Unlocking shareholder value by moving closer to the optimal capital structure

Abstract

According to Ehrhardt and Brigham, the value of a business based on the going concern expectation is the present value of all the expected future cash flows to be generated by the assets, discounted at the company's weighted average cost of capital (WACC). An investigation into the research to date on capital structures reveals that there are currently four acknowledged capital structure theories. These are the trade-off theory, the pecking order theory, the signaling theory and the managerial opportunism theory. The work of Modigliani and Miller (1958:261), incorporating subsequent adjustments, is still regarded as groundbreaking and relevant in the modern business environment. The trade-off theory has the most support currently, although the pecking order theory has become a strong rival in explaining capital structures. Many factors determine the way in which a company raises finance. These, in turn, influence its capital structure. The trade-off model can be used as a point of departure to assist companies to engineer their capital structures in such a way that it remains in an optimal interval (zone) and maximises value for the shareholders.