FINANCIAL DECISIONS THEORIES OF CAPITAL STRUCTURE – NET
INCOME APPROACH, NET OPERATING INCOME APPROACH, MM
APPROACH, AND TRADITIONAL APPROACH
Financial decisions are those made by management about a company's finances. These are
critical considerations for the company's financial well-being. These decisions can pertain to
asset purchase, finance and fundraising, day-to-day capital and spending management, and so
on. As a result, financial decisions affect both a company's assets and liabilities. They can
result in profits, revenue, and the receiving of capital and assets for the company. They can
also be expressed in terms of expenditure, the development of liabilities, and a company's
migration of funds.
Of course, any of these financial decisions can be made for both long and short-term goals.
Long-term financial decisions are those made for a year or longer. Capital budgeting and
investment decisions, as well as the raising of long-term capital and loans with terms of 5 to
10 years, are examples of these. Financial decisions made in the short term, usually less than
a year, are known as short-term financial decisions. Working capital management, arranging
short-term financing and credits, dividend distribution, and other decisions are all part of this
process.
CAPITAL STRUCTURE:-
The capital structure of a business is the proportion of its total capital devoted to various
long-term and short-term sources of funding. Management selects sources of funding that
have the lowest risk and lowest cost of capital, and this capital structure is known as the
optimal capital structure.
The capital structure helps in determining the risk assumed by the firm, and the cost of capital
of the firm, and it affects the flexibility and liquidity of the firm and the control of the owner
of the firm.
The capital structure is the combination of equities and liabilities as debts and decides how
much cost or funds to be collected. When the cost increases the profitability declines
proportionate to the value of the firm and vice versa.
Various rival capital structure theories look at the link between debt financing, equity
financing, and the firm's market value in somewhat different ways.
The ideal structure includes the minimized cost of capital, reduces business risk, flexible
control in nature, and maximizes the value of the firm. The financial manager decides the
capital structure with the combination of equity and debt which forms the total fund of the
firm. The most pivotal part of beginning a business is capital. It goes about as the
groundwork of the organization. Obligation and Equity are the two essential kinds of capital
hotspots for a business.
Capital construction is characterized as the mix of value and obligation that is placed into
utilization by an organization to back the general tasks of the organization and for its
development.
, The money owed by the shareholders or owners is referred to as equity capital. It is divided
into two categories.
a) Retained profits: Retained earnings are a portion of a company's profit that is held
separately and will be used to assist the company to grow.
b) Contributed Capital: Contributed capital is the amount of money that the firm's owners
invested when the company was founded or received as a price for ownership from
shareholders.
The borrowed money that is used in a company is referred to as debt capital. There are
several types of debt capital.
Long-Term debts: These bonds are the safest of debts since they have a long payback
duration and just need interest repayment while the principal is paid at maturity.
Short Term debts: This is a form of short-term financial instrument that corporations use to
raise funds for a limited period.
Capital structure relates to the value of the firm which depends upon two factors in essence
the earning and the cost of capital. The relations are the leverage, cost of capital, and value of
the firm.
NET INCOME APPROACH:-
The Net Income Methodology The capital structure of a company has an impact on its value.
It implies that lowering the weighted average cost of capital raises the firm's worth. With a
bigger debt component in the financing, the weighted average cost of capital might be
decreased. When compared to equity capital, the cost of borrowing funds through debt is
cheaper; Kd is less than Ke. The net income method of capital structure theory implies that
only capital may affect the firm's value and total cost of capital.
In defining the firm's worth, the capital structure is important. It suggests that the value of the
firm increase by decreasing the weighted average cost of capital. The weighted average cost
of capital could be reduced with a higher debt proportion of financing. The cost of raising
funds through debt is lower as compared to equity capital (kd<ke).
Lower cost of raising funds through debt results in a decrease in the overall cost of capital.
Thus, the value of the firm is maximized.
The assumptions of capital structure are:
1) Two sources: Equity & Debt.
2) Total assets are given and remain constant in the investment decisions.
3) No retained earnings.
4) Operating profit (EBIT) given and not expected to grow.
