University essay from Blekinge Tekniska Högskola/Sektionen för management

Author: Arrey Bhit Enow; [2010]

Keywords: Capital structure; Cash options;

Abstract: Capital structure is a term in financial economics that delineates the proportion that the various claimants have to the assets of the company. It often describes the debt and stock ratio in the right hand side of a company’s balance sheet. Franco Modigliani and Merton Miller first propounded a theory in which they explained that, a firm‟s capital structure does not influence its value, only its underlying assets do. In 1963, after adjusting their initial assumptions to include corporate taxes, they propounded another theory which explained that in a world with corporate taxes, and where interest is tax deductible, an issue of debt adds value to the firm. In later years, other theories were developed which supported the view that capital structure influences the value of the firm. I have tried to support this view, while making a contribusion that a flexibilty in a firm‟s financial structure can be very meanful. Since cash helps in a firm‟s flexibility, having significant cash reserve can potentially make a difference to the firm. While studying firms in the developed world - case study Sweden, and firms in the developing world, case study - Cameroon, I found that though firms understand that the choices they make in financing their assets can create or destroy value, they all are united by one basic instinct - the instinct to survive. During crisis, firms in these countries, tend to choose debt over the other financing options apparently because the other sources of finance might be difficult to attain at such operose times. While I understand that the need to survive is the most basic need for all firms to consider, I suggest that, the flexibility argument should be a very important factor for all firms to consider in the dynamic and competitive environments of today. A firm should manage its capital structure such that, it can choose to take an action from different alternatives rather than have - 2 - circumstances compel it to take action. Reaction to events should come from within the firm based on its evaluation of its structure and its resources rather than from outside parameters restricting it to conform to circumstances in a manner that is unrealistic to a realistic aggrandisement of the firm. It is with this spirit that I demonstrated the value of the cash option.

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