AFM Assignment 4: An Examination of Capital Structure and Theory

This report, titled AFM Assignment 4, delves into the intricacies of capital structure theory, primarily focusing on the Modigliani and Miller (M&M) model. It examines the model's assumptions and its implications for financial decision-making, including the irrelevance proposition in perfect markets. The discussion explores how organizations finance operations through equity and debt, analyzing the impact of capital structure on firm value, shareholder wealth, and the cost of capital. The report highlights the importance of considering factors such as the risk of cash flow, earnings variation, and government policies when designing an optimal capital structure. The conclusion emphasizes the objective of maximizing shareholder wealth by minimizing the cost of capital through effective capital structure management. It references key academic papers to support its analysis.

Running head: AFM Assignment
AFM Assignment
Name of the Student
Name of the University
Author Note

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Table of Contents
Introduction................................................................................................................................3
Discussion..................................................................................................................................3
Conclusion..................................................................................................................................5
References..................................................................................................................................6

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Introduction
In the history of capital structure theory, the M & M model does have the realistic
assumptions, which has been related to the market fictions and the set of information, which
are related to the managers and shareholders. It is one of the influentialeconomic theory, that
does form the basis of the modern thinking upon the capital structure. Upon this theory, it
does advocate to the capital structure irrelevancy theory.
Discussion
The capital structure of organization is the way through which the entity can finance
its assets. The organization can finance its operations through the way of equity or by the
different combination of debt and equity. In any capital structure of an organization, it does
have the majority of debt that has been seen, or else it can be seen that there has been
majority of equity or it can be mix of both (Haq et al. 2018). It does not matter what the
capital structure an organization uses in financing the operations, there is hypnotized in the
perfect markets. The market value of firm is usually being determined by the earning power
and there is also another factor that also determines is the risk of underlying assets and the
value in which it is independent in choosing the finance for investments to dividends(Chen,
Harford and Kamara 2019).
As per the M & M capital structure model, there is an irrelevancy proposition which
has been assumed as there are no taxes also no cost of bankruptcy. In this the working capital
cost of capital will remain stable as there are certain changes in the organization’s capital
structure. There are also no changes or benefits upon the increase of the debt, the capital
structure will not influence the stock price of organization and thus the capital structure is not

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relevant to the stock price of organization (Matsa 2018). Moreover, the taxes and bankruptcy
cost will significantly affect the stock price of organization.
The optimal capital structure does refer to the proportion of debt and equity in which
the realmarginal cost of each available source of financing is the same. Through this capital
structure, it can be seen that it does help in maximizing the share price of market and can
minimize the overall cost of capital of firm(Grosse, Steffen and Streitz 2019). The concept of
the capital market structure can be easily explained in terms of theory, but if it is being
explained in operational terms then it is very much difficult in designing the optimal capital
structure as there are number of factors, which does include both qualitative and quantitative,
which will influence the optimum capital structure.
Through the M & M proposition, some of the assumptions can be unrealistic and does
have some implications, which are listed below:
 The capital structure cannot be relevant to the wealth maximization of shareholder.
 There can be increase of the extent in which the firm that can relies on debt, through
which it can increase the risk also the expected return on equity, but not on the price per
share.
 The value of organization can be determined through the capital budgeting decision of
organization.
The factors that does determine the capital structure decisions are:
 Risk of cash inventory: It does arise because of the failure in paying the fixed interest
liabilities. It does have the higher proportion of debt in which the capital structure does
compel the organization to pay higher rate of interest on the debt.
 Risk of variation upon the earnings: If the rate of debt is higher, then there will be higher
variation upon the expected earning which is available to the equity

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shareholders(Flannery and Öztekin 2019). If the interest rate does exceed the return on
investment, then the shareholders will not get any return at all.
 Cost of Capital: An organization should generate enough revenue, so that it can meet the
cost of capital and can finance its growth in future(Guinnane and Schneebacher 2018). As
it does mean that the capital can be raised from different sources, then it is the duty of
manager that it should consider each source of fund through which it can easily design the
capital structure.
 Government policies: The capital structure which is been done, is does influenced by the
government policies, rules and regulations of the SEBI and the lending policies of
financial institutions which can modify the pattern totally. The monetary and fiscal
policies of government will does affect the decisions of capital structure.
Conclusion
The main objective is to maximize the shareholder’s wealth, through which the
organization can seek in minimizing the cost of capital, through which it will help in the
formation of capital structure of organization.

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References
Chen, Z., Harford, J. and Kamara, A., 2019. Operating leverage, profitability, and capital
structure. Journal of financial and quantitative analysis, 54(1), pp.369-392.
Flannery, M.J. and Öztekin, Ö., 2019. Working-Capital and Capital Structure. Available at
SSRN 3479180.
Grosse-Rueschkamp, B., Steffen, S. and Streitz, D., 2019. A capital structure channel of
monetary policy. Journal of Financial Economics, 133(2), pp.357-378.
Guinnane, T.W. and Schneebacher, J., 2018. Capital structure and the choice of enterprise
form: theory and history. Yale University Economic Growth Center Discussion Paper,
(1061).
Haq, M., Hu, D., Faff, R. and Pathan, S., 2018. New evidence on national culture and bank
capital structure. Pacific-Basin Finance Journal, 50, pp.41-64.
Matsa, D.A., 2018. Capital structure and a firm's workforce. Annual Review of Financial
Economics, 10, pp.387-412.