The modern capital structure was formed in 1958 by F. Modigliani and M. Miller, they were important contributors of capital structure in corporate finance. They proposed irrelevance theorem which means that it does not matter how the companies finance their capital. The main sources of companies that finance their capital is by issuing debt or equity. The debt can be obtained from Banks and equity is when the capital is raised by issuing shares or selling the stake of the company. The irrelevance theorem focused on the capital structure without tax, when there is tax it does matter on how the company finance their capital, which was published in 1963.
Why capital structure is very important for investors?
Every company pays tax which reduces the profit therefore companies would rather finance their capital by debt because debt is tax deductible and dividend payments are not. The investors should be aware of the capital structure of companies because it can be vital information on giving signals.
Signals by Capital Structure
In conclusion on the ideal capital structure of company is always depends on the managers of the company. Increasing debt can increase the risk of company being bankrupt due to redirection in ability to payback their debt. To much of equity can also signal that the manager might not be motivated and instead they might use too much of the companies money for their personal use. They might also try to increase their equity by investing too much in new projects. It is best for the investors to learn corporate finance to understand how the corporate finance can increase or reduce the value of the company.