Concept of capital structure and it's various theories

Capital Structure of a company gives an insight into how it has been funded. In this article we will try to understand what does capital structure actually means & it's different forms. In addition, we will learn about three prominent theories of capital structure viz. net income, net operating income and Modigilani-Miller approach

In financial management, capital structure is a very important concept. It is imperative for understanding how a company is able to finance its operations and its future growth. Before moving to the core definition of capital structure, let's first visit the word capital again.

The word capital in finance domain refers to the financial assets of a firm. It is basically the funding through which a firm acquires its assets and run its operations. Now this capital can either be in the form of equity (owners' funds) or borrowing (loans etc.). Generally it is a combination of both. This is where the concept of capital structure comes in.

Capital Structure

Capital structure is a combination of long term sources of fund employed by a company. The sources of fund here are equity as well borrowing in form of debt like bonds/debentures and may include preference shares, debentures and retained earnings. It's the permanent financing of the company and gives us an idea how is the structure of the liabilities of the firm.

There is another term used with capital structure – financial structure. Both the terms, though sounding similar, have certain differences. Unlike capital structure, financial structure includes short term sources of funds. So, financial structure tells us about the entire liabilities of an organisation including its current liabilities. For determining the value of a firm, we make use of capital structure, and not financial structure.

Forms of capital structure

The two main objectives of capital structure are maximizing the value of the company while trying to minimize the capital of the cost. So, various companies belonging to same or different sectors can opt for different types of capital structure. There are 4 popular forms of capital structure.

Equity shares only i.e. the firm is using the owners' fund in form of equity/retained earnings for the business

Equity and preference shares only i.e. the firm has raised money through the allotment of preference shares along with equity

Equity and debentures only i.e. Firms make use of long term debt instruments like debentures along with equity

Equity & preference shares and debentures

Capital Structure theories

As we had mentioned above, the objective of a firm is to get an optimal capital structure that can maximize the value of the firm and minimize the cost of the capital. The capital structure theories try to find the relationship between capital structure, value of firm and cost of capital to find that best capital structure.

The capital structure theories are divided into two –
Traditional approach
Modern approach

Traditional approach

This theory was given by Ezta Solomon and Fred Weston. As per traditional approach, there is a right mix of equity & debt i.e. an optimal debt to equity ratio in the capital structure where market value of a firm is the maximum and the cost of capital is the minimum. If debt is increased beyond this point, it will result in the reduction in the market value of the company.

Modern approach

Under modern approach, there are three different theories:
1. Net Income approach
2. Net operating income approach
3. Modigilani-Miller approach

1. Net Income approach – This theory was suggested by Durand. As per this theory, the capital structure decision is related to the valuation of the firm. So a change in the capital structure will lead to change in the cost of capital (precisely WACC i.e. Weighted Average Cost of Capital) and the value of the firm. With increase in the proportion of debt, the WACC goes down & value of the firm goes up. Similarly, a reduction in the proportion of debt will lead to higher WACC and lower value of the firm.

In simple words, using more debt to finance your firm will increase the value of the firm while reducing the cost of the capital.
There are certain assumptions associated with this theory –
The cost of debt is less than the cost of equity
There are no corporate taxes
Risk perception of the investor isn't altered due to use of debt in financing the firm

2. Net operating income approach – As per this theory, change in the debt portion of the capital structure won't affect the valuation of a firm. In this way, this theory is in complete contrast with the net income approach. The reason for that is that with increase in debt there will be a simultaneous increase in the risk associated with the company. This, in turn, will increase the expectations of the investors of getting higher returns (high risk, high returns). So even if the firm would have got benefit from the added debt, this will be negated by the higher required rate of return by the equity investors.

This theory too has certain assumptions like –
There are no corporate taxes
The overall cost of the capital will remain constant

3. Modigliani and Miller Approach – This theory was given two professors in the 50s. As per their theory, in a perfect market, the capital structure of a firm doesn't have any impact on the market value of the firm. Instead, the value of the company is determined by its earning capacity as well as the risk associated with its underlying assets. So using higher debt or lesser debt in the capital structure won't affect the market value of the firm.

Just like the first two theories, this theory too is based on certain assumptions -
There are no corporate taxes
There are no transactions costs
There is a perfect capital market in existence

This concludes our article on capital structure theories.


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