Optimal Leverage Analysis: Implications of Capital Structure Theories

CORPORATE FINANCE
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Optimal leverage analysis (implications of various capital structure
theories)
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CORPORATE FINANCE
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Introduction
Leverage refers to the debt to equity ratio in a company’s total capital
structure. Optimal leverage therefore is the average amount of debt that
a company can obtain when raising total capital. A Business can use a
number a capital structure theories with the major objective of increasing
or raising its capital. Some of the most pronounced theories of raisin g
capital include the trade-off theory of raising capital, the Modigliani and
miller theory, the traditional theory approach, agency theory of capital
structure among others. Therefore, different capital structure theories will
have varying impacts on the financing decisions of the company. The
company should therefore ensure that different alternative capital
structure theories are assessed and analysed. Some of these implications
are discussed as follows.
The agency theory of capital structure for example will require the crown
resort company to raise capital from debt, external sources and internal
sources as well. The implications that managers face with this type of
capital structure include the following. First they will have to constantly
strike a balance between payment of dividends to share holders and at
the same time make sure that other stake holders’ requirements are met
(Welchi, 2011). When the stock holders realise that they are not receiving
returns effectively, they may choose to withdraw their money invested in
the company. This is dangerous as it ends up making the run short of the
necessary capital (Karmar,n.d).

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On the other hand, the trade off theory off capital structure operates on
the principal that a company has to choose either to operate on debt or on
equity. Here crown Resort Company is allowed to create a balance
between the amount of debt and equity for the benefit of its share holders
and the company itself. Funds can be generated through obtaining long
term loans form financial institutions. These long term loans can be used
as the starting point of generating capital for the business (Naseer, 2019).
The positive effect of taking a debt is that the company receives tax
breaks. These exemptions would provide the company such as crown
resort with more dividends to pay to its shareholders while reinvesting
part of it as well.
However to in determining the optimal capital structure of the firm,
agency theory states that the value of the firm =internally generated
funds + externally generated funds+ value of debt. This equation can be
summarised by denoting the internal funds together with external funds
with a single letter” ( Xe) and( D) for debt. Therefore the value of the firm
will be equal to Xe +D.
The trade –off theory of capital structure works on the principle that for a
firm to raise optimum capital, the difference between interests on tax
shields and financial distress costs must be calculated. Therefore, the
value of the crown resort company =equity +value of tax relief –value of
financial distress (Oolderink,2013). According to this type of theory, it is
much better for a company to use debt financing if such a company a
company owns enough fixed assets. For those companies whose taxable