Capital Structure and its Theories

Capital Structure means a 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 sources of finance. A company has to decide the proportion in which it should have its finance and outsider’s finance, particularly debt finance. Based on the ratio of finance, WACC and Value of a firm are affected. There are four capital structure theories: net income, net operating income, and traditional and M&M approaches.

Capital Structure

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

Financial leverage is how a business firm employs borrowed money or debts. In financial management, it is an important term, and it is a crucial decision in business. In a company’s capital structure, broadly, there are mainly two types of capital, i.e., Equity and Debt. Out of the two, debt is a cheaper source of finance because the interest rate will be less than the cost of equity, and the interest payments are a tax-deductible expense. (Also read Capital Structure Analysis).

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Capital Structure Theories

Capital structure or financial leverage deals with a crucial financial management question. The question is – ‘what should be the ratio of debt and equity? and what are the factors that affect a capital structure‘. 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, any financial decision aims to maximize the shareholder’s wealth or increase the firm’s value. The other question that hits the mind in the first place is whether a change in the financing mix would impact the value of the firm or not. The question is valid as some theories believe that financial mix impacts the value and others believe it has no connection. Sometimes, the management also uses the pecking order theory concept for their capital structure.

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 we are discussing later. Changing the financing mix means changing the level of debts, and this 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 a rise in the firm’s value.

Apparently, under this view, financial leverage is a helpful tool to increase value, but, at the same time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is because the higher the level of debt, the 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 firm’s value. If the cost of capital is high

Critical 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 firm’s value. If the cost of capital is high

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

Net Income Approach

Durand suggested this approach, and he favored the financial leverage decision. According to him, a 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.

For more – Net Income Approach.

Net Operating Income Approach

Durand also provides this approach. It is the opposite of the Net Income Approach if there are no taxes. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate that has no relation to the debt-equity ratio. If tax information is given, it recommends that WACC reduces with an increase in debt financing, and the firm’s value will start increasing.

Read more – Net Operating Income Approach.

Traditional Approach

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

For more details – Traditional Approach.

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 remain the same, and value would not affect the choice 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 the value of a firm and reduces WACC. It is when tax information is available.

For more about Modigliani and Miller’s Approach of Capital Structure.

To summarize, it is essential for finance professionals to know about the capital structure. Accurate analysis of capital structure can help a company optimize the cost of capital and improve profitability.

Continue reading Net Income (NI) vs. Net Operating Income (NOI) Approach

Frequently Asked Questions (FAQs)

What does traditional capital structure theory say about a company’s structure?

The traditional theory says there is an optimal debt to equity ratio in the financing mix that minimizes the cost of capital and maximizes the value of the firm.

What are the four theories of capital structure?

Net income approach.
Net operating income approach
Traditional approach.
Modigliani and Miller’s approach.

Why is capital structure theory important?

Capital structure theory helps the company in deciding an optimal capital structure and determining its effect on the value of the firm.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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