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ORIENTATION OF THE TERM PAPER
1.1 INTRODUCTION
The term Paper tries to visualize “Capital Structure Decisions” and
represent the facts that include features of Capital structure,
determinants of capital structure, patterns or forms of capital structure,
types and theories of capital structure, theory of optimal capital
structure, risk associated with capital structure, external assessment of
capital structure and some assumption related to capital structure.
The Term paper provides itself as the conspicuous view of the capital
structure and open up the facts that leads to making decisions.
1.5 METHODOLOGY
The ultimate goal of the Term Paper is to discover the facts concerned
with capital structure decisions. So a well-planned research
methodology has been formulated to get a conspicuous view. In this
section, research processes that been followed while prepared the
Term Paper is been listed:
• Investment Decision
• Financing Decision
• Managing Resources
Financial Services is the area of finance concerned with the
design and delivery of advice and financial products to
individuals, businesses, and government. Career opportunities
include banking, personal financial planning, investments, real
estate, and insurance.
PROFIT MAXIMIZATION
To achieve this goal, the financial manager would take only those
actions that were expected to make major contribution to the firm’s
overall profits. Corporations commonly measure profits in terms of
earning per share (EPS). The objections of profit maximization are,
WEALTH MAXIMIZATION
The goal of the firm, and therefore of all managers and employees is to
maximize the wealth of the owners for whom it is being operated. The
wealth of corporate owners is measured by the share price of the
stock. Maximizing shareholder wealth properly considers cash flows,
the timing of these cash flows, and the risk of these cash flows.
Firms have ongoing needs of funds. They can obtain funds through the
following ways,
The following figure will show how funds flow between financial
institutions and financial markets,
SOLE PROPRIETORSHIP
A sole proprietorship is a business own by one person who operates it
for his or her own profit. About 75% of all business farms are sole
proprietorships. The strengths and weaknesses are as follows,
STRENGTHS: WEAKNESSES:
• Low organizational cost • Unlimited liability
• Income taxed once as personal • Limited funding
income • Proprietor must be all
• Independence • Difficult to develop staff career
• Secrecy opportunities
• Ease of dissolution • Lack of continuity on death of
proprietor
PARTNERSHIP
A partnership consists of two or more owners doing business togather
for profit. Partnerships account for about 10% of all businesses and
they are typically larger that sole proprietorships. Finance, Insurance
and Real estate firms are the most common types of partnerships. The
written contract used to formally establish a business partnership.
STRENGTHS: WEAKNESSES:
• Improved funding sources • Unlimited liability to all partners
• Increased managerial talent • Partnership dissolved upon death
• Income split by partnership of partner
contract, taxed as personal • Difficult to liquidate or transfer
income ownership
STRENGTHS: WEAKNESSES:
• Owners’ liability limited • Higher tax rates
• Large capitalization possible, • Expensive organization
greater funding • Greater government
• Ownership readily transferable regulation
• Indefinite life • When publicly traded, lacks
• Professional management secrecy
The firm’s capital structure should result from balancing the costs
of certain relationships between firm related groups. Sometime
agent does not act in line with the set objectives of the principal.
When you raise debt, leverage will increase. The overall values of
the firm will increase. Debt will have lower cost, so overall cost of
capital will reduce (it is better if the cost of capital reduces).
V = S+ D
Where,
V = value of the firm, S = equity, D = debt
The cost of equity for a levered firm equals the constant overall
cost of capital plus a risk premium that equals the spread
between the overall cost of capital and the cost of debt multiplied
by the firm’s debt-equity ratio. For financial leverage to be
irrelevant, the overall cost of capital must remain constant,
regardless of the amount of debt employed. This implies that the
cost of equity must rise as financial risk increases.
It is assumed that the firm will borrow the same amount of debt
in perpetuity and will always be able to use the tax shield. Also, it
ignores bankruptcy and agency costs.
TRADITIONAL APPROACH
It says that with the use of debt, the overall cost of capital comes
down up to some extent and thereafter the overall cost of capital
increases. Thus there is an ideal point, up to which the overall
cost of capital will decrease with the help of increase in debt,
beyond which the use of debt is detrimental to the company.
Balance Sheet
Current
Debt
Liabilities
Capital
Long term
Total Capital
Assets:
• Stockholder’s
Equity Capital
equity
• Preferred stock
• Common stock
equity
BUSINESS RISK
FINANCIAL RISK
Financial risk is the risk added by the use of debt financing. Debt
financing increases the variability of earnings before taxes (but
after interest); thus, along with business risk, it contributes to the
uncertainty of net income and earnings per share. Business risk
plus financial risk equals total corporate risk.
4.1 FINDINGS
Capital Structure makes a difference to the organizations overall
retained earning. Such measures have consistently promoted
business performance criteria such as profit, sales and
productivity.
The overall findings from this term paper are listed below,
4.2 CONCLUSION
This paper uses a novel data set to explore the capital structure
decisions that firms make in their operations. In the vast majority
WEBSITES
• Md. Tauhidul Alam-10: 30 AM (25-06-09)
HTTP://WWW.ESNIPS.COM
OTHER
• Lecture Notes of Financial Management