Capital Structure

Capital structure mentions to methods of generating sources of capital in order to businesses can purchase assets and physical means as well as maintain operating activities. In general, a suitable capital structure is considered as the most important decisions with business not only because the needs of maximizing benefits from individuals and organizations who related to operations of the business, but also due to this decision could impact to the capability of enterprises in the competitive environment. As normal, a company can raise capital from two main sources: equity financing or debt financing, even combine both of them.

In terms of raising capital through equity financing, the company usually uses the way to issue ordinary shares. This method is expected to bring higher benefits and returns; however, it seems to be more risky than debt financing. The main advantage of equity financing is the owners of business have without obligations to return capital. But, the expenses of this method will higher too much due to the company has to spend money to issue shares and satisfy investors.

On the other hand, debt financing method is cheaper (due to tax-deductible and lower cost). Moreover, it is also less risky and lower expected returns because of this method forces to pay interest and return initial capital for investors and shareholders. However, there are still risks exist in this method which can bring dangerous to business. Firstly, cost of capital is not stable; it depends on many outside factors, such as the market values, the trust of investors in company’s ability to raise capital or the expectation of company. Besides, if the company use debt finance method, they have to paid loan every year, although it will be successful or unsuccessful year. It could lead to credit rating of business will be affected and the higher the risk company must face with bankruptcy. The value of shareholders also due to this reason will decrease.

Under the traditional view, in the beginning, if WACC decreases and gearing increases, it will lead to an increasing share price and value of company. Then, in optimal level where the company can gain optimal capital structure, if the gearing continues raise, the risks also increase follow that.

In contrast with traditional view, Modilligani and Miller (1958) gave opposite ideas and theory about capital structure. They assumed that the capital market is perfect, so there will be no transaction costs, taxation is ignored and the risk is evaluated by the volatility of cash flows. From that, they argued that there is no relationship between capital structure and WACC as well as capital structure can not affect to WACC. As a result, the optimal capital structure also not exists and the value of company depends on business risk. However, the perfect markets will not exist in the real world and their assumptions is not suitable and reality. In fact, the company should borrow money in a reasonable level. Moreover, owners of company must consider other factors which can affect to the borrowing decisions, for example, the ability to loan, risks in reinvestment, operating as well as effective strategy.