Issues in corporate finance Assignment Example | Topics and Well Written Essays - 2000 words

Issues in corporate finance - Assignment Example Most important, companies have to understand the value of trading-off aspects of capital because such practise results to better performance. The trade-off theory of capital structure maintains the positive relationship between earnings and leverage. Empirical evidences, however, argue that such observation is fallible (Sarkar and Zapatero, 2003). Despite the contradicting outcomes, trade-off has considered as valuable mechanism in gauging corporate revenues. In most instances, the trade-off theory has consistently predicted information related to debt structure. The theory suggests that weak firms are more inclined to finance exclusively with bank debts. Apparently, weak firms tend to ignore other debt sources in particular public debts. Another important idea posited by the theory is that the optimal debt structure seen among strong firms pertains to combinations of bank and market debt. Basically, strong firms have become adept in successfully managing both bank and market debts. It has to be noted that the nature of both debts are differently perceived. Strong firms have the capacity to acquire different forms of debt instruments because of their financial scope. In uncertain markets, the strategy of using varied debt mechanisms allow strong firms to be more flexible in handling risks. According to Brealey and Meyers (2000), the trade-off theory pu... Furthermore, critics claim that the theory is ill-equipped to justify relevant practises. The concept developed by Modigliani and Miller (1958) revolves on the market imperfections that eventually affect capital structures. Indeed, market imperfections occur in several forms. The most prominent observed among firms include taxes, market distresses, and agency costs. For most firms, the challenge is to create an optimal capital structure when these market imperfections emerge. The theory assumes that after a certain firm establishes the optimal combination of financial resources all succeeding financing is raised in the same proportion of debt and equity financing. This, however, is expected to vary in the method of reporting and practising. Among publicly trading companies, Houston and James (1996) observed that there is an insignificant use of market debt. The percentage of non-market debt among listed companies is greater in value as evident in the majority of firms preferring non-market debt. In addition, the listed firms that use market debts show that non-market debts still occupy the most shares on the overall debt. Johnson (1997) pointed out that the long-term debt structure suggests better use of market debts. Among the users of market debt, more than half of the total long-term debt is considered as market issued. Trade-off has usually been used to determine financing decisions. Traditionally, firms either maintain a target capital structure or follow the hierarchy of financing. Pinegar and Wilbritch (1989) conducted a survey on firms belonging to the Fortune 500 on their financing preference. Based on the results, majority of the firms listed in Fortune 500 have been using target capital structure to