Capital Structure
Response Guidelines
Respond to at least two peers . Your responses should be substantive and could involve one or more of the following:
o Debate the topic.
o Ask a probing question.
o Share an insight you gained from your peer's post.
o Make a suggestion.
o Share a personal experience related to the topic.
o Expand on your peer's post.
Student 1
Capital structure refers to the outstanding debt and equity of a company; debts comes in the form of bond issues or long-term accounts payable and equity is common stock. Modigliani and Miller suggests that the value of the firm is not affected by the debt-toequity ratio.
The authors obtain their results by showing that either a high or a low corporate ratio of debt to equity can be offset by homemade leverage.
The result hinges on the assumption that individuals can borrow at the same rate as corporations, an assumption we believe to be quite plausible. The companies market value is determined by the companies earning power and by any risk of investment; this helps the company determine if they want to finance their investment.
The pecking order theory assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort. The theory works off of the fact that information costs are not equal.
As a manager or supervisor you seek to increase assets, investments, revenue by purposely borrowing money and bringing attention to negativity with their stock.
References
Ross, S. A., Westerfield, R. W., Jaffee, J. F., & Jordan, B. (2018). Corporate Finance: Core Principles and Applications (5th ed.). New York, NY: MCGraw-Hill.Ross, S. (n.d.).
Student 2
I chose to examine Pecking-Order Theory versus Modigliani and Miller. The PeckingOrder Theory centers on the tenants that corporate financial strategizing orders on internal financing, debt options and raising equity, in that order (Ross, et al., 2014).
The theory suggests that the financial strategizing involves a greater knowledge in-house than, relying on information external to the company.
Therefore, the leadership would make decisions based on the analysis of known information of risks and opportunities when determining which route to pursue. This thought process creates a pecking-order.
For example, raising equity in this example refers to releasing shares externally, which would create external ownership and influence. This is why this is the least favorable option of the three.
On the other hand, Modigliani and Miller theory is built on the assumption that there exists no difference when weighing a financial strategy considering debt or equity. The theory is focused on the earning power and risk of its assets, when determining the value of a company.
If you consider both approaches, the underlying thought-process to me suggests that optimizing capital structure is paramount for leadership to alleviate financial repercussion from over-leveraging one area to another.
Ideally, the chosen strategy would be steeped in creating a position which gives the company maximum financial flexibility to avoid cataclysmic outcomes like bankruptcy.
Reference:
Ross, Stephen, Westerfield, Randolph, Jeffrey, Jaffe, Jordan, Bradford. (2018). Corporate Finance: Core Principles and Applications, 5th Edition. [Vitalsource].