Capital Structure: A Sectoral Case Study of Indian Corporate (Period-2004-06)

Since the objective of financial management is to maximize shareholder wealth, the key issue in the capital structure decision is: What is the relationship between capital structure and firm value? Alternatively, what is the relationship between capital structure and cost of capital? Remember that valuation and cost of capital are inversely related. Given a certain level of earnings, the value of firm is maximized when cost of capital is minimized and vice versa.

There are different views on how capital structure influences value. Some argue that there is no relationship whatsoever between capital structure and firm value; others believe that financial leverage (i.e. the use of debt capital) has a positive effect on firm value up to a point and negative effect thereafter; still other contend that, other things being equal, greater the leverage, greater the value of the firm.