Theories of Capital Structure
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.
Assumptions of NI approach:1.There are no taxes
2.The cost of debt is less than the cost of equity.
3.The use of debt does not change the risk perception of the investors
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.
Features of NOI approach:1.At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.
2.The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm - Value of debt
3.Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.
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.
Basic Propositions of MM approach:1.At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.
2.The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.
3.The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.
Assumptions of MM approach:
1.Capital markets are perfect.
2.All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.
3.Within similar operating environments, the business risk is equal among all firms.
4.100% dividend payout ratio.
5.An assumption of "no taxes" was there earlier, which has been removed.
Designing capital structure
Leading companies manage capital structure effectively to take advantage of opportunities, manage risk and meet the changing needs of the business. The following are some of the best practices used by companies in designing capital structure:
1. Select the instruments that effectively meets company’ s funding requirements
There is no one single source or a combination of sources of capital is appropriate for a company. Leading companies evaluate available funding options, pros and cons of debt and equity and cost of capital in order to understand the financial, regulatory and operational risks they are likely to face.
Each company will take the options that best fit it with the confidence that it has flexibility to handle a drastic change in the business.
2. Align capital structure with company strategy
Best practice companies develop a capital mix that supports the company strategy leaving room for flexibility to be able to respond to changing business environment.
By determining an appropriate credit risk threshold and putting in place a disciplined private equity management tactics, effective companies create a capital structure that supports organizational objectives and operational excellence.
3. Establish the company’s cost of capital
Leading companies keep awareness of their cost of capital to accurately determine threshold of capital investment. The most popular method to compute cost of capital is getting a company’s weighted average cost of capital (WACC).
WACC formula is straight forward but can be complicated by fluctuating input that determines its outcome. Leading companies regularly keep measuring its cost of capital to keep a close tab where its losing or gaining value.
The companies that use various different methods of computing WACC get a more comprehensive understanding of their position and enable them to make better strategic decisions to deal with the industry and its competitors.
4. Make effort to reduce cost of capital on an ongoing basis
Leading companies strive to make efforts to reduce cost of capital. While ways of reducing cost of capital may not be specific their cumulative effects may help a company reduce cost of capital through strategy as opposed to just cutting capital cost.
Best practice companies exercise financial transparency to attract investors who offer their capital at lower cost than competitors.
They keep good relationship with banks to enjoy favorable lending rates which in turn has a positive impact on the profitability.
5. Manage flexible capital actively
Best practice companies are proactive in balancing debt to equity ratio to be able to respond to internal and external factors that affect cost of capital. Flexible financial policies that affect dividends where lower amounts can be paid as dividend and the rest retained to grow the business are useful to many companies.
6. Keep exploring new finance sources continuously
Best practice companies move from reliance on traditional sources of capital like commercial banks, public debt, equity markets or institutional investors to avoid being victims of the changes in the market by continuously searching for alternative non traditional sources of capital on a continuous basis.
They partner with other business, use assets as collateral and creating corporate structures to insulate the parent company from excessive risks.
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.
Assumptions of NI approach:1.There are no taxes
2.The cost of debt is less than the cost of equity.
3.The use of debt does not change the risk perception of the investors
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.
Features of NOI approach:1.At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.
2.The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm - Value of debt
3.Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.
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.
Basic Propositions of MM approach:1.At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.
2.The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.
3.The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.
Assumptions of MM approach:
1.Capital markets are perfect.
2.All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.
3.Within similar operating environments, the business risk is equal among all firms.
4.100% dividend payout ratio.
5.An assumption of "no taxes" was there earlier, which has been removed.
Designing capital structure
Leading companies manage capital structure effectively to take advantage of opportunities, manage risk and meet the changing needs of the business. The following are some of the best practices used by companies in designing capital structure:
1. Select the instruments that effectively meets company’ s funding requirements
There is no one single source or a combination of sources of capital is appropriate for a company. Leading companies evaluate available funding options, pros and cons of debt and equity and cost of capital in order to understand the financial, regulatory and operational risks they are likely to face.
Each company will take the options that best fit it with the confidence that it has flexibility to handle a drastic change in the business.
2. Align capital structure with company strategy
Best practice companies develop a capital mix that supports the company strategy leaving room for flexibility to be able to respond to changing business environment.
By determining an appropriate credit risk threshold and putting in place a disciplined private equity management tactics, effective companies create a capital structure that supports organizational objectives and operational excellence.
3. Establish the company’s cost of capital
Leading companies keep awareness of their cost of capital to accurately determine threshold of capital investment. The most popular method to compute cost of capital is getting a company’s weighted average cost of capital (WACC).
WACC formula is straight forward but can be complicated by fluctuating input that determines its outcome. Leading companies regularly keep measuring its cost of capital to keep a close tab where its losing or gaining value.
The companies that use various different methods of computing WACC get a more comprehensive understanding of their position and enable them to make better strategic decisions to deal with the industry and its competitors.
4. Make effort to reduce cost of capital on an ongoing basis
Leading companies strive to make efforts to reduce cost of capital. While ways of reducing cost of capital may not be specific their cumulative effects may help a company reduce cost of capital through strategy as opposed to just cutting capital cost.
Best practice companies exercise financial transparency to attract investors who offer their capital at lower cost than competitors.
They keep good relationship with banks to enjoy favorable lending rates which in turn has a positive impact on the profitability.
5. Manage flexible capital actively
Best practice companies are proactive in balancing debt to equity ratio to be able to respond to internal and external factors that affect cost of capital. Flexible financial policies that affect dividends where lower amounts can be paid as dividend and the rest retained to grow the business are useful to many companies.
6. Keep exploring new finance sources continuously
Best practice companies move from reliance on traditional sources of capital like commercial banks, public debt, equity markets or institutional investors to avoid being victims of the changes in the market by continuously searching for alternative non traditional sources of capital on a continuous basis.
They partner with other business, use assets as collateral and creating corporate structures to insulate the parent company from excessive risks.