest upon request by the company.

Thus, capital structure is a vital component in the running of any given organization. Hence, reviewing literature on the topic is paramount in understanding the theories surrounding it and important aspects surrounding the structure. The review is done on scholarly material in a bid to provide valid information that managers can utilize while making capital structure decisions.

Literature Review

Various literary materials describe capital as the integral resource for ensuring accomplishment of business goals and such is the case of the works of Graham Mark and Roberts.5 According to the scholars, the duty of capital generation entails sourcing funds through sales of shares, soliciting debts and using security from outside the firm. The works mention capital management as an important practice in ensuring the collected capital serves its purpose. The motivation in the explanation could be encouraging managers to examine the structure in an attempt to balance business needs with existing resource. In reiterating the importance of managing debts using trade-off theory, the article sums it up that rise in marginal costs affects the outcome of operations of similar nature in a different environment. It is for this reason that the scholar encourages the simulation of situation is as a risk avoidance practice in business funding.6In citing example of business focus on managing working capital at the expense of other activities, the reading intends to affirm the significance of capital in business. The motivation of the author is aiding people envisage ways for minimizing risks that emanate from misappropriation of cash among many other funds considered as working capital. The article concludes that malpractice of business such as increasing debts as a way of balancing existing capital with financial records is a detrimental practice that exposes a business to unforeseen risk.

Another piece that employs a similar ideology in explanation of the significance of capital structure is the work of Hovakimian, Hovakimian and Tehranian in which the scholar identifies the determinant of working capital structure. The goal of the exploration of the concept is encouraging coordination in business management. Even though the focus is on the source of the resource and such knowledge can only help business administrators, the scholar considers the use of the resource as equally important to regulators.7 Their explanation is the collection of capital is a continuous task, and any business regulator ought to monitor slight adjustments in operations since they havefinancial implication.The study utilizes financialrecords of various institutions as the guide for the conceptualization of debt equity as part of target capital. Similar to Baker and Wurgler who explores the concept by focusing on the need for timing in the collection of the resource, the scholar uses a qualitative approach in evaluating equity issues. The motivation is to demystify the concepts of corporate structure in addition to encouraging the generation of capital using diverse means such as securities. Their argument is that the management of the resource is not as complex as people think. Instead, the task is simple and any individual with proven knowledge of business administration can steer the process, as long as one can balance liabilities with assets.8 The idea can help managers advance research on ways of solving problems attributable to funds management that bedevil many operations in corporategovernance.

The reading of Flannery and Rangan, “Partial Adjustment toward Target Capital Structures” implies that the utilization of financial tools is an integral aspect of corporatefinancing, hence the reason for the focus on capital structure in business.9 Their explanation resembles Graham, Markand Michael’s idea that the leveraging of debt and equity is integral activity in business administration. While inferring to various theories, Flannery and Rangan mention that the ownership structure plays an integral role in business financing. For that reason, it is important balancing agency cost and managerial responsibility in collection of capital. As per the explanation of the article of Jensen and Meckling, managerial costs which consume part of capital ought to be regulated to ensure maximization of returns from any venture. However, such is possible when the source of financing for a business is not limited. Unlike Flannery and Rangan who place much emphasis on balancing capital needs, theauthors believe that problems attributable to imbalance in capital use are difficult to solve at times. This applies even in situations where the administration utilizes the relevant tools in visualizing dangers of various business decisions. The knowledge is relevant in contemporary times for firms that rely solely on sale of shares as means of generating extra capital.

The piece commences by highlighting history as the integral determinant of capital structure activities before shifting to examine the significance of the use of financial tools in the quantification of the performance of business based on ability to utilize capital effectively. Just like many other scholars who review the sources of businessfinancing, the scholar opines that the conceptualization of the modes of business funding is integral in facilitating effective decision-making in business.10The motivation could be to inspire managers devise ways of cushioning business from foreseeable risks such as overreliance of debt due to historical influence. The study implies that budgeting among many other valuation activities depends on the outcome of corporatefinancing activities which aid capital generation. It considers taxation as consequential in funding, in the same way, Modiglaini and Miller quantify the significance of income corporate tax on business performance.11 However, unlike the two the scholar evaluates the tradeoffs using historical data in the projection of future investments.

Pecking order is one of the theories that stand to improve the curativeness of the company. According to Firer and Williams, the managers using this theory have to understand the notion that there is a safeguarding the image of the organization from the outside investors12. In this regard, the internal users keep the certain information away from the external users to avoid leaking the data to the competitors. As such, the investors receive the guidance from the capital structure of the company. In addition, the managers prefer financing the projects using the internal sources of finance than the outside investors. Therefore, the company shies away from the external debts. When the situation forces the managers to solicit funds from the external sources, then they will go for the short-term debts other than the long-term ones. Therefore, it is clear that the value of the firm depends on the internal sources of finance. The public become the shareholders after analyzing the internal performance of the firm.

