4 Important Capital Structure Theories

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What is Capital Structure?

The capital structure is how a firm finances its overall operations and growth by making using of various sources of funds. Debt is collected in the form of bond issues or long-term notes payable, whereas, equity is classified as common stock, preferred stock or retained earnings. Short-term debt like the working capital requirements is also considered to be a part of the capital structure.

Capital structure refers to the outstanding debt and equity of the company. It shows the proportions of senior debt, subordinated debt, and equity in funding. The main purpose of the capital structure is to provide an overview of the level of a company’s risk.

In financial management, capital structure theory refers to a systematic method of financing various business activities using a combination of equities and liabilities.

Following are the four Capital Structure Theories:

1. Net Income Approach

The net income approach says that the value of the firm can be increased by reducing the overall cost of capital through a higher proportion of debt. This means that the weighted average and capital cost of the firm can be reduced by the increase in the value of the firm and its equity shares. This can be done by debt financing. This approach of capital structure is based on the following assumptions:

  1. The cost of debt is less than the equity cost
  2. There are no taxes
  • The risk perception of the stakeholders is not altered by using debt

The line of argument in favor of the net income approach is that with the increase in the proportion of debt financing capital in the capital structure, the proportion of cheaper source of funds also rises. This results in the reduction in the overall weighted average cost of capital, further leading to a rise in the value of the firm. The reasons for supposing the cost of debt to be less than the cost of equity are that the rates of interests are lower than the dividend rates because of the risk factor and advantage of tax as interest is a deductible expense.

2. Net Operating Income Approach

The Net Operating Income Approach was suggested by Durand. This approach is said to be the exact opposite of the Net Income Approach. This method suggests that the change in the capital structure of a company has no effect on the market value of the firm and thereby the overall cost of capital stays the same regardless of the method of financing. This implies that the overall cost of capital remains constant if the debt-equity mix is 50:50 or 20:80 or 0:100. Hence, there is nothing like an ideal capital structure and every capital structure is optimum. This approach presumes that:

  • The market capitalizes the value of the firm as a whole
  • The risk of business stays the same at each and every level of debt equity mix

The reasons proposed for such assumptions are that the higher use of debt increases the financial risks of the equity shareholders, that further increases the cost of equity. The cost of debt is constant with the increased proportion of debt as the financial risk is not affected. Hence, the advantage of making use of the cheaper source of funds.

3. The Traditional Approach

The traditional approach is also known as the Intermediate Approach. It is a negotiation between the two extremes of the net income approach and net operating income approach. According to this theory. The value of the firm can be increased or the capital cost can be reduced by using more debt as debt is a cheaper source of funds than equity. Hence, the optimum capital structure can be reached by a complete debt-equity mix. Thus, according to this theory, the overall capital cost decreases up to a particular point, stays more or less unchanged and increase beyond a certain point. The cost of debt may also increase at this point due to the rise in the financial risk.

4. Modigliani and Miller Approach

This theory was planned by Modigliani and Miller during the 1950s. The basics of this approach resemble that of the Net Operating Income Approach. This approach suggests that the assessment of a firm is irrelevant to the capital structure of the company. If a firm has a highly leveraged or lower debt element in the financing mix, it has no bearing on the value of the firm. The theory further stated that the value of the firm doesn’t depend upon the choice of capital structure of the firm. Following are the assumptions of the MM approach:  

  • There are no taxes
  • The cost of transaction for buying and selling and bankruptcy cost is nil
  • There is an order and manner of information. This means that a stakeholder will have access to the same data that a corporation and investors would behave rationally.
  • The borrowing cost is the same for the stakeholders and the companies.
  • There is no floatation cost, like underwriting commission, payment to merchant bankers, advertisement expenses etc.
  • There is no corporate dividend tax.
  • The cut-off point of investment in the organization is a capitalization rate.
  • The risk to investors depends upon the fluctuations of the expected earnings and the probability that the actual value of variables may be different from their best approximations.

These are some of the major approaches of the capital structure.

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