Title: The Capital Structure Puzzle If an optimum financing mix exists, then it would be in a company’s best interests to locate it and move towards this optimal capital structure. There has been a...

Capital Structure
Capital Structure
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Contents
Introduction    3
Overview    3
Justification of Choice    4
Current Position    4
Analysis    5
Discussion    7
Capital Structure Theories    8
Conclusion    9
References    10
Introduction
Capital structure refers to the measurement of the amount of debt or equity that a business uses to make sure that its workings have been financed. Financial managers of the corporate are faced with basic decisions in deciding on the capital structure. In the recent past, a economic economist has been committed to ensuring the scientific nature of company financing through empirical research on the company’s market as well as stock behavior. The basic principles of capital structure attempt to clarify the combination of financing sources and securities used by the company to ensure that actual investments are correctly financed. But, the research on capital structure focuses more on the debt or equity ratios in the company's balance sheet.
The mix of stocks and debt is used to fund the company’s assets. This is called capital structure. When the stock price is maximized rather than the enterprise value is maximized, the corporate capital structure is considered to be optimal. The increase in debt will lead to subsequent changes in equity, which is due to the difference in dividends and cash flow due to shareholders and the risk of cash flow. As long as the cost of fixed debt increases to the company’s capital structure, the rate of return will increase. When earnings per share increase, higher stock prices can be observed, and dividends per share can be observed from the increase in return (Quan, 2002). But, a high rate of return will cause shareholders to take higher risks, lower stock prices and bring higher rates of return to equity holders. This report will define the phrase capital structure moreover its purpose, an summary and overview of the four major capital structures, empirical proof from research, and Tesco's capital structure analysis.
Overview of capital structure theory
• M&M without taxes Theory: The key initiative of M&M theory is capital structure. The primary version of the M&M theory was complete of limitations because it was urbanized under the theory of a fully efficient market in which industries do not have to pay taxes, and there are no bankruptcy expenses or information asymmetry.
• M&M with taxes Theory: The main idea of M&M theory is capital structure. The business corporate capital structure does not affect the company’s overall value. ... Subsequently, Miller and Modigliani developed the second edition of their assumption by increasing taxes, bankruptcy expenses or asymmetric information.
• Pecking Order Theory: In corporate financing, the theory of pecking order considers that financing costs increase with information asymmetry.
• Trade-off Theory: The theory of trade-off of capital structure is the opinion that a business selects how much debt financing or how much equity financing to use by balancing expenses or advantages. A vital purpose of this theory is to define the fact that companies generally partly finance through debt or partly through equity financing.
To know the recent economic decisions of a company furthermore their impacts on long-lasting financial conditions, it is essential to review some capital structure assumptions. Under traditional capital structure theory, organizations must strive to decrease their weighted average expense of capital as well as increase the value of their assets for sale (Heughebaert, Vanacker and Manigart, 2012). From this favorable perspective, it’s clear that Tesco made a wise decision when deciding to decrease its net debt to strengthen its balance sheet. The two main credit rating agencies considered this to be a “step in the right direction” and commented on the company's actions. It must be kept in mind that after calculating the company's capability to repay debt, Moody's downgraded Tesco from Baa3 to Ba1 in 2015 (Nini, Patrisia and Nurofik, 2020). After the reduction in net debt, the debt-to-EBITDA ratio of retailers fell from 2.9 to 2.5. But, this year the organization increased its debt share, which is arguably not the most reasonable long-lasting financing decision. Miller's and Modigliani's trade-off theory shows that the capital composition of a company is related to its WACC. Tesco's WACC changed and then its debt share was reduced, which confirmed the main proposition of the theory (Picu, Rotaru and Covaci, 2009).
Another method of capital structure decision-making depends on the pecking order theory. According to this theory, companies should fund their present operations as well as progress through retained profits. But, if for a few reasons the retained earnings cannot be used for financing, the company must increase its debt level. When there are no other sources of external financing, the equity should be issued (Yang and Zheng, 2018). Tesco's long-lasting financial decisions are not affected by the Theory of Pecking Order. The debt-to-equity ratio of the company is very high in the business, which means that earnings are highly volatile.
Empirical evidence from research studies
The increase in debt exposes equity holders to widespread changes in dividends per share moreover earnings per share. Because of debt, business risks are now concentrated on shareholders. Business risks increase because lenders who receive fixed interest will bear less business risks than company shareholders. The use of debt raises the risks faced by equity holders. As the debt capital in the company's capital structure increases, the cost of debt will also increase (Graham & Harvey, 2001). In this case, the raise in the cost of equity is higher than the increase in the debt cost. This is because after paying the cash flow of the lender from the company, enhance in the company will be paid to its equity holders. When the company is about to face bankruptcy and bankruptcy, this concept is factual (Myers, 2001). The normal operation of the company will ensure that debt holders receive their interest before the company pays dividends to dividend holders. During the period of financial crisis and bankruptcy, the company’s assets are about to be liquidated, and after payment to the lender, returns and capital will be provided to shareholders. Therefore,...