The review of issues concerning capital structure is defined by the perceptions expressed by various authors. In the article capital structures theories, a critical approach (2011), Brendea defines capital structure as the financial structure of a firm coupled with the long term financing used by the firm. She observes that capital structure is very important to any firm since it relates to the ability of the firm to meet the needs of its stakeholders; capital structure can also be defined as a the mix of debt and equity capital within a firm.
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According to Brendea’s explanation, theories have been developed to explain equity and debt but in the theory developed by Miller, there is an assumption that in the absence of taxes and bankruptcy costs, a firm’s value is not affected by how firms are financed. Miller’s theory further holds that capital structure cannot be used to determine the firms’ values and its performance in the future in terms of meeting its financial obligations. An increase in debt level causes an increase in bankruptcy costs (Brendea, 2011).
There is a link between the firm value and the capital structures, since the firm value is affected in many ways by capital structure; Modigliani and Miller state that their model is not effective when the tax is put into consideration since tax subsidies on debt interest payments will cause a rise in firm value when equity is traded for debt. Optimal capital structure is attained in financial management if a benefit received from tax sheltering brings about an increase in debt level that is equal to the costs of the bankruptcy. Managers of the firms have the responsibility of ensuring that the optimal capital structure is always maintained at a reasonable level.
The trade-off theory
The trade-off theory was developed in a bid to explain family related theories, this theory changed Modigliani and Miller’s propositions. In this theory it is assumed that an inside solution in a firm can be achieved and that the marginal costs and benefits are balanced, thus the top managers in a firm evaluate cost and benefits within the firm. Modigliani and Miller in their theory developed in 1963 brought in taxes in the model which led to formation of trade-off theory of capital structure, whereby the tax-related benefits of debt were offset by costs of financial distress (Brendea, 2011). The Trade-off theory describes that profitable firms use debt since they are aware that they cannot be bankrupt and there is high chance of taking advantage of debt financing.
Pecking –order theory
The pecking order theory by Myers shows that firms portray their unique preferences by using internal finances through retained earnings over the external preferences, if internal funds are more, the firms may or may not acquire external financing to minimize incurred or additional costs of asymmetric information. Myers model indicates that outside investors rationally discount the firm’s stock price when managers issue equity instead of riskless debt. To avoid this discount, managers should avoid equity when possible. Through this model managers through predictions will follow a pecking order, by first utilizing up internal funds and secondly utilizing up risky debt and then resorting to equity. If there are no investment opportunities, the firms would retain profits and build up on financials (Brendea, 2011).
The Market timing theory
In this theory firms sell or issue new stock when the stock price is perceived to be overvalued, they then buy back when their shares are undervalued. If the stock fluctuates it affects the capital structure, this theory is based on the market timing so that mispricing is not experienced. In financial management, the top management should know the best time to sell the shares of a company of so as to maximize profit and cash flows within the firm.
The view of capital structure provided by Brendea (2011) shows clear evidence that there exists a relationship between the capital structure and ownership structure. The capital structure of any firm is received from transactions the firm has with suppliers of finance in various areas. The theories of capital structure are different in terms of the concepts that they emphasize.
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Brendea, G. (2011). Capital structure theories: A critical approach. Studia Universitatis Babes-Bolyai, 56(2), 29-29-39.