Why Do Firms Choose Their Capital Structure - 1623 Words

1. Introduction In order to grow, an enterprise needs investments. So they need to start wondering about which securities to acquire and how to finance those investments: with equity, debt or a combination of both (Myers, 2001). The study of capital structure tries to clarify this variety of securities and financing opportunities. In accounting terms, this decision is situated on the right-hand side of the balance sheet (Myers, 2001). In his Capital Structure Puzzle article, Myers (1984) poses the question â€Å"How do firms choose their capital structure?†. But even today, there is no right solution to this question. In the literature, there are three central theoretical models: the tradeoff model, the pecking-order hypothesis, and the agency†¦show more content†¦There is no obligation of an effective repayment to the shareholders and in return, the firm pays out a dividend to cover for the incurred risk. The amount of the dividend depends on the profitability of the firm. If the firm is not capable of paying out a dividend to its shareholders, this does not necessarily lead to bankruptcy. The other option firms have, is to use debt. Creditors invest money in the company, and the company has the obligation to repay an effective payment, with an agreed interest rate and maturity date (Proenà §a, et al., 2014). 2.1. Theories of capital structure The base for the modern capital structure theory comes from Modigliani and Miller (1958). They stated that it is irrelevant for a firm to choose between equity and debt in perfect and frictionless markets (Modigliani Miller, 1958). In those markets there are no taxes, perfect information disclosure of information and no transaction costs connected with the raise of money or going bankrupt (Chen, 2004). 2.1.1. Tradeoff theory Five years after their pioneering research, Modigliani and Miller relaxed the perfect market assumptions and added corporate tax decision to their models. Consequently, they found that an increase in debt levels will raise the value of the firm, because firms who finance their activities with long term debt experience a debt tax shield (Modigliani Miller, 1963). Modigliani and Miller (1963) do not show any evidence for bankruptcy