The following points will highlight the top four theories of capital structure. Capital Structure Theory 1.
In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities.
Competing capital structure theories explore the relationship between debt financingequity financing and the market value of the firm. Traditional Approach According to the traditional theorya company should aim to minimize its weighted average cost of capital WACC and maximize the value of its marketable assets.
This approach suggests that the use of debt financing has a clear and identifiable limit. Any debt capital beyond this point will create company devaluation and unnecessary leverage.
Managers and financial analysts are required to make certain assumptions under the traditional approach. For example, the interest rate on debt remains constant during any one period and increases with additional leverage over time.
The expected rate of return from equity also remains constant before increasing gradually with leverage. This creates an optimal point at which WACC is smallest before rising again. Other Approaches One popular alternative to traditional capital structure theory is the Modigliani and Miller approach.
The MM approach has two central propositions. The second proposition then asserts that financial leverage increases expected future earnings but not the value of the firm. This is because leverage-based future earnings are offset by corresponding increases in the required rate of return.
The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance.
Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.Capital Structure and its Theories Capital Structure Theories deals with the question whether a change in capital structure influences the value of a firm.
|Theories of Capital Structure||Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. In this simplified view, the weighted average cost of capital WACC should remain constant with changes in the company's capital structure.|
|Traditional Approach||Here, I have made these theories simplified.|
|Theories of Capital Structure | Accounting Education||The early work made quite a few assumptions in an effort to simplify the problem and assumed that both the cost of debt as well as the cost of equity were separate from capital structure and that the appropriate figure for consideration was the net income of the firm. Using these suppositions, the average cost of capital reduced by using leverage and the value of the firm the value of the debt and equity combined improved while the value of the equity remained the same.|
|The Importance of Capital Theory||Top 4 Theories of Capital Structure Article shared by:|
There are four approaches to this, viz. net income, net operating income, . Modigliani and Miller's Capital-Structure Irrelevance Proposition The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs.
In this . Capital Structure Theory # 4. Modigliani-Miller (M-M) Approach: Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital structure and the valuation of the firm should be explained by NOI (Net Operating Income Approach) by making an attack on the Traditional Approach.
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.
Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure.
At that optimal structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal Real cost of equity in equilibrium. In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments.