Discussion Question 2 Week 8 Capital Structure Decisions - Assignment Example

CAPITAL STRUCTURE al Affiliation) The capital structure of any company is the way in which the company finances its growth and operations by using funds from different sources. These sources include short-term debts, long-term debts or the use of equity (Brigham, 2010). Looking at debt financing, this comes from notes that are payable or bonds. Equity involves the issue of preferred stock, common stock or using the company’s retained earnings. When talking about the capital structure of a company, this means the debt to equity ratio.

This is important because it can be able to show how risky a company. This is where companies with higher amount of debt are riskier. Decisions on the capital structure of a company will be influenced by the business risk of the company, the management style, the market conditions and the growth rate (Bierman, 2003). Therefore, any approach taken when making this decision should consider these factors. There are a number of theories to capital structure, which include: the net income theory of capital structure.

This theory encourages companies to decrease their cost of capital and increase their market value. This is by increasing debt and decreasing equity, also known as having a financial leverage. The second theory of capital structure is the net operating theory of capital structure. This method does not agree with increasing the financial leverage as in the net income theory. This means that change in capital structure has no effect on the company’s market value. There is also the Modigliani and miller method which states that no relationship exists between the capital structure of the company and its cost of capital (Shim, 2008).

This theory indicates that the cost of capital plus the value of any company depend on the expectations of investors. Finally, there is the traditional theory of capital structure which combines net operating income approach and the net income approach. It involves increasing the debt which raises the market value of the company until an optimal level.Looking at the theories, it is clear that the traditional theory of capital structure is the most applicable across the widest number of scenarios.

This is because this method looks at the best mix of debt and equity while ensuring that the company does not go beyond the optimal level. This optimal level ensures that the market value of the company does not decrease and thus the stock prices remain optimal. Since this method optimizes the stock prices, the weighted-average cost of capital will decrease.BibliographyBierman, H. (2003). The capital structure decision. Boston: Kluwer Academic Publ.Brigham, et. al. (2010). Intermediate financial management.

Mason, OH: South-Western.Shim, J. & Siegel, J. (2008). Financial management. Hauppauge, N.Y: Barrons Educational Series.