Forex Trading

Capital Structure Theories

capital structure theories
capital structure theories

Capital structure is how a company funds its overall operations and growth. Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by disposing-off 1% holding. He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007% of equity from the firm ‘A’. Each of these three methods can be an effective way of recapitalizing the business. Commodity prices and those for securities must be brought into harmony with producing and consuming power. A check must be imposed upon unrestricted expansion which has been engendered by the preceding period of improvement.

The total value of the firm is equal to the capitalized value of the operating earnings of the firm. Investors are rational and well informed about the risk return of all the securities. The capital markets are perfect and the complete information is available to all the investors free of cost. The operating profits of the firm are given and nor expected to grow. Under-capitalisation is just the reverse of over-capitalisation but it should never be taken to indicate deficiency or inadequacy of capital. The stage of under-capitalisation arises when the concern starts earning at a rate higher than current rate.

capital structure theories

The capital structure of a company should aim at maximising the long-term market value of its equity shares. The financial management of a company is expected to design and develop a sound capital structure which is most advantageous for the company and its equity shareholders. The capital structure decision helps a business to maximize the value of its firm and minimize its overall cost of capital structure theories capital. Therefore, an optimum capital structure refers to the optimum combination of debt and equity, which leads to maximization of firm`s value and minimization of its weighted average cost of capital. David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs.

Generally the cost of debentures and preference shares is less than that of equity shares, and therefore companies prefer to include them in the capital structure. Suppose a company requires a total sum of Rs.20, 00,000 on which it would earn a profit at the rate 10 percent. If the whole of the capital is raised through equity shares, the rate of dividend cannot exceed 10 per cent. If the proportion of the equity capital is lower than borrowed funds carrying fixed interest/dividend, it is referred to as highly geared. Similarly, when the equity share capital is equal to other securities, it is called evenly geared. Thus capital gearing may be defined as the proportion of the equity share capital to the total capital of the company.

The optimal structure, then would be to have virtually no equity at all. Quite often the promoters want to raise capital from the general public while retaining effective control of the affairs of the company. For this purpose, they raise a large part of funds by the issue of debentures and preference shares. The debenture holders and the preference shareholders are usually not given the voting rights enjoyed by the equity shareholders. The technique of capital gearing plays a very important role in the hands of the finance manager.

Capital Structure – Capital Gearing

It is therefore very important that an ideal proportion of different types of securities is maintained in the capital structure. It is important to note that higher the gear the more speculative would be the equity shares. According to the traditional approach, there is an optimal capital structure and the management can increase the total value of the firm through judicious use of financial leverage. This approach assumes that the firm can initially lower its cost of capital and increase total value by employing more fixed charge debt.

capital structure theories

In seeking to maximize shareholder wealth or their own, managers may create conflicts of interest in which one or more groups are favored at the expense of others, such as a debt-equity conflict. If corporate taxes are considered the MM approach will be unable to discuss the relationship between the value of the firm and the financing decision. For example, we know that interest charges are deducted from profit available for dividend, i.e., it is tax deductible. As such, the levered firm will enjoy a higher market value than the unlevered firm. The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain level and thereafter increases rapidly. Under this approach, the most significant assumption is that the Kw is constant irrespective of the degree of leverage.

Capital Structure Decision

The capital structure of a firm should not pose risk to ownership control. The capital structure should provide a room for expansion or starting of new projects by raising debt and equity capital when need arises. An appropriate capital structure of a firm should have the scope for raising funds as need arises. Thus, the capital structure of a firm consists of shareholders’ funds and debt.

The above analysis shows that Proposal No. 3 gives the highest earning per share. The corporation tax does not exist and there is no bankruptcy cost. Indifference point refers the level of EBIT at which EPS under two different options are same. Kd, Ko and MV of Firm will remain constant in case of without tax structure. This theory is based on the fact that the amount of Capitalisation is deeply and intimately correlated with the amount of earnings. Once the concept of capitalization is explained and made clear, a natural question arises as how to ascertain the required capital for a newly-promoted concern .

Therefore a company can manage to pay dividends to its equity shareholders at higher rates. An optimum capital structure can be framed with the help of capital gearing. Usually in the beginning, a company should follow the policy of low capital gearing, and as the business and profits grow in future the policy of high capital gearing should be adopted. In fact a balanced and overall capital gearing is very helpful in successful operation of a business concern. Financial structure of a company is concerned with both long term and short term sources of funds.

