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Capital structure represents the proportion in which various capital components are
employed and that too long-term. This decision has been recognized as the most important
decision that a firm has to take because the capital structure affects the cost of capital, net
profit, earning per share, dividend payout, and liquidity position of the firm. These variables,
along with a number of other factors, determine the value of a firm. If a firm entirely relies
on internal funds or equity, then the growth may be restricted due to unavailability of
large amount of finance, and also, if a firm goes for external finance, then chances of risk
increases as the liability of firm enhances. Thus, a firm has to manage various objectives in such a
way that sufficient liquidity is maintained in the business and, at the same time, the firm is
able to manage the risk. So, in the light of this, capital structure is considered to be a very
important determinant of the value of a firm.
Modigliani and Miller (1958 and 1963) highlighted the issues involved in
financial structure decisions, viz., the cheaper cost of debt compared to equity; the increase in risk
and the cost of equity as debt increases; and the benefit of the tax deductibility of debt.
They argued that in the absence of taxes, the cost of capital remained constant as the
benefits of using cheaper debt were exactly offset by the increase in the cost of equity due to
increased risk. They concluded that with taxes and the deductibility of interest charges, firms
should use as much debt as possible. Myers (1984) stressed that capital structure has proved to be
a recurrent puzzle in the field of finance. |