Modigliani and miller approach is another famous theory used by the managers in the determination of the capital structure. Koslowsky posits that this theory is unique in the sense that it disputes the capital structure theory13. It states that the value of the firm depends on its future value of the firm. However, the theory uses two propositions to explain the irrelevance of the capital structure in the organizations. For instance, under proportion one, both the debtors and the shareholders have equal priorities in terms of profit and dividends sharing. In normal cases, the shareholders receive the greater share of the profits as stipulated in the articles of association. Moreover, under this proportion, leveraging a company does not affect its future valuation because there are no taxes involved. On the other hand, in proposition two, the financial leveraged is related to the cost of debt of the company. The debt holders have an upper hand because the shareholders may tend to increase the cost of equity. Notably, this theory operates under various assumptions that the managers should observe and uphold. For instance, there are no taxes involved and there is symmetrical flow of information; the company shares the financial information of the firm with the outside investors. Finally, Tham posits that the debt borrowing does not affect the operations of the companies14. As a result, most of the managers prefer using this theory while developing the capital structure of the company because it attracts the external investors. In most of the cases, the public prefer getting involved in the financial information of the firm to affirm the profit maximization. The theory also helps the external investors to make a proper decision before investing their shares.

Traditional theory is a unique approach because it argues that that there is a relationship between the cost of equity and the capital structure. In essence, the theory affirms the existence of optimization of the capital structure. The profit margin of ant firm depends on the cost of the equity as per the capital structure. In this case, an efficient capital structure should balance the cost of equity with the profit maximization. Primarily, an increase in the cost of equity will increase the profit of a company up to a certain level. The theory compares the two variables; the weighted average cost of capital (WACC) and the market value of the company. In this correlation, the maximum market value of the firm results from the combination of the debt and equity as the main components of the capital. However, the inclusion of the debt in the capital structure is up to a certain level. According to Shamshur, the analysis of this approach shows that more debt in the capital reduces the market value of the firm in the end15. However, the managers should note that debt is a vital component in achieving the maximum capital within the organization. Finally, the directors should realize that WAAC should reduce to achieve the optimum market value of the firm. Consequently, the theory operates under assumptions that the managers should accept while operating under this theory. Some of these theories include constant rate of interest on debt and the expected rate of equity shareholders increases gradually for a specific period. According to the research, most companies should embrace this theory since it has the empirical format of achieving the optimal value of the company in the contemporary market.

Graph of traditional approach

CAPITAL STRUCTURE

Net income approach is one of the present theories that evolved due to the changes within the technological environment. Liu indicates that Durand was the pioneer of this theory and it has a significant impact in the determination of the relevant capital structure16. According to this theory, the managers can increase the value of the firm by reducing the cost of capital. In this connection, the cost of capital results from the calculation of WACC. WACC represent the average cost of sources of capital with their weights, which indicates the value of the capital from each source. Remarkably changing the financial leveraged of a firm will lead to corresponding changes in the value of WACC as well as the general value of the firm. The theory also denotes that an increase in the value of WACC reduces the market value of a firm. Some of the assumptions in this approach include the cost of debt is less than that of equity and the reduction in the value of WACC will not discourage the investors.

Conclusion

Management of capital structure, which describes the approaches for generation of resources for running business operations, is integral to any operations. It is for this reason that the article places much emphasis on the need to understand the constituents of the capital that include equity, debts and securities. As discussed in the sources for review, the mode of calculation of capital is critical in estimation of business worth prior to advancing means of increasing exiting resources for revenue generation. Another important point for consideration as highlighted in the article exploring the subject of capital structure as a component of corporate financing is that the success of operations depends on the manner in which business source the capital. For instance, when opting for debts, it is crucial ensuring tradeoff for taxation to ensure balance.

Even though in some cases effectiveness in the use of securities and owner contribution can prove helpful, the estimation of risks is mandatory as an administrative practices since all the factors put together to determine the outcome of business operations. Given that the management of capital is essential for success in both short-term and long-term and it is a continuous process, the comprehension of the sources of the funding is also an importance financial practice. It is equally important devising ways for minimizing the wastage of the resources. This explains why the review covered the concepts that quantified debts, securities and equity as the essentials of capital structure. By understanding the way of leveraging the sources of the fund, a business is poised for greater heights of success despite the difficulties that characterize administrative duties.

In retrospect, every company operates under a defined capital structure. The managers decide on the appropriate capital structure depending on the level of return on capital as well as the size of the company. From the above sources, it is clear that the type of the capital structure in an organization may influence the attitude of the investors towards the company. Moreover, most of the companies use the modern theories in adopting a relevant capital structure to maximize their profits.

Bibliography

Baker, Malcolm, and Jeffrey Wurgler. “Market Timing and Capital Structure.” Journal of Finance 57, no. 1 (2002): 1–32.

