Question

Make a brief introduction to the theory of capital structure and present it to the financial manager. Briefly refer to the various theories mentioned in this field (approximately 500 words).

Answer 1

Capital structure is the proportion of all types of capital viz Equity, debt, preference etc. It is also used as financial leverage or financing mix. Capital structure is also referred to as degree of debts in financing or capital of a business firm.

Important theories or approaches to financial leverage or capital structure or financing mix are as follows:

1) Net income approach: This approach was suggested by Durand and he was in favor of financial leverage decision. According to him, a change in financial leverage would lead to a change in cost of capital. If the ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of firm increases

2) Net operating income approach: This approach is also provided by Durand. It is opposite of Net Income approach if there are no taxes. In this, weighted average cost of capital remain constant. Market analysis of a firm as a whole remain constant and discounts at a particular rate which has no relation to debt equity ratio. If tax information is given, it recommends that with an increase in debt financing, WACC reduces and value of the firm will start increasing.

3) Traditional approach: It says that cost of capital is a function of the capital structure. It believes in an optimal capital structure which implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum.

4) Modigliani and Miller Approach (MM Approach): MM Theory proposed 2 propositions:

I - Capital structure is irrelevant to the value of the firm. Value of 2 identical firms would remain same and will not affect by the choice of finance adopted to finance the assets. The value of the firm is dependent on the expected future earnings. It is when there are no taxes

II - Financial leverage boosts the value of the firm and reduces WACC. It is when tax information is available.