Business Finance and the Capital Structure Research Paper

Business Finance and the Capital Structure - Research Paper Example The most important disadvantage of debt financing is the interest burden and the repayment of loan. If the loan and interest are not repaid on time then banks and financing institutions can seize the assets of the company. The history of bond and stock market shows that risk and returns are indispensably attached to each other. Investors cannot get higher returns if their risk portfolio is low. Lower risk will bring lower returns and in order to get higher returns investors need to take high risk. William Sharpe (1964) and John Lintner (1965) have contributed to the origin of asset pricing theory in the Capital Asset Pricing Model (CAPM). The CAPM was built on the model of choice of portfolio developed by Harry Markowitz (1959). According to the model of Markowitz, an investor opts to select a portfolio at time t-1 which would generate a stochastic return at time t. The model assumes that investors are generally risk averse, and at the time of choosing their portfolio they are concerned about only mean and variance of their return at the end of investment period. So investors prefer to choose mean & variance efficient portfolios that would either minimize variance with a certain expected return or would maximize expected return given variance. Thus, CAPM is a theory that defines the relationship between risk and the expected return of a security or a portfolio of securities. The theory is based on the assumption that the security market is generally composed of risk-averse in vestors and the type of investors who prefer and will to take more risk only when they expect to earn a higher return in commensuration with that risk. The return from an asset varies through successive periods and an asset which has a fluctuating return is considered to have greater risk. So, the tendency of investors is to diversify their investment portfolio so that they could minimize the effect of risk volatility, i.e. the unsystematic risk attached