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Write a 10 page essay on Financial accounting College.But in reality the interest cost is tax deductible thereby giving an edge for their inclusion to create leverage to a certain point.This point of
Write a 10 page essay on Financial accounting College.
But in reality the interest cost is tax deductible thereby giving an edge for their inclusion to create leverage to a certain point.
This point of view was first espoused in theModigliani-Miller theorem, proposed byFranco ModiglianiandMerton Miller, which is the very foundation of further thought process on capital structure,
even if it is purely theory based as the assumption of tax neutrality and risk neutrality. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. On the contrary Market timing hypothesis states that capital structure is the outcome of the historical cumulative timing of the market by managers (Baker, Malcolm P.. Wurgler, Jeffrey p. 57).
An analysis of capital structure is undertaken to assess the health of the organisation from the above mentioned points of view. Overall objective of ideal capital structure remains to maximise shareholders wealth without inflicting risk on the enterprise beyond acceptable levels.
Financial Leverage- So long as the cost of funds is low ROE (Return on Equity) is high compared to ROA (Return on Assets). If and when the cost of debt rises beyond threshold levels the ROE falls compared to ROA thereby making debt funds disadvantageous for the equity share holders. "Leverage is non stationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line." (DeMarzo Peter M., Sannikov Yuliy, p 1)
Risk Analysis- Risk is directly proportional to the proportion of debt in capital structure. As debt inherently carries fixed servicing and repayment obligations, adverse earning conditions increase credit risk which rises in the same direction as the quantum of debt in relation to equity funds. Similarly low risk is associated with high equity (low debt) funds of an organisation. Even in periods of lower earnings, the existence of the organisation will be at lower risk as compared to an organisation with higher debt capital. Debt to Capital ratio (average debt / average assets) provides the slice of assets financed through debt. Debt to Equity ratio (average debt / equity base) shows the share of debt in capital structure.
What is optimal capital structure There are no definite answers. It varies from industry to industry. Economic cycle of the industry being examined and within the industry the business cycle of the organisation would determine the best mix of capital structure so as to meet the overall objective of