Capital social system refers to the proportion of finance from debt and from equity capital (D/E ratio). An efficient mixture of capital reduces the price of capital. Lowering the monetary value of capital attachs net economic returns, which, ultimately, increases firm value. There ar a number of theories that explain capital structure, namely, M& angstrom unit;M, Static Trade-off Theory and the Pecking Order Theory.
M& vitamin A;M system assumes that the market is in a blameless capital market status as no dealings or bankruptcy embodys, asymmetric information flow, firms and individuals can sorb at the same interest rate, no taxes and investment decisions are not affected by financing decision. All these guess made firms away from the impact of different take of debt and equity. Their ii ?propositions? were about the value of company is independent of its capital structure and the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. However, imperfections exist in the real world so that we need trade-off theory and the pecking order theory to explain more.
The trade-off theory begins with the intellect of an optimal capital structure. When a firms debt increases, the accompanying tax advantages increase and tend to offset the firms debt- connect, expected costs of financial affliction and bankruptcy.
With additions to debt at relatively low levels of debt, the tax advantages increase fleet than expected financial distress costs, therefore, the value of the firm increases. However, if the debt level continues to increase beyond the optimal debt level, then the increasing fringy expected cost of bankruptcy more than overcomes the marginal debt related tax advantage and the value of the firm declines. (Claggett, 1991)The Pecking Order theory suggests there should be a preferred hierarchy for financing decisions. Internal financing (i.e.
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