Under MM https://1investing.in/, it is assumed that there are no transaction costs. But in actual practice, when securities are purchased or sold, transaction costs in the form of brokerage are incurred. As a result of transaction costs, the net amount received by the investor from sale of the shares of the levered firm would be less.

• This arbitrage process restores equilibrium in both the markets.
• The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of leverage is made.
• 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.
• This is because cost of debt financing is cheaper that equity financing as the theory assumes that cost of debt and cost of equity are independent to the capital structure.
• This, in turn, results in the decrease in overall cost of capital leading to an increase in the value of the firm.

It is one of the major determinations of the value of the firm. It will not be more important while determining the value of the firm. INVESTMENT BANKING RESOURCESLearn the foundation of Investment banking, financial modeling, valuations and more. It further ensures the appropriate utilization of funds for business. Let us understand the intricacies of this concept through discussions about types, formula, examples, and importance. The debt is assumed to be perpetual and no existence of flotation cost at the time of issuance of securities.

Net Operating Income Approach

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. The cut off rate of the investment decision of the firm depends upon the risk class to which the firm belongs, and thus is not affected by the financing pattern of this investment. The business risk complexion of the firm is given and is not affected by the financing mix. Capital gearing stands for the determination of proportion of various kinds of securities to the total capitalisation. In other words an undercapitalized company lacks adequate cash to carry out its functions and usually fails to qualify for loans from financial institutions due its unacceptably high Debt-to-equity ratio.

So capital structure is relevant in maximizing value of the firm and minimizing overall cost of capital. To finance any investment or arrange any single rupee, firm has to take capital structure decision. The cost of equity is equal to capitalisation rate of a free equity stream plus a premium for financial risk. The financial risk increases as the proportion of debt is increased in the capital structure. The company can change its capital structure either by redeeming the debentures with the help of issuing shares or by raising more debt and reducing the equity capital. The behaviour of the investors of firm X will have the effect of- increasing the share prices of the firm Y whose shares are being purchased; and lowering the share prices of the firm X whose shares are being sold.

Thus the overall cost of debt decrease up to a certain point, remains more or less unchanged for l\moderate increase in debt thereafter and increases or rises beyond a certain point. In truth, most business situations call for a capital structure theory that combines or moderates these two extreme theories. The independence theory is flawed because too much financial leverage may eventually cause a company to go bankrupt or fail. Dependence capital structure theory is fallible because debt financing can, and often does, increase the value of outstanding stock. The traditional view is a compromise between the net income approach and the net operating approach.

Net Income Approach to Capital Structure Theory

This has the effect of increasing the amount of debt and decreasing the amount of equity on the balance sheet. 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. In fact during the boom period the rate of interest or dividend payable on fixed cost securities is much lower than the rate of profitability. Therefore a company can manage to pay dividends to its equity shareholders at higher rates. An optimum capital structure can be framed with the help of capital gearing.

You are required to calculate the value of the firm under NI approach. Modigliani and Miller agree that the value of the firm will increase and cost of capital will decline with the use of debt if corporate taxes are considered. Since interest on debt is tax-deductible, the effective cost of borrowing will be less than the rate of interest.

In this period various theories of capital structure interest bearing capital is used more and more as the profits increased considerably. Cash flow generation capacity of a firm increases the flexibility of the financial manager in deciding the capital structure. Sound cash flow facilitates the raising of funds through debt, insufficient cash takes a company to a disastrous situation, it loses its creditworthiness and many times goes into liquidation. Yearly cash inflow matters much to decide the capacity of a company to borrow debt. Thus, an appropriate capital structure should be such as to maximise the returns on stock at the minimum level of financial risk.

This results in the decrease in overall cost of capital leading to an increase in the value of the firm. Debt investors take less risk because they have the first claim on the assets of the business in the event of bankruptcy. For this reason, they accept a lower rate of return and, thus, the firm has a lower cost of capital when it issues debt compared to equity. The cost of capital refers to the expectation of the suppliers of funds.

It is the mix of different long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. This approach was suggested by Durand and he was in favor of financial leverage decision. According to him, a change in financial leverage would lead to a change in the cost of capital.

Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit. The degree of average can be changed by selling debt to purchase shares or selling shares to retire debt. According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm. The NOI approach is definitional or conceptual and lacks behavioral significance.

Views

Financial structure refers to financial resources and the composition of percentage of short term and long term sources of funds. According to Schwartz, “The capital structure of a business can be measured by the ratio of various kinds of permanent loan and equity capital to total capital”. According to Gerstenbeg, “capital structure of a company refer to the composition or make-up of its capitalization and it includes all long term capital resources viz., loans, reserve, share, and bonds.

Determine the company’s debt-to-equity ratio based on the given information. 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 and whether existing debt for both companies is left in place or not. 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 cut-off point for investment is always the capitalisation rate which is completely independent and unaffected by the securities that are invested.
• A firm can choose a degree of capital structure in which debt is more than equity share capital.
• In a leveraged buyout transaction, a firm will take on significant leverage to finance the acquisition.
• The increase of proportion of debt in the capital structure results in an increase in the financial risk which causes an increase in the cost of equity Ke.
• 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.

How to structure permanent finance is the primary focus of several types of capital structure theory. These theories include the independence hypothesis, the dependence hypothesis, and several moderate theories that balance between independence and dependence. Capital refers to the total investment of a business in terms of money and assets. Capital requirements for a business can be determined on the basis of size and nature of the business concern. It is the integral and major part of all business activities and may be acquired from a various sources. The composition of various long-term sources of finance such as equity capital, preference capital and debt capital make up the capital structure of a business.

Various factors might affect the evaluation of the structure; these factors are categorised into two groups, internal factors and external factors. Raising higher amount of debt at higher rate than rate at which company can earn. Debt Equity mix is irrelevant for computation of market value of firm. You are required to ascertain the total market value of each firm. The operating profits of the company are given and not expected to grow. Capital markets are perfect – Securities are traded in a perfect capital market situation.

But here we shall understand how sensitive is earnings per share to the changes in earnings before interest and tax under different financial plans/capital structures. Use of fixed cost sources of finance in the capital structure of a firm is known as financial leverages or trading on equity. This theory is suggested by Durand and he is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the WACC declines and market value of firm increases. 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.

NET OPERATING INCOME APPROACH

As regards capital structure, the significant point to be noted is the proportion of owned capital and borrowed capital by way of different securities to the total capitalisation for raising finance. Thanks for providing this topic on theories of capital structure in financial management. According to narrow perspective capitalization means total of shares and long term debt. Net Income Approach – Durand presented the Net Income Approach which suggested that capital structure is relevant to the valuation of a firm. This means that a change in capital structure of a firm will lead to a change in a firm`s market value and overall cost of capital .

According to the independence theory, no amount of debt financing can affect the price of the company’s stock. To record assets and liabilities under this system, accountants use a valuation approach known as net operating income, or NOI. According to this theory, the cost of debt is recognized as cheaper source of financing than equity capital.

However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income Approach. The image below demonstrates how the use of leverage can significantly increase equity returns as the debt is paid off over time. In a leveraged buyout 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. Determining the pro forma capital structure of the combined entity is a major part of M&A financial modeling. The screenshot below shows how two companies are combined and recapitalized to produce an entirely new balance sheet.