Theories of Capital Structure

Theories of Capital Structure (explained with examples) | Financial Management

The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.

The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm.

If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value 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.

If average affects the cost of capital and the value of the firm, an optimum capital structure would be obtained at that combination of debt and equity that maximizes the total value of the firm (value of shares plus value of debt) or minimizes the weighted average cost of capital. For a better understanding of the relationship between financial average and the value of the firm, assumptions, features and implications of the capital structure theories are given below.

Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital controversy property, the following assumptions are made:

Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of average can be changed by selling debt to purchase shares or selling shares to retire debt.

The firm has a policy of paying 100 per cent dividends.

The operating earnings of the firm are not expected to grow.

The business risk is assumed to be constant and independent of capital structure and financial risk. The corporate income taxes do not exist. This assumption is relaxed later on.

The following are the basic definitions:

The above assumptions and definitions described above are valid under any of the capital structure theories. David Durand views, Traditional view and MM Hypothesis are tine important theories on capital structure.

1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There exist two extreme views and a middle position. David Durand identified the two extreme views – the Net income and net operating approaches.

a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be independent of the capital structure. The weighted average cost of capital declines and the total value of the firm rise with increased use of average.

b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is assumed to increase linearly with average. As a result, the weighted average cost of capital remains constant and the total of the firm also remains constant as average changed.

Thus, if the Nl approach is valid, average is a significant variable and financing decisions have an important effect on the value of the firm, on the other hand, if the NOI approach is correct, then the financing decision should not be of greater concern to the financial manager, as it does not matter in the valuation of the firm.

2. Traditional view:

The traditional view is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost, of capital can be reduced by the judicious mix of debt and equity capital.

This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with average. Thus an optimum capital structure exists and occurs when the cost of capital is minimum or the value of the firm is maximum.

The cost of capital declines with leverage because debt capital is chipper than equity capital within reasonable, or acceptable, limit of debt. The weighted average cost of capital will decrease with the use of debt. According to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three stages and this can be seen in the following figure.

Criticism:

1. The traditional view is criticised because it implies that totality of risk incurred by all security-holders of a firm can be altered by changing the way in which this totality of risk is distributed among the various classes of securities.

2. Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit.

3. MM Hypothesis:

The Modigliani – Miller Hypothesis is identical with the net operating income approach, Modigliani and Miller (M.M) argue that, in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes.

Assumptions:

The M.M. hypothesis can be best explained in terms of two propositions.

It should however, be noticed that their propositions are based on the following assumptions:

1. The securities are traded in the perfect market situation.

2. Firms can be grouped into homogeneous risk classes.

3. The expected NOI is a random variable

4. Firm distribute all net earnings to the shareholders.

5. No corporate income taxes exist.

Proposition I:

Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total market value is independent of the debt equity combination and is given by capitalizing the expected net operating income by the rate appropriate to that risk class.

This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not affected by leverage.

Arbitrary-process:

M-M opinion is that if two identical firms, except for the degree of leverage, have different market values or the costs of capital, arbitrary will take place to enable investors to engage in ‘personal leverage’ as against the ‘corporate leverage’ to restore equilibrium in the market.

Proposition II: It defines the cost of equity, follows from their proposition, and derived a formula as follows:

Ke = Ko + (Ko-Kd) D/S

The above equation states that, for any firm in a given risk class, the cost of equity (Ke) is equal to the constant average cost of capital (Ko) plus a premium for the financial, risk, which, is equal to debt-equity ratio times the spread between the constant average of ‘capita’ and the cost of debt, (Ko-Kd) D/S.

The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of leverage is made. This conclusion could be valid if the cost of borrowings, Kd remains constant for any degree of leverage. But in practice Kd increases with leverage beyond a certain acceptable, or reasonable, level of debt.

However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital, Ko, will remain constant. They argue that when Kd increases, Ke will increase at a decreasing rate and may even turn down eventually. This is illustrated in the following figure.

Criticism:

The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in which arbitrage is expected to work. Due to the existence of imperfections in the capital market/arbitrage will fail to work and will give rise to discrepancy between the market values of levered and unlevered firms.

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