Firer, Steven, and S. Mitchell Williams. «Intellectual capital and traditional measures of corporate performance.» Jnl of Intellectual Capital 4.3 (2003): 348-360.

Flannery , Mark J. and Rangan, Kasturi. “Partial Adjustment Toward Target Capital Structures. AFA 2005 Philadelphia Meetings, 2004. Available at SSRN: http://dx.doi.org/10.2139/ssrn.467941

Graham, John R., Mark T. Leary, and Michael R. Roberts. “A Century of Capital Structure: The Leveraging of Corporate America.” Working Paper, 2014.

Hovakimian, Armen G., Gayane Hovakimian, and Hassan Tehranian. «Determinants of Target Capital Structure: The Case of Dual Debt and Equity Issues.» SSRN Electronic Journal 71, no. 3 (2004): 517-540.

Hovakimian, Armen, Tim Opler, and Sheridan Titman. “The Debt-equity Choice”. The Journal of Financial and Quantitative Analysis 36 no. 1 (2001): 1–24.

Jensen, Michael C. and Meckling, William H. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics (JFE), 3, no. 4 (1976): Available at SSRN: http://dx.doi.org/10.2139/ssrn.94043

Kayhan, Ayla, and Sheridan Titman. “Firms’ Histories and Their Capital Structures.” Journal of Financial Economics 83, no.1 (2007): 1-32.

Koslowsky, David. «Optimal Capital Structure.» SSRN Electronic Journal 3.1 (2010): 1. Print.

Liu, Ying. «Corporate Culture and Employee Mentality Capital Agree with Influencing

Factor Analysis.» International Education Studies 3.2 (2010): 45. Print.

Modigliani, Franco, and Merton Miller. “Corporate Income Taxes and the Cost of Capital: A Correction.” The American Economic Review 53, no. 3 (Jun., 1963): 433-443

Myers, Stewart, and Nicholas Majluf. “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have.” Journal of Financial Economics 13, no. 2 (1984): 187-221.

Shamshur, Anastasiya. «Access to Capital and Capital Structure of the Firm.» SSRN

Electronic Journal (1990): 105. Print.

Tham, Joseph. «Weighted Average Cost of Capital (WACC) with Risky Debt: A Simple

Exposition (I).» SSRN Electronic Journal 1.2 (2010): 69.

1
“Ayla Kayhan, and Sheridan Titman, “Firms’ Histories and Their Capital Structures” Journal of Financial Economics 83: 15”

2
“John Graham, Mark Leary, and Michael Roberts, “A Century of Capital Structure: The Leveraging of Corporate America” Working Paper, 2014”

3
“Lakshmi Shyam-Sunder, and Stewart Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure,” Journal of Financial Economics 51 (1999): 220”

4 “Anastasiya Shamshur, «Access to Capital and Capital Structure of the Firm» SSRN Electronic Journal (1990): 105”

5“John Graham, Mark Leary, and Michael Roberts, “A Century of Capital Structure: The Leveraging of Corporate America” Working Paper, 2014”

6
“Stewart Myers, and Nicholas Majluf, “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have” Journal of Financial Economics 13, no. 2 (1984): 189”

7
“Armen Hovakimian, Tim Opler, and Sheridan Titman, “The Debt-equity Choice” The Journal of Financial and Quantitative Analysis 36 no. 1 (2001): 1–24”

8
“Lakshmi Shyam-Sunder, and Stewart Myers, “Testing Static Tradeoff Against Pecking Order Models of Capital Structure” Journal of Financial Economics 51 (1999): 220”

9
“Mark Flannery, and Kasturi Rangan, “Partial Adjustment Toward Target Capital Structures” AFA 2005 Philadelphia Meetings, 2004”

10
“Ayla Kayhan, and Sheridan Titman, “Firms’ Histories and Their Capital Structures” Journal of Financial Economics 83, no.1 (2007): 13”

11
“Franco Modigliani, and Merton Miller, “Corporate Income Taxes and the Cost of Capital: A Correction” The American Economic Review 53, no. 3 (1963): 432”

12
“Steven Firer, and Mitchell Williams, «Intellectual capital and traditional measures of corporate performance» Jnl of Intellectual Capital 4.3 (2003): 350”

13
“David Koslowsky, «Optimal Capital Structure» SSRN Electronic Journal 3.1 (2010): 78”

14
“Joseph Tham, «Weighted Average Cost of Capital (WACC) with Risky Debt: A Simple Exposition (I)» SSRN Electronic Journal 1.2 (2010): 69”

15
“Anastasiya Shamshur, «Access to Capital and Capital Structure of the Firm» SSRN Electronic Journal (1990): 105”

16
“Ying Liu, «Corporate Culture and Employee Mentality Capital Agree with Influencing Factor Analysis» International Education Studies 3.2 (2010): 45”