Study to determine optimal capital structure for company and empirical evidences for its support

Abstract

The report deals with one the the most popular and nagging question of corporate finance "how to find an optimal capital structure of a company". the report firstly deals with all the advantage of debt in capital structure namely tax shield, higher return to shareholders, asymmetric information cost of issuing shares , lower issue cost of debt and financing of capital requirements. Subsequently disadvantage of debt are also dealt which are bankruptcy cost, cost of financial distress because of debt and loss of future financial flexibility . Keeping in view these advantages and disadvantages , several theories has been propounded to reach the optimal capital structure of company.First theory is tax theory which proposes to look at after tax return of debt investor and equity investor in a company to decide optimal capital structure . As tax debt returns is higher than that on equity returns, the investor demands a higher return. Second is contracting cost theory which says the information asymmetry between managers and investors is high for equity. So any announcement of equity issue is viewed with signaling overpricing of company's shares. Similarly an announcement of debt is taken as the signal of under priced shares. Generally a manager in company is unable to abolish this information asymmetry. Mainly because any information from him to market is not believed easily as he is supposed to be used biased to his company . Another theory of pecking order take information cost theory a step further. It assumes that company will not issue equity unless it has totally exhausted its debt raising capacity. after this the report deals with selection of right kind of the basis of maturity, currency and fixed/floating rates. It then deals with use of two more parameters namely asset class and certainty of future cash flows to reach debt equity ratio. For most of above mentioned theories. This report includes and empirical study carried out on Indian companies (e.g. Low debt equity ratio of high growth Indian companies is tabulated in Table 1) Towards the end , the report analyses the effect of announcements of changes in capital structure of the company on the share prices. We took twenty five such announcements (debt repayment, raising debt and raising equity ) by Indian companies over last year (beginning December 2005) and found its impact on the share prices. We found 17 out of those 25 announcements causing a change in share price in expected direction. A theoretical explanation of the expected trend is also covered in this part of the report.