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Capital Structure Essay

9634 words - 39 pages

CAPITAL STRUCTUREABSTRACTOver the years, numerous theories and studies on Capital structure have appeared. Modigliani and Miller laid down the foundation by being the first to theorize the issue. In 1958 they put forward their "M&M capital structure irrelevance proposition." However, with this first attempt, they failed to include important factors that could explain why daily observations of reality proved the opposite.In their response that followed in 1963, Modigliani and Miller relaxed one of their initial assumptions, the absence of corporate taxes.The paper then goes on to build in the effects of taxes, bankruptcy and it's attendant costs until the 'mainstream' Trade-off Model also (known as the Optimal Capital Structure model) emerges. While this approach has some valuable explanatory power, it fails to explain several commonly observed practices in modern corporate finance.The Pecking Order theory, and the closely related Signaling theory are intriguing alternatives to the explanation of Capital Structure.The paper also discusses the Free Cash Flow theory- an extension of the Trade-Off model.It looks at which theories S.A. Managers use in practice: Pecking Order or Trade-off model? , And gives a brief comparison of the pecking order and Trade-off model. The paper examines these two competing theories and determines which one better explains a firm's Capital Structure decision. Finally, it observes what influences Capital Structure choices between countries and different industries.The paper concludes that although Capital Structure is important, Capital Structure theories on their own fail to explain a firm's Capital Structure decision completely.Instead, it seems that firms follow a combination of the theories, with each theory filling a gap of the Capital Structure puzzle.CONTENTS Page1. Introduction 32. What is Capital Structure ? 43. Theories on Capital Structure 43.1 The Modigliani and Miller theorem 43.1.1 Empirical Evidence 83.1.2 Shortcomings of the M&M theorem 83.2 The Static Trade-Off theory 113.2.1 Empirical Evidence 123.3 The Free Cash Flow theory 133.4 The Information Asymmetry hypothesis 133.4.1 The Signaling theory 133.4.2 The Pecking Order theory 143.4.3 Empirical Evidence 154. The Pecking Order model vs. the Trade-Off model 164.1 Reported Practice 174.2 Empirical Evidence 175. Which theory do South African managers use ? 186. The Capital Structure Decision : International Evidence 197. Conclusion 228. Bibliography 239. Diagrams 251. INTRODUCTIONCapital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer.Franco Modigliani and Merton Miller were who sparked interest in capital structure theory. Their original insights (1978) and continued developments (1963, 1965) laid the foundation for modern...

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