Capital Structure

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Introduction

The relationship between capital structure and firm value has been discussed frequently in the literature by different researcher accordingly, in both theoretical and empirical studies. It has also been discussed that whether the firm has any optimal capital structure that has been adopted by an individual firm, or whether the proportions of debt usage is completely irrelevant to the individual firm value.

A firm can choose a mix of three modes of financing i.e. issuing shares, borrowing from the market and use of retained earnings. The ratio of this mix of funds purely depends on the firm and known as optimal capital structure of the firm. This leads to the different capital structure theories. These theories explain their point of view about optimal capital structure how an optimal capital structure can increase the value of the firm and its impact on the cost of capital of the firm.

Capital structure refers to the mix of debt and equity used by a firm in financing its assets. The capital structure decision is one of the most important decisions made by financial management. The capital structure decision is at the center of many other decisions in the area of corporate finance. These include dividend policy, project financing, issue of long term securities, financing of mergers and so on. One of the many objectives of a corporate financial manager is to ensure the lower cost of capital and thus maximize the wealth of shareholders. Capital structure is one of the effective tools of management to manage the cost of capital. An optimal capital structure is reached at a point where the cost of the capital is minimum.

Pakistan is a developing country with three stock exchanges, the Karachi Stock Exchange (KSE) bei...

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...icult in terms of cost and technical difficulties (Shah and Hijazi 2004). The main sources of debt in Pakistan have been commercial banks, which do not encourage long term loans, with almost no reliance on market based debt until mid 1994 when government moved to remove most of the constraints among. Which one action was to amend company law to permit corporate entities to raise debt directly from the market in the form of TFCs (Term Finance Certificates). So corporate bond market has limited history and is in the process of development. This explains why firms on average in Pakistan have more short term financing than long term financing. Booth et al (1999) also pointed in their study on determinants of capital structure in developing countries including Pakistan that the use of short term financing is higher than long term financing in developing countries.

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