5) No corporate and personal tax.
INCOME APPROACH, NET OPERATING INCOME APPROACH, MM
APPROACH, AND TRADITIONAL APPROACH
Financial decisions are those made by management about a company's finances. These are
critical considerations for the company's financial well-being. These decisions can pertain to
asset purchase, finance and fundraising, day-to-day capital and spending management, and so
on. As a result, financial decisions affect both a company's assets and liabilities. They can
result in profits, revenue, and the receiving of capital and assets for the company. They can
also be expressed in terms of expenditure, the development of liabilities, and a company's
migration of funds.
Of course, any of these financial decisions can be made for both long and short-term goals.
Long-term financial decisions are those made for a year or longer. Capital budgeting and
investment decisions, as well as the raising of long-term capital and loans with terms of 5 to
10 years, are examples of these. Financial decisions made in the short term, usually less than
a year, are known as short-term financial decisions. Working capital management, arranging
short-term financing and credits, dividend distribution, and other decisions are all part of this
process.
CAPITAL STRUCTURE:-
The capital structure of a business is the proportion of its total capital devoted to various
long-term and short-term sources of funding. Management selects sources of funding that
have the lowest risk and lowest cost of capital, and this capital structure is known as the
optimal capital structure.
The capital structure helps in determining the risk assumed by the firm, and the cost of capital
of the firm, and it affects the flexibility and liquidity of the firm and the control of the owner
of the firm.
The capital structure is the combination of equities and liabilities as debts and decides how
much cost or funds to be collected. When the cost increases the profitability declines
proportionate to the value of the firm and vice versa.
Various rival capital structure theories look at the link between debt financing, equity
financing, and the firm's market value in somewhat different ways.
The ideal structure includes the minimized cost of capital, reduces business risk, flexible
control in nature, and maximizes the value of the firm. The financial manager decides the
capital structure with the combination of equity and debt which forms the total fund of the
firm. The most pivotal part of beginning a business is capital. It goes about as the
groundwork of the organization. Obligation and Equity are the two essential kinds of capital
hotspots for a business.
Capital construction is characterized as the mix of value and obligation that is placed into
utilization by an organization to back the general tasks of the organization and for its
development.
, The money owed by the shareholders or owners is referred to as equity capital. It is divided
into two categories.
a) Retained profits: Retained earnings are a portion of a company's profit that is held
separately and will be used to assist the company to grow.
b) Contributed Capital: Contributed capital is the amount of money that the firm's owners
invested when the company was founded or received as a price for ownership from
shareholders.
The borrowed money that is used in a company is referred to as debt capital. There are
several types of debt capital.
Long-Term debts: These bonds are the safest of debts since they have a long payback
duration and just need interest repayment while the principal is paid at maturity.
Short Term debts: This is a form of short-term financial instrument that corporations use to
raise funds for a limited period.
Capital structure relates to the value of the firm which depends upon two factors in essence
the earning and the cost of capital. The relations are the leverage, cost of capital, and value of
the firm.
NET INCOME APPROACH:-
The Net Income Methodology The capital structure of a company has an impact on its value.
It implies that lowering the weighted average cost of capital raises the firm's worth. With a
bigger debt component in the financing, the weighted average cost of capital might be
decreased. When compared to equity capital, the cost of borrowing funds through debt is
cheaper; Kd is less than Ke. The net income method of capital structure theory implies that
only capital may affect the firm's value and total cost of capital.
In defining the firm's worth, the capital structure is important. It suggests that the value of the
firm increase by decreasing the weighted average cost of capital. The weighted average cost
of capital could be reduced with a higher debt proportion of financing. The cost of raising
funds through debt is lower as compared to equity capital (kd<ke).
Lower cost of raising funds through debt results in a decrease in the overall cost of capital.
Thus, the value of the firm is maximized.
The assumptions of capital structure are:
1) Two sources: Equity & Debt.
2) Total assets are given and remain constant in the investment decisions.
3) No retained earnings.
4) Operating profit (EBIT) given and not expected to grow.
5) No corporate and personal tax.
