In general, people think that in different kinds of capital structures,
equity has higher risk and debt refers to lower risk. Thus for higher risk,
investors demand higher returns and the cost of overall capital has also
increased which is not good to the development of companies. And that allows a
core concept about financial management “gearing level” and there are some
relationships between gearing level, overall cost of finance and risk of
companies. The chain reflections between them are that if companies hold
capitals at low gearing levels, the risk of financial distress will be low and
moreover the overall cost of capital may be high, at last they will take an
effect on risk held by companies in the same direction. Therefore, with regard
to companies, debt finance is cheaper and riskier.
In my opinion, in order to
achieve an optimal capital structure, I will suggest companies’ managers to
keep the gearing levels at an appropriate rate to reduce the risk as much as
possible. In other words, companies should be as highly geared as
possible.
In capital structure, there is one famous theory in the academic
literature which is called as ' the trade-off theory'. This theory illustrated
that when gearing rises causing the weighted average cost of capital to rise
and the firm's value to fall, financial distress and agency costs eventually
outweigh the lower cost of debt. The situation like this is not very good,
the managers of companies should take charge of it and begin to take some
effective actions to improve the financial dilemmas. As for Miler and Modigliani argument, they introduced the significance of tax shield of debt which suggests a method for companies to decrease their taxation distribution and this important influence also makes companied have lower risk and higher returns to shareholder compared to no gearing in capital structure.
Other main models
for capital structure theory are as follows: Pecking Order models, Signaling
Models and Agency Cost Models. Because of the existence of Pecking Order, the
managers of companies have their own preference to the various ways how to
gather more money. When I become a financial manager in a multinational
company, I will build up our company’s optimal capital structure by taking
Pecking Order models into consideration. In order to raise more money and keep
risks at a low level, I will get internally generated funds firstly and then
get borrowings as debt finance, lastly issue equity. According to these
choices, the company could minimize their WACC figure as low as possible and
make profits to the shareholder that can be close to maximum size.
In practice, for
the sake of realizing the shareholders’ values, any company should compare the
WACC with different degrees of gearing to get an optimal level or a reasonable
level. The sufficiently thorough analysis of past date could help managers make
some exact decisions avoiding the unnecessary high-risk.
