This document discusses the effective management of capital structure. It begins by defining capital structure as the mix of debt and equity used to finance a firm. It then reviews several theories around optimal capital structure, including the Modigliani-Miller theory and more recent market timing theory. The document presents the methodology used, which was a qualitative analysis of secondary literature. It discusses the results, including that an optimal capital structure balances debt and equity to minimize costs. Finally, it concludes that financial performance depends on a well-structured mix of debt, preferred stock, and common equity.
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The Effective Management of Capital Structure
Emmanuel Teitey,Ph.D
Kings University College- School of Business,Ghna
teitey2000@gmail.com
Tel.+233-0548704485/0277430485
June,2019
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The Effective Management of Capital Structure
Abstract: Capital structure has always been one of the main topics among the studies of finance
scholars. Its importance derives from the fact that capital structure is strongly associated to the
ability of firms to fulfil the needs to various stakeholders. The last century has observed a
continuous developing of new hypothesis on the optimal debts to equity ratio. This a qualitative
research and employed descriptive analysis. This research paper proposed that a mix of debt,
preferred stock and common equity will maximize shareholders wealth or maximize market per
share.
Keywords: Hypothesis, Capital, Structure, Debt, Equity
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Introduction: The Effective Management of Capital Structure
Capital Structure is a mix of debt and equity capital maintained by a firm. Capital structure is
also referred as financial structure of a firm. The capital structure of a firm is very important
since it related to the ability of the firm to meet the needs of its stakeholders. Modigliani and
Miller (1958) were the first ones to landmark the topic of capital structure and they argued that
capital structure was irrelevant in determining the firm’s value and its future performance. On
the other hand, Chatterjee and Lubatkin (1994) as well as many other studies have proved that
there exists a relationship between capital structure and firm value.
In more recent literatures, authors have showed that they are less interested on how capital
structure affects the firm value. Instead they lay more emphasis on how capital structure impacts
on the ownership/governance structure thereby influencing top management of the firms to make
strategic decisions (Hitt, Hoskisson & Harrison, 1991). These decisions will in turn impact on
the overall performance of the firm (Jensen, 1986).
Problems of the Study
Nowadays, the main issue for capital structure is how to resolve the conflict on the firms’
resources between managers and effective management of owner’s resources (Jensen, 1986).
This research paper is a reviewed of literature on the various theories related to capital structure
and effective management of owner’s resources of the firm (debt, preferred stock and common
stock).
The discussion about limitations on capital structure decisions, agency cost is one of the major
constraints, which is crucial for management and other stakeholders. Fundamentally agency
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problem arises due to divergence of interest of stakeholders (managers, employees and creditor).
Jensen (1989) presented the agency theory by focusing on the management and shareholders.
Theoretical Framework
Recently, a new theory, the market timing theory of capital structure which was first introduced
by Baker and Wurgler (2002), develops a different kind of view about capital structure. The
market timing theory suggests that managers are able to identify certain time periods during
which equity issuance is less costly due to the high valuation of company’s stock. It means, firms
are more likely to issue equity when their market values are high, relative to book and post
market values, and to repurchase equity when their market values are low. As a consequence,
current capital structure is strongly related to historical market values. This result provides
market. However, Hovakimian (2005), Flannery and Rangan (2006), Alti (2006) and Kayhan and
Titman (2007) disagree with Baker and Wurgler on the persistence of the effect on capital
structure because the importance of historical average market-to-book ratios in leverage
regressions does not influence the past equity market timing. Kayhan and Titman (2007) make
the point that the significance of the historical market-to-book series in leverage regressions may
be due to the noise in the current market-to-book ratio.
Methodology
Data on capital structure was collected from Secondary sources like Articles, Journals, empirical
literatures, Textbooks and Internet sources (peer-review data) for analysis on capital structure.
Qualitative methodology was applied for this research paper. Descriptive research design and
analysis on capital structure were employed to investigate the capital structure. For the purpose
of analysis, a secondary data was used to analysed the various literature on capital structure. The
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researcher obtained both primary and secondary data from the various case studies for the
analysis of the capital structure. The primary data was in the form of interviews with the concern
officials on capital and Money market in Ghana. Secondary data was in the form of documents
obtained from the internet (peer-review data), literatures reviewed and other articles for the
analysis of the capital structure.
