Advantages And Disadvantages Of Capital Structure

The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
The decisions around capital structure lie with the managerial members of the firm, however, it is the debt holders and shareholders who are more prone to bear risk. The normal business risk is always present, but when there is a higher level of debt the equity holders also bear an additional financial risk as there are additional charges relating to the financing. There is also a risk that if future liquidation or bankruptcy was to occur, the creditor hierarchy would favour debt holders first.
Modigliani & Miller, M&M, (1958) found that in a world without taxes, the value of the firm is not affected by its capital structure, and also that the total return to investors remains the same regardless. M&M showed the

In order to maximise firm value under this model, the firm should seek to borrow until that tax benefit from an extra £1 of borrowing equals the cost arising from increased likelihood of financial distress. It is clear that this theory regards the capital structure as highly relevent to firm value, and supports a real world scenario more strongly than M&M as it allows for bankruptcy costs. On an empirical level this perhaps explains why there are differences in capital structures between different