Capital Structure theories

Topics: Finance, Weighted average cost of capital, Generally Accepted Accounting Principles Pages: 9 (2148 words) Published: October 12, 2013
Capital Structure Theories

Capital Structure

Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets. The main objective of financial management is to maximize the value of the equity shares of the firm. Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called as the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm through its cost of capital and can affect the share of the earnings that pertain to the equity shareholders. 

Introduction to Capital Structure Theories

There are 4 basic Capital Structure theories. They are:
1. Net Income Approach
2. Net Operating Income Approach
3. Modigliani-Miller (MM) Approach and
4. Traditional Approach

Generally, the capital structure theories have the following assumptions: 1. There are no corporate taxes (this assumption has been removed later). 2. The firms use only 2 sources of financing namely perpetual debts ad equity shares 3. The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms. 4. The total assets are given which do not change and the investment decisions are assumed to be constant. 5. Business risk is constant over time and it is assumed that it is independent of the capital structure. 6. The firm has a perpetual life.

7. The firm’s earnings before interest and taxes are not expected to grow. 8. The firm’s total financing remains constant. The firm’s degree of leverage can be altered either by selling shares and to retire the debt using the proceeds or by raising more debt and reduce the equity financing. 9. All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm. Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases. 

Assumptions of NI approach:
1. There are no taxes
2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investors Example

A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%.  Calculation of the Value of the firm: 

Effect of change in the capital structure: (Increase in debt capital)

Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of new debt issue worth the same amount. The cost of debt and equity would remain the same as per the assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.

Calculation of new value of the Firm 

Please note: 
Overall cost of capital can also be calculated by using the weights of debt and equity contents with the respective cost of capitals.

This proves that the use of additional financial leverage (debt) causes the value of the firm to increase and the overall cost of capital to decrease.

Net Operating Income Approach

Net Operating Income Approach was also...
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