Capital Structure and its Theories

Capital Structure means combination of all long term sources of finance. It includes Equity Share Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other such long term source of finance. A company is required to decide that in what proportion, it should have its own finance and in what proportion it should have outsiders finance. Based on proportion of finance, WACC and Value of firm are being affected. There are four approaches to this, viz. net income, net operating income, traditional and M&M approach.

Capital Structure

Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is synchronously used as financial leverage or financing mix. Capital structure is also referred as the degree of debts in the financing or capital of a business firm.

Financial leverage is the extent to which a business firm employs borrowed money or debts. In financial management, it is a significant term and it is very important decision in a business. In the capital structure of a company, broadly, there are mainly two types of capital i.e. Equity and Debt. Out of the two, debt is considered a cheaper source of finance because rate of interest will be less than cost of equity and the interest payments are a tax-deductible expense.

Capital Structure Theories

Capital structure or financial leverage deals with a very important financial management question. The question is – ‘what should be the ratio of debt and equity?’ Before scratching our minds to find the answer to this question, we should know the objective of doing all this. In the financial management context, the objective of any financial decision is to maximize the shareholder’s wealth or increase the value of the firm. The other question which hits the mind in the first place is whether a change in the financing mix would have any impact on the value of the firm or not. The question is a valid question as there are some theories which believe that financial mix has an impact on the value and others believe it to be not connected.

How can financial leverage affect the value?

One thing is sure that wherever and whatever way one sources the finance from, it cannot change the operating income levels. Financial leverage can, at the max, have an impact on the net income or the EPS (Earning per Share). The reason is explained further. Changing the financing mix means changing the level of debts and change in levels of debt can impact the interest payable by that firm. The decrease in interest would increase the net income and thereby the EPS and it is a general belief that the increase in EPS leads to increase in the value of the firm.

Apparently, under this view, financial leverage is a useful tool to increase value but, at the same time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is because higher the level of debt, higher would be the fixed obligation to honor the interest payments to the debts providers.

Discussion of financial leverage has an obvious objective of finding an optimum capital structure leading to maximization of the value of the firm. If the cost of capital is high

Important theories or approaches to financial leverage or capital structure or financing mix are as follows:

Discussion of financial leverage has an obvious objective of finding an optimum capital structure leading to maximization of the value of the firm. If the cost of capital is high

Important theories or approaches to financial leverage or capital structure or financing mix are as follows:

Net Income Approach

This approach was suggested by Durand and he was in the favor of financial leverage decision. According to him, change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of the firm increases.

Net Operating Income Approach

This approach is also provided by Durand. Its is opposite to the Net Income Approach, if there are no taxes. It says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses firm as a whole which discounts at a particular rate which is not related to debt-equity ratio. If tax information is given, it recommends that with increase in debt financing WACC reduces and value of firm will start increasing.

Traditional Approach

This approach is not defined hard and fast facts but it says that cost of capital is a function of the capital structure. The special thing about this approach is that it believes an optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum.

Modigliani and Miller Approach (MM Approach)

It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed two propositions.

  • Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would be same and it would not be affected by the mode of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when, there are no taxes.
  • Proposition II: It says that the financial leverage boosts value of firm and reduces WACC. It is when tax information is given.

To summarize, it is essential for finance professionals to know about the capital structure to be suggested to the management. Accurate analysis of capital structure can help a company save on the part of their cost of capital and hence improve profitability for the shareholders.


Last updated on : November 23rd, 2018

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