Fianance enterpreship - Essay Example

The financial manager of the company tries to strike a balance between debt and equity with the aim of maximization of firm value and minimization of cost. It has been seen that the managers are biased in favour of debt owing to the tax benefits associated with debt financing. The interest paid on borrowings is a tax deductible expense. This is the reason the managers prefer debt over equity as it reduces the outflow of the business. However, an excessive reliance on debt is not in the financial interest of the company.

An ideal mix of debt and equity is essential. There are various theories on capital structure such as pecking order theory, signalling theory, agency theory, trade-off theory, signalling theory etc. As per the pecking order theory the firm should rely mainly on the internal means of financing like retained earnings. This theory gives credence to retained earnings over the issue of equity. In the event of additional funds requirement the debt mode of funding is preferred. The equity issue is used only as a last resort.

The main reason for the preference of debt over equity is the lower information costs associated with this mode of funding (Zhao, et al., 2004). The static trade off theory states that the firms try to strike a balance between the benefits associated with interest tax shield and the probability of bankruptcy and failure. The firms with strong cash flows can afford to have high levels of debt as they are assured of fixed future cash flows. But the small sized firms or nascent business firms with limited free cash flows must not use high levels of debt in their capital base.

As per the agency theory the managers handle the affairs of the company on the behalf of the company shareholders. This gives rise to agency problems. As the reins of management of the company passes onto the managers and does not remain in the hands of its ‘actual’ owners it gives rise to conflict of interest. It is said that there is a misalignment of the objectives. The managers of the company are accused of investing in risky or unprofitable business ventures instead of passing on the surplus cash flows to the owners (Boodhoo, 2009).

On the other hand there is also a view that the shareholders intervene in the smooth functioning of the business which often forces the company to forego lucrative business opportunities. The signalling theory of capital structure suggests that the issue of equity is based on the prevailing market conditions. Suppose the management of the company is of the view that the shares of the company are overpriced then it can resort to the issue of equity. This will help the company in raising higher proceeds from the issue of equity.

On the other hand if the managers of the company are of the view that the market has failed to price the shares of the company correctly then it can opt for the debt mode of financing. If the shares of the company are underpriced then it is not feasible to issue equity as this would mean lesser proceeds. It will not just limit the amount of funds raised but will also lead to unnecessary dilution of ownership which is not in the interest of the company from the long term perspective. The financing decisions of a company are influenced by the above theories and views.

However the financial managers in a company are biased towards issue of debt owing to the inherent benefits of debt issue. The