AN EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANIZATION

CHAPTER ONE

INTRODUCTION

Capital structure is one of the most puzzling issues in corporate finance literature (Brounen and Eichholtz, 2001). Capital structure is the combination of debt and equity that make the total capital of firms. The proportion of debt to equity is a strategic choice of corporate managers. Capital structure decision is the vital one since the profitability of an enterprise is directly affected by such decision. Hence, proper care and attention need to be given while determining capital structure decision. In the statement of affairs of an enterprise, the overall position of the enterprise regarding all kinds of assets, liabilities are shown (Velnampy and Niresh, 2012). Capital is a vital part of that statement. The term capital structure of an enterprise is actually a combination of equity shares, preference shares and long-term debts. Attention has to be paid as far as the optimum capital structure is concerned. With unplanned capital structure, companies may fail to economize the use of their funds. Consequently, it is being increasingly realized that a company should plan its capital structure to maximize the use of funds and to be able to adapt more easily to the changing conditions (Pandey, 2009).

Modigliani-Miller (MM) theorem is the broadly accepted capital structure theory because it is the original capital structure theory which has been used by many researchers (San and Heng, 2011). Capital structure is one of the most important and effective parameters on the valuation and direction of economic enterprises in the capital markets. Current changing and evolving environment causes rating companies in terms of credit to depend partly on their capital structure and strategic planning, requiring them to select effective resources to achieve the wealth maximization goal of shareholders (Drobetz and Fix, 2003). During the financial crisis of 2007, many firms had difficulties in their operations occasioned by the inadequacy of their capital structures. The financial crisis affects all the industries and thus it indirectly affects a firm’s performance. Campello, Graham, and Harvey, (2010) did a study on whether corporate spending plans differ conditional on this survey-based measure of financial constraint. The result shows that constrained firms planned deeper cuts in technology spending, employment, and capital spending. Besides that, constrained firms also used up more cash, drew more heavily on lines of credit because they afraid that banks would limit access in the future, therefore they sold more assets to fund their operations (Campello, Graham, and Harvey, 2010).

1.1 Capital Structure

The capital structure a firm opts for is only a choice between debt and equity in financing long term investments. The amount of debt a firm uses for finance depend on the interest on debt, corporate income taxes, withholding taxes, personal income taxes, costs of financial distress, and covenant restrictions in other financing agreements, and other market imperfections (Hovakimian, Opler, and Titman, 2002). The lower the rate of interest on long term debts, the higher will be the desire of a firm to opt for it; but higher leverage increases the risk of financial distress. In the extreme, a firm may find itself unable to meet its service obligations, and forced into bankruptcy by disappointed creditors. This normally leads to substantial legal and administrative expenses and in addition, costs implicit in selling assets at distress prices. If not forced into bankruptcy, high leverage can make the firm’s stock less attractive to investors as the probability of financial distress increases (Flannery and Rangan, 2004).

TOPIC: AN EVALUATION OF CAPITAL STRUCTURE AND PROFITABILITY OF BUSINESS ORGANIZATION
Format: MS Word

Chapters: 1 - 5, Abstract, References
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Number of Pages: 71

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