The Effect of Capital Structure on Profitability - Literature review Example

CRITICAL LITERATURE REVIEW The extent to which the Modigliani and Miller theory holds in practice both historically, and in thecurrent climate of conservatism by the financial markets following the recent financial crisis. Modigliani and Miller (1958) felt that in the presence of taxes and bankruptcy costs, the structure of the capital of a company is linked directly to its market capitalism. This notion has been widely debated as some feel that this theory may be true while other disagree. This notion suggests that the managers in companies should aim to establish an optimal gearing a maximum ratio to maximize shareholder value. This theory also attempts to explain the financial cycle and how each sector may be interconnected with the other sector. Outside forces may affect a company or an organization when it comes to shaping its capital and the distribution of finances to each sector. It shows how the independent market that is not controlled by particular forces can be influenced by factors such as bankruptcy cost. When there is free, market, there is the freedom of venturing in many different risks some of which may lead to engagement of debt. Continuing to accumulate debt while settling other debts with debts may lead to a situation such as bankruptcy cost. Such a situation in a company may determine a different structure of capital within this business in an attempt to strike a balance between the usage of present finances and the settlement of debts. In order to have a stable organization, an organization needs to shape its capital structure keenly in order to fit the goal and objectives of the organization. It needs to use new ideas from within itself. It also involves not making quick assumptions about matters without first considering their viability. This explains why most innovators come from different countries or regions. It may even come from a new industry that has a founder who has a very nontraditional background or one whose ideologies were not taken seriously back where they are from. New innovators from other regions have the ability to view things from a different perspective and see opportunities that others have not. They are also not too reluctant to act on these opportunities and hence end up becoming successful innovators. If a company aspires to achieve success in their industry, it first should boost its capital structure and be willing to accept new ideas from different people. It will enable companies to relocate from less productive to better-performing ones. This shows that factor and demand conditions do not have to be purely national as markets expand to different nations (Abor, 2005, p. 440). In a different context, Modgiliani and Miller (1958) suggest that when there are changes in the free market then this may be reflected in the capital structure. An asset that is physical will be worth acquiring so long as it can help increase the profits of the business. In the free market, when one acquires these assets, then they increase the amount of capital they have. This then determines the structure of their capital as it is set to fit the needs of the organization. Such an asset will increase the yield of the business as it will increase the rates of interest that the returns of the business will come with. In this event, the asset will also increase the value of the organization’s equity, as it will contribute more to the market value of the firm. It will, therefore, be rated is a higher order and be on a higher economic level. The distribution of capital from one sector to the other within the firm will be keenly structured in order to generate more profits. This includes the covering of debts even in the form of bonds and payable notes that are long-term (Villamil, 2008, p. 6). The equity of the firm is then based on the stock that is common or earnings that are retained in the business. Optimal capital structure in the past, most economists did not seriously look into the problem of the cost of capital risk. They did not have established principles that controlled the investment that was rational. There were also no financial policies established in order to govern. However, the current economists have drawn various factors that determine the impact that a product will have in the free market. These include leadership and strategic practice as well as business assets. The firm’s prosperity is created, and it does not just happen because a country is endowed with natural resources, human labor or the value of its currency. As much as each country has its own unique and beneficial features when it comes to gaining or achieving competitive advantage, the individuals in that firm have to put effort to be successful. If not so, the resources will be left unused, and someone from a different country might come around and utilize all these resources. The competitiveness of firm relays on the ability of its staff to be inventive and innovative. The reason companies gain an advantage against great competitors is the challenge they face as well as pressure to perform. This comes because of the presence of tough homeland rivals to keep them on their toes. Great demand from local clientele also contributes to this success. Most of the companies that have achieved to maintain their position as great international competitors are there because of local factors within their nation’s history, culture, and structure of their economies. There are outstanding differences in the national values and the characteristics of each firm (Harris, 1991, p. 300). This is what limits the firms from being competitive in many areas at once. Countries prosper in certain industries due to their home setting being advanced, vibrant and testing. With great knowledge and information from the customers and the staff members, as well as results obtained from research, an organization is advantaged in various ways. The management will have a variety of different perspectives to consider including those of the employees. The organization is also able to keep up with the trends in technology, marketing strategies and profit generation of profits. When management can acquire information from these areas, the plans and strategies employed to achieve them are more reachable. New ways of thinking about strategy are also realized in the running of these processes. This is because of the different ideas from different individuals who have different knowledge and experiences on different matters. The management is also at a position of gathering useful information from professionals on various matters. A strategic plan that will impact change is backed up with sufficient