6.1 The company’s managers will have better information when compared to the
investors, regarding the prospectus of a given company. But the MM theory
assumes, both will have the same information.
6.2 In a situation where a company had invented a new variety of product, it is better
opt for debt finance rather than equity finance. This may be because, if funded
through equity, the new stock holders may get a higher share of new profit of new
product when compared to the old stockholders. If the new product is financed
through debt finance, then a portion of the new profit arising out of the new
product, will go to old stock holders. Therefore one can say, the firm with good
prospectus will prepare financing through debt.
6.3 If the future prospects are not good, the firm may invite new investors to purchase
stock and to share the new higher cost or losses. When new shares are issued,
normally, the share price will come down.
6.4 This signaling theory holds good for smaller firms but not for larger firms having
many financing options.
6.5 The surplus cash will normally be used for debt-servicing or to pay higher
dividends or it may be used for perquisites or it may be used for further debt
rising. Use of surplus cash for debt servicing is called “bonding the free cash
flow”.
6.6 The surplus cash may also be used to finance its own shares.
6.7 Higher the debt means, higher the problems for the managers in the form of risk
of bankruptcy.
6.8 Now, it is clear that, an optimal capital structure means, the level at which the
value of capital is maximized and the overall cost of capital is minimized.
6.9 In practical terms, it may be very difficult to determine precise optimal capital
structures. Therefore using of leverages is purely of judgment approach to
determine the composition of capital structures.
6.10 Outsiders, say, lenders, and analysis made by experts may influence the financial
structure of a firm. These outsiders pressurize a firm to keep their debt activities
below the existing industrial norms. A firm will have to pay heavy interest if it
takes its debt activities beyond the existing industrial debt norms. It may even
lead to a problem of encountering financial distress.
6.11 The fired financial charges may also lead to financial distress, if the sinking fund
payments are not grossed up from time to time.