  • Normally speaking, the equity part includes share capital and retained earnings.
  • It proposes that there is an optimal capital structure where the WACC is at minimum and the value of the firm is at maximum.
  • However, the cost of capital curve need not always be saucer-shaped.
  • Investors can monitor a firm’s capital structure by tracking the D/E ratio and comparing it against the company’s industry peers.

In this approach, when debt capital is introduced up to a certain limit, then it is assumed that debt capital would increase EPS by decreasing overall cost of capital and increasing the value of an organization. However, when the debt capital is raised beyond a certain limit the overall cost of capital increases and the value of the organization decreases. The traditional approach stands between the net income approach and the net operating income approach.

If tax information is provided, it states that WACC decreases with an increase in debt financing, and the value of a firm will increase. The rate of interest will have a direct impact on borrowed funds. If the expectation of the banker or financial institutions is to get a high rate of interests then the firm can postpone the mobilization of funds or make use of retained earnings. It mainly depends on flexibility in fixed charges, restrictive covenants, terms of redemption and the debt capacity.

Capital Structure Theory # 1. Net Income (NI) Approach:

However, the use of debt in capitalisation will depend on expected profits of the firm. Financial risk factor is involved in the use of debt in the total capital of a firm. If profits are low, lower proportion of debt should be used so that interest burden on the firm does not pose a threat to the existence of the firm. Capital structure is one of the most vital and complex areas of decision making to any organization due to its relationship with other financing variable and its closely related to the value of the firm.

So if this fixed rate of interest or dividend is lower than the rate of over-all earnings, then the equity shareholders gain. If the whole of this capital is raised by the issue of only equity shares, then the company cannot pay more than 10 percent as dividend. The traditional theory suggests that investors value levered firms more than unlevered firms. This implies that they willingly pay a premium for the shares of levered firms.

In essence, there should neither be over-capitalisation nor under-­capitalisation. It is very essential for a business entity to have fair capitalisation. Fair capitalisation is that stage of capitalisation where the amount of capitalisation is the same as warranted by the amount of earnings. However, when the amount of capitalization is the same as warranted by the amount of earnings, it is a case of ‘Fair Capitalisation’. Forecasts are to be made in respect of preliminary expenses, fixed assets and working capital.

Cost of equity capital rises with the additional dose of debt but the rate of increase will be less than the rise in net earnings rate. Investors are generally of different tastes and of economic status. Modest investors like debentures or preference shares while investors interested in speculation prefer equity shares. So, a firm will have to use a variety of securities in order to appeal to various types of investors. The capital structure will be affected by the degree of control the promoters wish to have over the company.

To subscribe to our weekly newsletter please log in/register on

This process will be continued till both the firms have same market value. They are similar in all respects except in the composition of capital structure. Assume that Firm ‘A’ is financed only by equity whereas Firm ‘B’ is financed by a debt-equity mix.

A company is said to be “high-geared” if it has agreed to pay a fixed rate of interest or dividends on a very large proportion of its total capital funds. However, on borrowings, interests are to be paid whether or not there are profits. Similarly, on the preference capital too, the dividends have to be paid at a fixed rate out of profit, but before the equity shareholders are paid any dividends. Gearing means the ratio of different types of securities to the total capitalisation. When applied to the capital of a company, it means the ratio of equity share capital to the total capital of the company. But if the amount of equity capital is relatively larger than the amount of borrowed funds and preference shares, then it is said to be trading on thick equity.

The irrelevance proposition theorem is a corporate capital structure theory that posits that financial leverage has no effect on the value of a company. There are several competing capital structure theories, each of which explores the relationship between debt financing, equity financing, and the market value of the firm slightly differently. At the end it may be said without any doubt that all the policies regarding capital structure and financial management or administration of capital depends only on the balanced capital gearing. If the general price level of stocks or raw material is constant over a period of time, management prefers to invest such funds through long term or medium term financing. If the prices are fluctuating widely Short term sources are the best alternative for investments.

A sound capital structure provides a room for expansion or reduction of debt capital so that, according to changing conditions, adjustment of capital can be made. Fixed interest or dividends imposed a recurring burden on the company. As has been pointed out, payment of a fixed rate of interest must be made even if there are no profits.

He argued that the market value of a firm depends on its net operating income and business risk. The change in the degree of leverage employed by a firm cannot change these underlying factors. The capital structure of a company is designed keeping in mind the potential investors. Equity shares will attract investors that prefer risks along with a say in the management. However, if investors choose to avoid risks, the company will prefer preferential shares and debentures instead. The company’s expected earnings before interest and tax is Rs. 2 lakh.

Leave a Reply

Your email address will not be published.