Capital Structure Decisions
The article “Debt is good for you” examines the theories relating to equity and debt financing as the developments in the corporate bond markets. While the article “Debtor’s prison: Companies made a fashionable mistake” talks about the relation between the credit ratings of non financial companies with so-called “efficient” balance sheet approach.
“Debt is good for you” talks about the different approaches a firm can take when it comes to debt to equity ratio. While the most commonly taught and most commonly talked about theory is the Modigliane-Miller theory which suggested that a firm’s overall value should increase as it substitutes debt for equity, the one’s preferred by managers are the variations of the trade-off theory which says that the amount of debt a firm is willing to take on depends, among other things, on the business it is in Profitable companies with stable cash flows and safe, tangible assets can afford more debt; unprofitable, risky ones with intangible assets, rather less. The article also talks about another kind of theory called the “the pecking-order theory”. The main point of this theory is that outside investors in a firm know less about the health of a firm than its managers do, which can cause a problem when the company wants to issue equity, managers cannot control what the investors may believe hence Issuing debt generally is less dramatic effect, but external finance is still costly, hence retained earnings becomes the main source of financing for the firms.
