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Change of Capital structure

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Introduction

U52024 Theory of finance To what extent does the capital structure of companies depend upon the availability of particular source of funds? What are the implications of your answer for the validity of the original Modigliani- Miller theorem on capital structure and for the trade-off and pecking order theories of capital structure? Module Leader: Andy Kilmister Name: Bee Cheng Khoo Student No: 07133309 Word Count: 2139 words Contents 1. Introduction 2. The Modigliani and Miller (M&M) Theorem on capital structure 3. The way in which capital structure of companies may be affected by constraints in the availability of funds 4. Trade off Theory 5. Pecking order Theory 6. Conclusion 7. References Introduction Nowadays, the capital structure of most companies has to depend heavily on the availability of particular sources of funds which is incompatible to the Modligliani and Miller theorem. In the next section, the idea of the Modigliani and Miller's theorem on capital structure will be discussed. The issues of the capital structure of companies which depend on the availability of particular sources of funds will be discussed in the third section. In the section that follows, we discuss the trade-off and pecking order theories of capital structure and the conclusion are in final section. The Modigliani and Miller (M&M) Theorem on capital structure According to Modigliani and Miller (1958) theorem on capital structure, optimal capital structure usually believe that whatever form of securities that a firm wishes to issue, can be issued with the pricing conditioned on the risk of the security. ...read more.

Middle

They show that 'financial covenant violations' give rise to a huge and constant decrease in net debt issuing activity by giving creditors with limited rights to influence financial policy via altering the conditions of the credit agreement. Furthermore, they find two reasons to why the financing response to 'covenant violations' is stronger. Firstly, various actions can be taken by the existing creditors to decrease the acceptable borrowings in order to moderate the supply credit such as increase interest rates. Secondly, the access of borrowers to alternative sources of finance is either limited or rather costly. Therefore, covenant violations play a key role in affecting the flow of capital to companies due to their ability to assign control rights to capital supplier in a state-contingent way. Furthermore, Dichev and Skinner (2002) find that managers tend to take actions to avoid debt covenant violations especially the managers of healthy company. Since any review of the operations of a company by outsiders is expected to be costly, the managers would prefer to avoid it. For example, the administrative time, the need to generate updated financial reports, and the need for management to explain and justify its forecasts and strategy. Consequently, it is likely that even managers of company with good performance will try to find the way to avoid violations, in particular if they can do so at rather low cost. Trade off Theory In the trade off theory, the benefits of increased the level of debt are weighted against the costs of increased leverage. ...read more.

Conclusion

G and Pennacchi. G (1990) Financial intermediaries and liquidity creation, Journal of Financial, Volume. 45, pp 49-71 Holmstrom. B and Tirole. J (1997) Financial intermediation, loanable funds, and the real sector, Quarterly Journal of Economics, Volume. 112, pp 663-692 Korajczyk. R and Levy. A ( 2003) Capital Structure Choice: Macroeconomic Conditions and Finance Constraints, Journal of Financial Economic, April 2003, Volume. 68, pp75-109 Leary. M.T (2008) Bank Loan Supply, Lender Choice and Corporate Capital Structure, Working Paper, Cornell University Lemmon. M and Roberts. M (2007), The Response of Corporate Financing and Investment to Changes in the Supple of Credit: A Natural Experiment, Working Paper, University of Utah and University of Pennyslvania Myers. S (1984) The Capital structure Puzzle, The Journal of Finance, Volume. 39, pp575-592. Modligliani. F and Miller M.H. (1958) The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review, Vol. 48.No.3, pp 261-297 Pandey. M (2001) Capital structure and the firm characteristics: evidence from an emerging market, Working paper, Indian Institute of Management Ahmedabad Rajan. R. G and Zingales. L (1995) What Do We Know about Capital Structure? Some Evidence from International Data, Journal of Finance, Volume. 50, Issues. 5, pp. 1421-60 Roberts. M and Sufi. A ( 2009), Control Rights and Capital Structure: An Empirical Investigation, Journal of Finance, August 2009 Sufi. A (2009) The real effects of debt certification: Evidence from the introduction of bank loan ratings, Review of Financial Studies, Volume. 22, pp. 1659-1691. Titman. S and Wessels. R (1988) The Determinants of Capital Structure Choice, Journl of Finance, Volume. 43, Isseus.1 pp1-19 Um. T (2001) Determination of Capital Structure and Prediction of Bankruptcy in Korea, unpublished PhD Thesis, Cornell University ?? ?? ?? ?? 8 ...read more.

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