knowledge on a variety of matters. Each generation has new ways of thinking based on the lessons learned from past strategies or innovation on existing strategic plans within the organization. Improving on past strategies or better yet coming up with brand new ideas on new strategies can benefit an organization both internally and externally Bradley, 1984, p. 860). This is because the new strategy may satisfy both those working within the organization as well as work towards adding on the customers or clients of the organization while maintaining those already in existence. New strategies can, therefore, be derived from evolved old strategies. For instance, past strategies were designed in a manner that dwelled on the predictable nature of circumstances. However, now the times are different, and the market and organizations in the industries cannot quite predict the changes that may occur in the market or society. For this, they have to be thoroughly prepared and come up with strategies and plans that will enable them emerge undisrupted by these turbulent changes. Unlike in the past when the methods used were almost the same and rarely are they revisited, the current strategies need to be able to keep up with competition in the market and protect the organization’s long-term survival in the industry. According to (Xavier, 2002, p. 56), a strategic process that is robust is required in order to ensure that an organization maintains its success despite the turbulence and unpredictability. The strategic use of trending platforms such as the internet and is, therefore, necessary in order to ensure that the reforms made are guiding the organization in the right direction. Old strategies did not prioritize the use of platforms such as the internet that would render most of the past strategy models as not so reliable strategies. Hence, there is a necessity for a complexity in the generation of new strategies in organizations. The theory of capital structure states that the free market can influence the structure of capital within a business. This is determined by the flow of cash from the market and to the organization and the amount of profit being made. The goal of any business or organization is primarily to generate profit. Therefore, the structure of capital within each organization will favor the mode that is most likely to earn the organization more returns. Capital structure refers to the way an organization covers its finances. It also refers to how the finances are distributed in order to meet the needs of an organization. This signifies that the organization’s market value depends on the earning power it possesses and by the risk, the underlying assets the company has. Leadership also involves not only being in a position of power, but the proper execution of roles while in management. Through the use of proper strategies, the leadership can be able to lead the organization into an era of success and expansion. It is, therefore, the responsibility of the management to ensure that the strategies they conclude to be used are going to deliver relevant results. This includes the choice of employees they chose to hire; their qualifications and excellence at their job as well as their dedication and commitment. It is also the responsibility of the employees to support and ensure that every move made by the members of the organization is aimed at promoting the following of the strategy. This is because even a great strategy by the brightest of persons can turn into a failure if the organization’s management does not work towards executing the strategy. It can, therefore, be useless to the progress of the organization. It is important that the management of the organization to have vast knowledge of the changing times and how to make the strategies work out for the good of the organization (Graff, Small, Zivin, 2005, p. 1). The agreement of the strategy to be used by the management is also God for the organization. It shows the management as a united front to the employees. In conclusion, all the above factors have a great impact on the capital structure of an organization. They show the importance of coordination of factors within an organization in shaping the capital structure of a firm. It also describes how they influence the stand of the market in the free market. The above factors also describe the importance of gaining relevant assets in a business that will help multiply the profits in the organization. It is important that the expertise used in an organization lead to the creation of a good capital structure that is in line with the free market. Therefore, the business structure is designed based on market capitalism, which is important in keeping the firm relevant to the industry. The agreement of the strategy to be used by the management is also good for the organization. It shows the management as a united front to the employees. This will be effective in ensuring that the strategy put in place is followed. The leaders have different levels of influence on the strategic influences to be followed. A strategic leadership approach is also formulated rather than something that the organization has. This is because the leaders are leading a people that are different from those of the past within the organization, and there have been various changes in the legalities in the sector of employment relations. The Modigliani and Miller’s conclusion about capital structure and how it is influenced by the market capitalism helps in defining the principles used in the market while defining the principles of governing finances. Each aspect of the organization and the management of finances are important to the organization as it determines the assets acquired and the methods used in multiplying the profits. References Abor, J. (2005). The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana. The journal of risk finance, 6(5), 438-445. Bradley, M., (1984) On the existence of an optimal capital structure: Theory and evidence. The Journal of Finance, 39(3): 857-878 Graff Zivin, J., & Small, A. (2005). A Modigliani-Miller theory of altruistic corporate social responsibility. Topics in Economic Analysis & Policy, 5(1). Harris, M. and Raviv, A. (1991) Theory of capital structure, The Journal of Finance, 46 (1): 297-355 Modgiliani and Miller (1958) Cost of capital, corporate finance, theory of investment. American Economic Review, 48(3): 261–297 Villamil, A. P. (2008). The Modigliani-Miller Theorem. The New Palgrave Dictionary of Economics, Second Edition. Eds. Steven N. Durlauf and Lawrence E. Blume. Palgrave Macmillan, 6. Xavier, F. B., & Hunt, R. A. (2002). Strategy in turbulent times. Managerial Auditing Journal, 17(1/2), pp. 55-59. Read More