Capital Structure

Capital structure is an important for a firm. Proportion of debt in the capital structure can influence the cost of capital and wealth of the shareholders. If, as a result of increasing the gearing ratio, this lead to increase in financial distress causes the shareholders and creditors to demand more return. But the gearing ratio can’t be too low. In the traditional view, the firm have to maintain optimum balance between cost of capital and debt.

In 1958, Modigliani and Miller’s concluded that the value of the firm remains constant; it doesn’t make difference between equity and debt. They assume, it not aligns with the real financial market such as taxation, perfect capital market with perfect information available all economic agents and no transaction cost.

Increasing in debt could be effect the share price of the firm.  So it wouldn’t make a sense to the shareholder and high risk faced the company. To mitigate the risk company have to invest in lower risk debt. This is further enhanced the tax relief on debt capital. Debt to equity can also be affected by other factors such as borrowing capacity, reinvestment risk.....etc.

In the recent BBC news ( 2009) De Beers, the world’s largest diamond producer plans to raise $1bn rights issue from investors to cut debt. Because the company debt’s currently have $3.5bn, by reducing the De Beers level of debt could improving the capital structure of the company. This enables the company to take an advantage of new investment opportunities.