Capital structure and firm value Literature review

Capital structure and firm value - Literature review Example Finally, the relationship between various aspects like credit ratings, target leverage, short term financing etc and their influence on the firm’s financing policy have also been discussed. Introduction The financial managers of a company work towards achieving an optimal capital mix. In large companies there is a separate financial department that takes care of financing issues. The managers strive hard to achieve a right mix of debt and equity as the capital base of the firm determines the cost of capital. The point at which the average cost of capital is minimum, the value of the firm is maximum. This point is referred as ‘optimal’. Methodology The choice of capital structure and firm value is an important topic in financial literature. This paper examines various capital structure theories like pecking order, trade-off theory etc and its impact on capital structure decisions. Mostly, the secondary sources of data have been used to determine the relationship be tween the capital structure of the firm and its value. ... The significant components of the capital structure include both debt and equity. Back in the year 1958, Modigliani and Miller had established the modern theory of capital structure. According to this theory, the value of a firm does not depend on its capital structure decisions. The Modigliani-Miller theorem is a significant arena of contemporary corporate finance. At its centre, the theory refers to an irrelevance proposition. The Modigliani Miller theory offers cases under which the financial decision of a firm does not have an effect on its value. According to the theorem, â€Å"with well-functioning markets ... and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets† (Villamil, n.d., p.1). As per Modigliani, the firm value should not be dependent on the portion of debt withi n the financial structure. The Modigliani Miller theorem is comprised of four separate results which are fetched from a series of research papers. According to the first proposition, under some specific conditions, the debt-equity ratio of the firm would not have an impact on the market value. Among them, the first two are related to the firm’s capital structure. As per the second proposition, the leverage of any firm would not have any effect on the firm’s weighted average cost of capital. This means that cost of equity has a linear relationship with the firm’s debt equity ratio. Miller has given an example for a better understanding of the theorem. For an instance, one can think that the firm is a huge tub of