Capital structure is such a general things in finance, however, we will still confuse about it. Hence, we are going to write a literature review about the capital structure. Capital structure can be explained in many ways as it can be divided into many parts. Our main focus is the effect on capital structure and the imperfection of the market. The most general effect of the capital structure is the trade-off theory, pecking-order theory and agency cost. Besides, capital structure may influence towards the shareholders and the company taxes. An argument also occurred since there is different explanation about capital structure between Miller Theorem and Myer Theorem. The purpose of the literature review is to gain our knowledge and have a truly …show more content…
First of all, we need to know the meaning of the capital structure. Based on the view of business finance, capital structure is about how a company operates their finance such as equity and debt. It is a common thing for a company has a debt and equity. For example, a company has 30% of equity-financed and 90% of debt-financed; the ratio of debt over total financing is the leverage of a company (Capital Structure 2015). Capital structure can be explained through the theory such as trade-off theory, pecking-order theory and agency cost. However, capital structure might be more complicated in reality.
According to Miller’s model, a company’s value is independent. A leveraged company of the cost of the equity is a company without leverage of the cost of equity plus the premium for financial risk (Capital Structure 2015). This shows that a raise of leverage and the individual risks is influenced between the investors but the total risk is retained. It means that it does not create any extra value. In real life, an imperfections market of capital structure might occurred, so, the theories of capital structure such as trade-off theory and pecking-order theory has been …show more content…
While a company of the WACC decreased, the market value will increase. The performance of the optimal capital structure is when the WACC is at minimum value. It was because as the value of WACC is decreased, the company or shareholder’s wealth will increase (Optimal Capital 2009). Therefore, when a company would like to have an optimal capital structure, the finance department might pay more attention about it. If a company was deeply in debt, interest must be paid when profit has been earned and shareholders can received the dividends. While payment of interest increased will also caused dividend payments to shareholders increased. Whether a company has a bad financial, the payments of interest still need to pay off and it will directly caused a company turn into bankrupt and could not pay back the dividends to shareholders. As everyone know, a rise of the dividend payment can also known as a rise in financial risk. When the financial risk is increasing, it will cause a greater return to compensate the risk and hence, the cost of equity will increase and increase in WACC as well (Optimal Capital 2009).
Tax Effect
Interest is tax-deductible means when a company’s liability increased, it will reduce the tax payment and usually this situation is named tax shield (Optimal Capital 2009). While liability of a company increased, generally will pay more interest then, the company might have a chance to avoid more