Question.5)What is meant by capital structure? Explain the
theories of capital structure in brief.
Ans :
Capital structure refers to the way
a corporation finances its assets through some combination
of equity, debt, or hybrid securities. A firm's capital structure is
the composition or 'structure' of its liabilities. For example, a firm
that sells 20 billion dollars in equity and 80 billion dollars in debt is said
to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to
total financing, 80% in this example, is referred to as the
firm's leverage. In reality, capital structure may be highly complex and
include dozens of sources(Figure 1). Gearing Ratio is
the proportion of the capital employed by the firm which comes from
outside of the business, such as by taking a short term loan.
Modigliani and Miller created a theory of
Capital Structure in a perfect market. There are several qualifications for a
"perfect market":
- no
transaction or bankruptcy cost
- perfect
information
- firms
and individuals can borrow at the same interest rate
- no
taxes
- investment decisions
are not affected by financing decisions
Modigliani and Miller made two findings under
these conditions:
- The value of
a company is independent of its capital structure
- The
cost of equity for a leveraged firm is equal to the cost of equity for an
unleveraged firm, plus an added premium for financial risk
This means, as leverage increases, while the
burden of individual risks is shifted between
different investor classes, total risk is conserved and hence no
extra value created.
Their analysis was extended to
include the effect of taxes and risky debt. Under a classical tax system, the
tax deductibility of interest makes debt financing valuable; thecost of
capital decreases as the proportion of debt in the capital structure
increases. The optimal structure, then would be to have virtually no equity at
all.
If capital structure is irrelevant in a
perfect market, then imperfections which exist in the real world must be the
cause of its relevance. The theories below try to address some of these
imperfections, by relaxing assumptions made in the M&M model.
Capital Structure Theory
Trade-off theory allows bankruptcy cost to
exist. It states that there is an advantage to financing with debt (the tax
benefits of debt) and that there is a cost of financing with debt (the
bankruptcy costs and the financial distress costs of debt). The
marginal benefit of further increases in debt declines as debt increases,
while the marginal cost increases, so that a firm that is optimizing its
overall value will focus on this trade-off when choosing how much debt and
equity to use for financing. Empirically, this theory may explain differences
in Debt/Equity ratios between industries, but it doesn't explain differences
within the same industry.
Pecking Order Theory tries to capture
the costs of asymmetric information. It states that companies prioritize their
sources of financing (from internal financing to issuing shares of equity)
according to least resistance, preferring to raise equity for financing as a
last resort. Internal financing is used first. When that is depleted, debt is
issued. When it is no longer sensible to issue any more debt, equity is issued.
This theory maintains that businesses adhere
to a hierarchy of financing sources and prefer internal financing
when available, while debt is preferred over equity if external financing is
required. Thus, the form of debt a firm chooses can act as a signal of its need
for external finance.
The Pecking Order Theory is popularized by
Myers (1984), when he argues that equity is a less preferred means to raise
capital because when managers (who are assumed to know better about true
condition of the firm than investors) issue new equity, investors believe that
managers think that the firm is overvalued and managers are taking advantage of
this over-valuation. As a result, investors will place a lower value to the new
equity issuance.
1st Theory of Capital Structure
Name of Theory = Net Income Theory of Capital Structure
This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.
For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.
High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.
2nd Theory of Capital Structure
Name of Theory = Net Operating income Theory of Capital Structure
Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.
3rd Theory of Capital Structure
Name of Theory = Traditional Theory of Capital Structure
This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:
Ist Stage
In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm.
2nd Stage
In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure.
3rd Stage
Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital.
4th Theory of Capital Structure
Name of theory = Modigliani and Miller
MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.
Ignou MBA Solved Assignment MS 04
Name of Theory = Net Income Theory of Capital Structure
This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.
For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.
High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.
2nd Theory of Capital Structure
Name of Theory = Net Operating income Theory of Capital Structure
Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.
3rd Theory of Capital Structure
Name of Theory = Traditional Theory of Capital Structure
This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:
Ist Stage
In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm.
2nd Stage
In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure.
3rd Stage
Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital.
4th Theory of Capital Structure
Name of theory = Modigliani and Miller
MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.
Ignou MBA Solved Assignment MS 04
Accounts And Finance for Managers Tutorial
ReplyDeleteCAPITAL STRUCTURE THEORIES
INTRODUCTION
ASSUMPTION OF THE CAPITAL STRUCTURE THEORIES
NET INCOME APPROACH
NET OPERATING INCOME APPROACH
MODIGLIANI–MILLER APPROACH
TRADITIONAL APPROACH
TYPES OF DIVIDEND POLICIES
LET US SUM UP