CAPITAL STRUCTURE THEORY
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.
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 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 debt's providers.
IMPRTANCE THEORIES OR APPROACHED TO
CAPITAL STRUCTURE
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.
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.
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 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 debt's providers.
IMPRTANCE THEORIES OR APPROACHED TO
CAPITAL STRUCTURE
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.
