Theories of Capital Structure explained with examples Financial Management

Theories of Capital Structure explained with examples Financial Management

To calculate WACC the manager or analyst will multiply the cost of each capital component by its proportional weight. Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained theories of capital structure earnings. To summarize, it is essential for finance professionals to know about the capital structure. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability. It postulates that the market analyzes a whole firm, and any discount has no relation to the debt-to-equity ratio.

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. In a leveraged buyout (LBO) transaction, a firm will take on significant leverage to finance the acquisition. This practice is commonly performed by private equity firms seeking to invest the smallest possible amount of equity and finance the balance with borrowed funds. There are many tradeoffs that owners and managers of firms have to consider when determining their capital structure. In order to optimize the structure, a firm can issue either more debt or equity. The new capital that’s acquired may be used to invest in new assets or may be used to repurchase debt/equity that’s currently outstanding, as a form of recapitalization.

  1. While developing a capital structure the finance manager should aim at maximizing the long-term market price of equity shares.
  2. In other words, using more debt capital with a corresponding reduction in cost of capital, the value of the firm will increase.
  3. This variation expresses that a firm can have lower cost of capital with the initial use of leverage significantly.

A blend of equity and debt financing can lead to a firm’s optimal capital structure. Several assumptions are at work when this theory is employed, which together imply that the cost of capital depends upon the degree of leverage. Based on this list of assumptions, it is probably easy to see why there are several critics. The degree of leverage is plotted along with the X-axis whereas Ke Kw and Kd on the Y- axis. It reveals that when the cheaper debt capital in the capital structure is proportionally increased, the weighted average cost of capital Kw, decreases and consequently the cost of debt Kd. Thus, it is needless to say that the optimal capital structure is the minimum cost of capital, if financial leverage is one, in other words, the maximum application of debt capital.

Leveraged Buyouts

Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. The business risk is assumed to be constant and independent of capital structure and financial risk. While developing a capital structure the finance manager should aim at maximizing the long-term market price of equity shares. The relative importance of each of these feature differ from company to company and may change with changing conditions. When firms execute mergers and acquisitions, the capital structure of the combined entities can often undergo a major change. Their resulting structure will depend on many factors, including the form of the consideration provided to the target (cash vs shares) and whether existing debt for both companies is left in place or not.

What Is the Traditional Theory of Capital Structure?

This gives the right combination of debt and equity and always leads to enhanced market value for the firm. It states that a firm’s value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in practice, and firms often have a strategic or philosophical view of what the ideal structure should be. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure.

Theories of Capital Structure (explained with examples) Financial Management

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. Traditional Theory is an intermediate approach between the net income and net operating income theories.

(ii) Net operating income is capitalized at an overall capitalisation rate in order to have the total market value of the firm. Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by the changes in capital structure. In the third approach, the firm moves in the opposite direction and issues equity by selling new shares, then takes the money and uses it to repay debt.

The debt-to-equity (D/E) ratio is a commonly used measure of a company’s capital structure and can provide insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth. It is the goal of company management to find the ideal mix of debt and equity, also referred to as the optimal capital structure, to finance operations. In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It’s important to remember, however, that this approach assumes an optimal capital structure.

Calculating the capital structure and preparing the plan depends upon the type of the business. The evaluation of structure must be maintained in such a way so that the ROI is always higher. When it comes to business terms and conditions, the capital structure is one of the basic foundations in this field.

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm’s capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity.

Usually, a company more heavily financed by debt poses a greater risk, as this firm is relatively highly levered. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC). The assumptions of this approach are quite related to the net income theory.

Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the corresponding increase in the equity-capitalisation rate. According to NI approach a firm may increase the total value of the firm by lowering its cost of capital. When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital structure for the firms and at this point, the market price per share is maximised. Company assets, also listed on the balance sheet, are purchased with debt or equity.

You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments. When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock. The four components of working capital are cash, account payable, account receivables, and inventory; these components determine a company’s cash flow. This theory came into existence by correlating the ideas of two co-members, Franco Modigliani and Merton Miller.