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 own finance and outsider’s finance particularly debt finance. Based on the proportion of finance, WACC and Value of a firm are affected. There are four capital structure theories for 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 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.

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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 a very important decision in 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 a cheaper source of finance because the rate of interest will be less than the 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 that believe that financial mix has an impact on the value and others believe it has no connection.

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. 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 an 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 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 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 favor of 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

This approach is also provided by Durand. 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 with an increase in debt financing WACC reduces and the value of the firm will start increasing. For more – Net Operating Income Approach.

Traditional Approach

This approach does not define hard and fast facts. It says that the cost of capital is a function of the capital structure. The special thing about this approach is that it believes in an optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and the value of the firm is maximum. For more – 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 by 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 by optimizing the cost of capital and hence improving profitability.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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