Capital Structure

How have the financing needs of multinational companies changed in a pre and post financial crisis in both the developed and emerging market economies? In determining the financing needs of a firm, one needs to examine its capital structure. Capital structure refers to how firms finance their overall operations and growth opportunities by using various sources of funding. Traditionally, firms finance themselves by using either debt, equity or a combination of the two. Modigliani-Miller (M&M) proposition 1, investigates the capital structure of firms under perfect market conditions. A perfect market is defined as a market where there are no transaction costs, no taxes, homogenous goods and that all firms are price takers, meaning they cannot influence the price of the goods. In this setting, M&M claim that regardless of their financing means, a firm’s capital structure does not change the value of a company under the perfect market conditions. Furthermore, the pecking order theory in corporate finance states that the cost of capital becomes more expensive for company’s due to the asymmetrical information between insiders and outsiders of the company. Specifically, the pecking order theory proposes that firms prefer to use internal funding through retained earnings or cash, followed by debt and lastly newly issued equity. This intuitively makes sense because using internal funding through the profits earned allows firms to use this excess capital to be reinvested in its operations. If internal funding is not sufficient, a company can reach out to external borrowings using debt since it is cheaper than newly issued equity. By externally borrowing through debt, the company overcomes the issue of asymmetrical information with its creditors since has a legal obligation to repay the loans granted to it, which to the contrary, is not the case with dividends and shareholders. Additionally, debt provides companies to take advantage of the tax shield since interest payments are tax deductible, which, as a result, increases the firm’s bottom line and decreases the firms cost of capital. As a last resort, a firm can choose to issue new equity to shareholders, but at a great expense due to the large investment banking fees the company must pay to complete the transaction. However, firms can profit from the newly issued equity when they have a high share price during a booming stock market. Although there is no simple way to determine the optimal capital structure of a firm, there are many other factors that influence the decision in how firms finance themselves such as the specific industry they are in, the lifecycle stage they are in, as well as, major macroeconomic factors.