Capital Structure: Meaning and Theories Management YouTube Lecture Handouts

Get unlimited access to the best preparation resource for competitive exams : get questions, notes, tests, video lectures and more- for all subjects of your exam.

Capital Structure: Meaning and Theories Management

Meaning

  • Capital basically implies a combination of all long-term sources of finance. It includes Equity share capital, Reserves and Surplus, Preference share capital, Loan, Debentures and all other long-term sources of finance.
  • A company must decide the proportion in which it should have these. Based on their proportion, Weighted Average Cost of Capital and Value of the firm are affected.

Financial Leverage

  • It is the extent to which a business firm employs borrowed money or debts. In financial management, it is a very important decision in business.
  • In capital structure of a company, there are mainly two types of capital, namely, debt and equity.
  • Financial leverage or capital structure deals with a very important question i.e.. , what should be the ratio of debt and equity?

Theories

Net Income Approach

This approach was suggested by Durand and he was in the favor of financial leverage decision i.e.. , there should be more debt than equity in the capital structure of a firm. If the ratio of debt increases, the weighted average cost of the firm decreases and thereby value of the firm increases.

Assumptions of Net Income Approach

  • The increase in debt will not affect the confidence level of the investors.
  • There are only two sources of finance namely debt and equity.
  • All the companies have uniform dividend payout ratio i.e.. , 1.
  • There is no flotation, transaction cost and corporate dividend tax.
  • All sources of finance are for infinity
Assumptions of Net Income Approach

Net Operating Income Approach

  • This approach is also provided by Durand. It is the opposite of net Income approach if there are no taxes. This approach says that the weighted average cost of capital remains same or constant even when the debt in the capital structure increases.
  • It is so because the benefit that the firm derives by infusion of debt is negated by simultaneous increase in the required rate of return by the shareholders.

Assumptions of NOI Approach

  • The overall capitalization rate remains constant irrespective of the degree of the leverage.
  • Value of equity is the difference between total firm value less value of debt.
  • WACC remains constant and with the increase in debt, the cost of equity increases.

Diagram of NOI Approach

Diagram of NOI Approach

Modigliani and Miller Approach

This Theory Proposed Two Propositions

  • It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms will remain same and won՚t be affected by the choice of finance adopted by them. The value of the firm is dependent on the expected future earnings provided there are no taxes.
  • It says that the financial leverage boosts the value of the firm and reduces WACC provided there are taxes.

Assumptions of Modigliani and Miller Approach

  • There are no taxes.
  • Transaction cost for buying and selling securities as well as the bankruptcy cost is nil
  • There is a symmetry of information
  • The cost of borrowings is same for investors and companies.
  • There are no flotation costs
  • There are no corporate taxes.

MCQs

Net operating income approach was given by?

1. David Ricardo

2. Durand

3. Modigliani and Miller

4. Alfred Marshall

Answer: 2

NOI Income approach believes there is no effect of financial leverage on Value of firm because?

1. Cost of debt reduce

2. Required rate of return of shareholders increases

3. Taxes paid come into the picture

4. None of the above

Answer: 2

✍ Manishika