Mereger

CAPITAL STRUCTURE:

INTRODUCTION:

The capital structure of a company is referred to the way in which the company finances itself through debts, equity and securities; it can therefore be referred to as the capital composition of the company taking into consideration its liabilities, Modigliani and Miller propose the Modigliani Miller theorem of capital structure which states that the value of a company in a perfect market is unaffected by the way the company is financed but through the capital structure it employs.

Other theories to describe the capital structures employed by a company include the trade off theory, the agency cost theory and pecking order theory, and however the Modigliani Miller theory provides the basis at which a modern company should determine its capital structure.

The trade off theory recognizes that capital raised by firms is constituted by both debts and equity, however the theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs. The theory further states that the marginal benefit of debts declines as the level of debts and at the same time the marginal cost of debts increases as debts increase, therefore a rational firm will optimize by the trade off point to determine the level of debts and equity to finance its operations.

The pecking order theory was developed by Stewart Myers (1984) and it states that firms will adhere to the hierarchy of financing whereby the firm will prefer to finance itself internally and when all internal finances are depleted it will opt for equity, therefore this theory supports the fact that debts are preferred by firms than equity.

The agency cost theory analyses three costs which give explanation to the importance of the capital structure, these costs include asset substitution, underinvestment and cash flow; it gives the importance of management to adopt the most...