Baker and Martin argue that the term capital structure refers to a combination of debt and equity capital that helps managers to achieve their objectives (Baker and Martin 144).
- First, managers should consider the merits and demerits of both equity and debt capital so that prognoses could be made and a flexible strategy could be designed to manage the emergent risks.
- Afterward, it is necessary to identify and select the instruments that meet the needs of the organization. Financial engineering is used to design the necessary tools.
- The next step is to align the capital needs of the company with the business strategy.
- The company should establish its own cost of capital that will maximize the value of the firm while minimizing the cost of capital (Sharan 321).
- Lastly, managers should ensure they develop strategies that will decrease the cost of capital on an ongoing basis.
Modigliani and Miller’s theories form a basis for the modern concept of capital structure. These theories are studied to understand how the capital structure of a company affects the cost of the firm’s capital. Moreover, these theories help students understand what the dividend valuation model is and how it must be applied in a specific context. For instance, Modigliani and Miller developed the dividend irrelevance theory. This theory argues that dividends and the underlying assets determine the value of a firm (Damodaran 378). The theory enables finance students to realize why a firm’s value is determined by its dividends policy and the cost of the capital. Modigliani and Miller’s theories help students understand why cash flow and dividends are used in the valuation of a firm. Bierman highlighted that these theories serve as the means of understanding the relationship between a firm’s financial leverage and its market value (Bierman 32).
Capital markets need to be efficient as their performance creates the background for a significant improvement in the economic relationships in the target environment. Moreover, premises for consistent growth are built with the advance of the capital market. The mechanism thereof provides an opportunity for updating the security prices as new information regarding the target environment, as well as the economic, social, political, financial, and environmental factors that may either enhance or impede the growth of the share prices (Kleinbrod 281).
However, the concept of the capital market is not entirely flawless. For instance, the liberalization thereof triggers an immediate rise in the exchange rates, as well as a rapid increase in interest rates. Moreover, with the reduction in bargain competitive advantage, there is a threat of facing significant losses unless the resource management strategy is revisited. Therefore, capital markets need to be controlled tighter (Reilly and Brown 191).
Baker, Kent H., and Gerald S. Martin. Capital structure & corporate financing decisions theory, evidence, and practice. Hoboken, NJ: John Wiley & Sons, 2011. Print.
Bierman, Harold. The Capital Structure Decision. Boston, MA: Springer US, 2003. Print.
Damodaran, Aswath. Applied Corporate Finance. Hoboken, NJ: John Wiley & Sons, 2011. Print.
Kleinbrod, Annette. The Chinese Capital Market: Performance, Parameters for Further Evolution, and Implications for Development. Wiesbaden: Deutscher Universitäts-Verlag, 2006. Print.
Reilly, Frank K., and Keith C. Brown. Investment Analysis and Portfolio Management. Mason, OH: South-Western Cengage Learning, 2012. Print.
Sharan, Vyuptakesh. International Financial Management. Upper Saddle River, NJ:: Prentice-Hall, 2010. Print.