Therefore, the cost of monitoring will be passed on to the stockholders. This
agency cost may reduce the tax benefit arising out of interest amount. Some
times it wipes out the tax benefit. This will have a major influence on the capital
structure.- Signaling Model
12.1 Prof. Gordon Donaldson of Harvard made some findings saying that, (1) Firms try
to manage with internal earnings. (2) They set targets regarding dividend share
ratios based on the future investment opportunities and returns. (3) They are
reluctant to raise dividends, because of the threat of difficulty in maintaining the
raised dividends at all time (4) they use surplus cash for servicing of debt, to
maintain dividend level, repurchase of shares, invest in other securities etc.
12.2 Equity finance will be raised in the form of earnings and new stock. First
preference will be in favour of using retained earnings. If the retained earnings
are not sufficient, a firm may go far debt financing rather than going for issuing of
new stock. This will cause debt ratio to go up.
- Conclusions
The analysis of capital structure must focus both on market values and the book values.
But a firm can stay on either of one. But the analysis is meant to find out the capital
structure which maximizes the firm’s market value. The credibility lies in the stock
price. Therefore capital structure can be determined by an analysis of market values.