Results and Discussion
The empirical data analysed from the primary and secondary sources has shown that adequate
mix of debt and equity financing is good a source of an organisation capital structure, and this
was possible due to results from the study enumerated as below:
The Capital Structure
Capital structure decision is the mix of debt and equity that a company uses to finance its
business(Damodaran,2009). It is mix of debt, preferred stock and common stock with which the
firm plans to finance its investment. The main points are to have such of a price mix debt,
preferred stock and common equity which will maximize shareholders wealth or maximize
market per share.
The Optimum Capital Structure
Weighted Average Cost of Capital(WACC)depends on the mix of different securities in the
capital structure. A change in the mix of different securities in the capital structure will cause a
change in the WACC. Thus, there will be a mix of different securities in the capital structure at
which WACC will be the least. An optimal capital structure means a mix of different securities
which will maximize the stock price share or minimize WACC.A higher debt ratio can enhance
the rate of return on equity capital during good economic times also increases the riskiness of the
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firm`s earnings stream. The weighted average cost of capital is also use to calculate the net
present value(NPV) of capital budgeting for corporate projects. A lower WACC will yield a
higher NPV, so achieving a lower WACC is always optimal. Refer to overseeing the capital
structure as capital structure management.
Managerial Implication
Management of an organisation or a firm need to plan strategically so as to design and
implement a well financial management which is expected to contribute positively to the creation
of a firm`s value. The dilemma in financial management is to achieve desired trade-off between
liquidity, solvency and profitability(Lazaridis,2006). Financial performance has implications to
organization’s health and ultimately its survival. High performance reflects management
effectiveness and efficiency in making use of company`s resources and this in turn contributes to
the organisation growth, development and profitability. High financial performance also leads to
good managerial compensation. A well-constructed managerial compensation not only to retain
competent of managers, but to align managers interest with those of shareholders as much as
possible. Thus, eliminate the agency problem.
Corporate World with Taxes Implication
According to MM theory, a corporate world with taxes, the value of levered firm equals the
value of unlevered plus the value of the tax shield. Accordingly, the more the debt in the capital
structure, the higher will be the value of levered firm. One can always increase firm value by
increasing leverage, implying that firms should issue maximum debt. This is inconsistent with
the real world, where firms generally employ moderate amount of debt. Debt also provides tax
benefits to the firm.
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Corporate World without Taxes Implications
Capital structure decision involves a trade-off between risk and return to maximize market prices
per share. According to Modigliani and Miller (1958) research, in a world without corporate
taxes, mix between debt and equity does not matter. Value of the firm is independent of capital
structure decisions and equals operating income divided by overall cost of capital.
Corporate Risk Implication
The cost of holding risk is a crucial concept for any corporation to understand. Most financial
policy decisions, whether they concern capital structure, dividends, capital allocation, capital
budgeting, or investment and hedging policies, revolve around the corporate costs of holding
risk. These decisions can be made well only with a thorough understanding of how costly it is to
initiate and warehouse risk. This issue is particularly important for financial firms, since the
initiation and warehousing of risk constitutes their core value added.
Conclusion and Practical Recommendations
The end of this research has been to generally fit the aims and objectives of this study.
Recommendation for the future is however made to further improve upon the findings of this
research. Based on the findings of the research, it is concluded and recommended that: Financial
performance has implications to organization’s health and ultimately its survival and these
depend on a well mix of debt, preferred stock and common stock. A well optimal capital
structure for any organisation or a firm is next step for future studies.
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Reference
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Chatterjee, S. and Lubatkin, M. (1994). Extending modern portfolio theory into the domain of
corporate diversification: Does it apply?.
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Damodaran, A. (2009). Corporate Finance,4th Edition, New York. John Wiley &Sons Inc.
Flannery, M.J. and Rangan, K.P. (2006). Partial adjustment d by equity market timing? Journal
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Kayhan, A. and Titman S. (2007). Firms' histories and their capital structure.
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Lazaridis,I & Tryfonidis, D. (2006). Relationship between working capital management and
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Lazaridis,I & Tryfonidis, D. (2006). Relationship between working capital management and
profitability of listed companies in the Athens stock exchange. Journal of Financial
Management and Analysis, l19 (1),1-12.
Modigliani, F. and Miller, M. (1958). The cost of capital, corporation finance, and the theory of
investment. American Economic Review, 48, 655-669.