Debt to Book Capitalization Ratio - Essay Example

Capital structure is one of the highly debated issues involving many complex problems related to what should be the optimum capital structure for the company to maximize its value. One such effort was made by Modigliani and Miller who suggested that the capital structure does not have any impact on the value of the firm under certain assumptions. (Smith) These assumptions were the following:

• No taxes
• No bankruptcy costs
• No cost for enforcing debt contracts
• Investment Opportunities are given
• Homogeneous expectations about the investment opportunities for the firm

Based on the above assumption, the theory suggests that the firm value is independent of the capital structure and there is no fixed combination of the debt and equity which can suggest that at this level the firm has the optimum capital structure.

However, in practice, it is largely believed that the capital structure with 60% of debt and 40% of equity can be optimum for the firm.  Higher debt capital may fund the growth of the firm however with increasing debt, it becomes hard for the organizations to keep the financial covenants of their debts intact therefore high debt ratios incur further risk for the organization, therefore, there is no such magical relationship between debt to book capitalization ratio.

The debt-to-book capitalization therefore varies from industry to industry and there Is no solid formula to determine the debt-to-book capitalization ratio of 60% therefore there is no capital structure theory under which it can be justified that a debt-to-book capitalization ratio should be 60%.

Lessons from Greenfield projects

A greenfield project is one which is built from scratch and is not constrained by any previous work. These projects are mostly constructed on unused land where there is no room or need to be required to remodel the existing piece of land to demolish the existing structures. According to the transaction theory of foreign direct investment, the mode of entry into markets especially foreign markets depends upon how efficient the greenfield projects will be as compared to the domestic facilities. If the greenfield projects are going to give more efficient results than the existing ones then going for greenfield projects can be a good move however if efficiencies are not achieved than in that case greenfield projects may go awry. Therefore one of the most important lessons which can be learned from this is the fact that how good greenfield projects can bring the desired efficiency and effectiveness to the company, especially in relation to operational efficiency. (Hennart). Apart from that the greenfield projects provide the organization necessary room to look for better and more efficient resources. If for example, a firm makes an acquisition then it may have to inherit the labor force and all efficient as well as inefficient resources therefore it may be difficult to obtain the desired results initially as the firm may find itself cleaning up the mess rather than concentrating on its core objectives.