Financial Decision Making Impact of Capital Structure

Question: Discuss about theFinancial Decision Makingfor Impact of Capital Structure. Answer: Impact of Capital Structure Decisions on Business Performance Capital structure refers to the method selected for financing the assets by a firm. A firm incorporates the use of either debt or equity or combination of both for financing its operational activities. Debt financing is the capital acquired through borrowing of funds whereas equity funds refer to the finance gained through selling of a companys stocks (Baker and Martin, 2011). It has been advocated through capital structure theory given by Modigilani and Miller that capital structuring decisions does not have an impact on the performance of a company. As per the theory, a company market valuation is not dependent on whether it has higher equity or higher debt component in its capital structure. The theory suggests that market valuation of a company is only impacted by the operating profits generated by it. Thus, the capital structure of a company whether having majority of debt or equity component does not impact its business performance. The theory given by Modigilani and Miller is known as capital irrelevancy theory according to which market value of a company is only affected by its future growth and does not have any relationship with the capital structure financing decision. The assumption of capital structuring irrelevancy on business performance is based on the fact that debt financing does not have any impact on the operating profits as cost of borrowing funds is same for investors and companies. The market value of a leveraged company having debt financing and an unleveraged company with no debt finance is relatively same as per capital structure theory if both have same future growth prospects (Brigham and Ehrhardt, 2007). References Baker, K.H. and Martin, G.S. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley Sons. Brigham, E. and Ehrhardt, M. 2007. Financial Management: Theory Practice. Cengage Learning.