Capital Structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. While the Modigliani-Miller theorem recognized that capital structure doesn't matter in a perfect market, various theories exist to recognize and address imperfections so that leverage may be used to maximize shareholder wealth (Modigliani & Miller (M&M propositions I & II) - Capital structure of corporations). One theory often applied to leverage is Agency Theory which exists to resolve problems arising from agency relationships, particularly when the principal and agent conflict with each other. According to Agency Theory, debt creation is good for a variety of reasons (Simerly and Li). Because it transfers wealth from the organization to investors, the manager has to keep in mind the promise to pay out future cash flows. Agency theory also holds that management has an incentive to engage in needless discretionary spending and that increases leverage imposes financial discipline by reducing the cash flow available for discretionary spending. Further, because companies have to make interest and principal payments to remain solvent, managers have to stay focused on key issues related to survival.
However, critics argue that just as the Modigliani-Miller theorem ignored transaction and bankruptcy costs, agency theory omits two important considerations, competitive markets and the need for managers to make choices beyond a stockholder wealth-maximizing perspective (Simerly and Li).
Simerly and Li believe that an organization must find a match or fit between the demands of its competitive environment and its internal management systems in order to succeed and to survive." In general, the authors recommend firms in industries with low rates of environmental change high economic performance choose equity over debt in financing projects with uncertain outcomes. Conversely, firms in industries with high rates of environment change and low economic performance should consider increasing debt to increase returns to investors. Further, Simerly and Li caution that increasing debt brings more external control and that management needs to decide how much autonomy is appropriate for the organization.
Bibliography
Modigliani & Miller (M&M propositions I & II) - Capital structure of corporations. Retrieved from Web site: http://www.financescholar.com/modigliani-miller-propositions.html
Simerly, R.L. And Li, Mingfang. Re-thinking the capital structure decision. Retrieved from Web site: http://www.westga.edu/~bquest/2002/rethinking.htm
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