26_capital structure theories

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Capital Structure Theories

-Dr A.N.Garg

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Capital Structure Capital structure refers to the composition or make-

up or mix of capital i.e. in what proportion equityshare capital, preference share capital, long termloans and debentures have been issued.

Capitalization refers to the sum total of all kinds of

long term securities i.e. equity share capital,preference share capital and long term loans anddebentures.

Financial structure refers to all the financialresources, short as well as long term. In nutshell it is

the sum total of the liability side of the balancesheet.

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Capital Structure

According to Gerstenberg, capital structure of acompany refers to the make-up of its capitalization.

There are no ready made rules so far as the proportionof different types of securities is concerned.

However, Gerstenberg has given two generalprinciples in this regard.

1)The greater the stability of earnings, the higher maybe the ratio of bonds to stock in capital structure.

2)The capital structure should be balanced with asufficient equity cushion to absorb the shocks ofbusiness cycle and to afford flexibility.

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Theories of Capital Structure

Net Income Approach

Net Operating Income Approach

Traditional Approach

Modigliani and Miller Approach

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Net Income Approach

According to this approach, which has been given by Durand, afirm can minimise the weighted average cost of capital andincrease the value of the firm as well as market price of equityshare by using debt financing. The theory propounds that acompany can increase its value and reduce the overall cost of

capital by increasing the proportion of debt in its capitalstructure. The basic Assumptions are:

The cost of debt is less than the cost of equity.

There are no taxes.

The risk perception of investors is not changed by the use ofdebt.

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Net Operating Income Approach

According to this approach, change in capital structure ofa company does not affect the market value of the firmand the overall cost of capital remains constantirrespective of the method of financing. The main

assumptions are: The market capitalizes the value of the firm as a whole.

The business risk remains constant at every level of debt-equity mix.

There are no corporate taxes.

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Traditional Approach

Traditional view is a compromise between netincome and net operating income approach which

says that the value of the firm can be increased or

cost of capital can be decreased by a judicious mix

of debt and equity. According to this theory, the

value of the firm can be increased initially or the

cost of capital can be decreased by using more debt

as the debt is a cheap source of finance. Beyond a

particular point, the cost of equity increases

because increased debt increases the financial risk

of equity shareholders.

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Modigliani and Miller approach

In the absence of Taxes

The theory proves that the cost of capital is

not affected by the changes in the capital

structure. The reason argued is that though

debt is cheaper to equity, with increased use

of debt as a source of finance, the cost of

equity increases.

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MM----From the above, it can be seen that MM approach supports NetOperating Income Approach relating to cost of capital and degree ofleverage.

Assumptions:

1. There are perfect capital markets.

2. Investors can borrow money without any restrictions.

3. Individuals and the firms can borrow at the same terms and

conditions.4. Availability of perfect information.

5. There are no transaction costs.

6. All investors are rational.

7. Business risk is equal among all firms with similaroperatingenvironment.

8. There are no taxes.

Operational justification for MM Hypothesis is the arbitrage processof buying a security at a lower price and selling at a higher price indifferent markets, bringing about equilibrium in the market price of asecurity.

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MM----

Limitations of MM Approach:1. Transaction costs.

2. Personal leverage.

3. Personal capital gearing.

4. Problems of personal leverage.

5. Influence of share prices.

6. Information Access.

7. Corporate taxes.

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When the corporate taxes are assumed to exist

MM later introduced their model with the effect oftaxes in two identical firms. They are similar but onefirm is levered and the other one is unlevered to findout the advantage of debt. The value of the firm will

increase or the cost of capital will decrease with theuse of debt on account of deductibility of interestcharges for tax purposes. Levered firm will havegreater value. Firm has been advised to use debt upto a certain level only.

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CRITICISMS OF MM APPROACH

The leverage irrelevance theorem of MM is valid if the

perfect market assumptions underlying their analysis aresatisfied. The real world, however, is characterized byvarious imperfections:

1. Firms are liable to pay taxes on their income, Inaddition, investors who receive returns fromtheir investments in firms are subject to taxes ata personal level.

2. Bankruptcy costs can be quite high.

3. Agency costs exist because of the conflict ofinterest between managers and shareholdersand between shareholders and creditors.

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CRITICISMS OF MM APPROACH

4. Managers seem to have preference for acertain sequence of financing.

5. Information asymmetry exists because

managers are better informed than investors.6. Personal leverage and corporate leverage are

not perfect substitutes.

MBA 205

26_capital structure theories

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