Understanding Capital Structure Theories Understand In corporate finance, capital structure theories examine the relationship of equity financing and debt financing with the market value of a company.
Your Query Theory of Capital Structure The long-term source of finance, which a company may use for investments, may be broadly classified into two types. The financial manager must determine the proportion of debt and equity and financial leverage.
Theoretically, the value of a firm can be maximised when the cost of capital in minimised. There exist extreme views. There are four major theories explaining the relationship between capital structure, the cost of capital and valuation of the firm.
Net Income approach NI 2. Modigliani-Miller approach Net Income Approach NI According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. This approach has been suggested by David Durand.
According to the theory, it is possible to change the cost of capital by changing the debt-equity mix. The formula to calculate the average cost of capital is as follows: The cost of debt is less than the cost of equity. The corporate income tax does not exist.
According to the theory, cost of debt is assumed to be less than the cost of equity. So the overall cost of capital will be minimum when the proportion of debt in the capital structure is maximum.
The NI approach may be compared to a dishonest trader who wants to sell 10 litres of milk Rs. If the cost of 1 litre of water is Re. This is just the opposite to NI approach.
All the capital structures are optimum. According to this theory, the market value of the firm is not affected by the capital structure changes. Assumptions The market capitalises the value of the firm as a whole.
Thus, the split between debt and equity is not important. The use of debt increases the risks of shareholders, So, Ke increases with the leverage and eats completely the advantage of low-cost debt.
The cost of debt remains same regardless of leverage. Corporate income tax does not exist. The critical assumptions of this approach are that Ko remains same regardless of the degree of leverage.
So, Ke is the function of the debt equity ratio.In , David Durand produced an article titled "Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement" (Durand, ), for the National Bureau of Economic Research.
|Net Income Approach||Top 4 Theories of Capital Structure Article shared by:|
|To explain the relationship among capital structure, cost of capital and value of the firm various theories have been propounded by different authors.|
|Theories of Capital Structure (explained with examples) | Financial Management||As per this approach, the WACC and the total value of a company are independent of the capital structure decision or financial leverage of a company. As per this approach, the market value is dependent on the operating income and the associated business risk of the firm.|
|The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.|
As a consequence cost of capital remains relatively constant. Finally, beyond the acceptable limit of leverage, the value of the firm decreases or the cost of capital increases with the leverage. This happens because investors perceive a high degree of financial risk and this increases equity and debt capitalization rates.
Chapter III CONCEPTS AND THEORIES OF CAPITAL STRUCTURE AND PROFITABILITY: A REVIEW A STUDY ON THE DETERMINANTS OF CAPITAL STRUCTURE AND PROFITABILITY 67 CHAPTER III CONCEPTS AND THEORIES OF CAPITAL STRUCTURE AND PROFITABILITY: A REVIEW David Durand, who argued that the market value of a firm depends on its net.
This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weighting in the calculation of the cost of capital.
This approach has been suggested by David Durand. Hence, optimum capital structure in this case is considered as Equity Capital Rs.
1,00, and Debt Capital Rs. 1,00, which bring the lowest overall cost of . ing it to the problems of capital cost. If the businessman raises capital to finance a venture, it must be in furtherance of his interests; and any defini-tion of the costs of raising this capital must be consistent with this principle.
This paper is unorthodox, however, in its conception of what actually constitutes a businessman's best interest.