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Capital Structure: Meaning and Theories Presented by Namrata Deb 1 PGDBM

The document summarizes various theories related to capital structure. It defines capital structure as the way a corporation finances its assets through a combination of equity, debt, or hybrid securities. It then discusses features of a good capital structure, assumptions of capital structure theories, and factors determining capital structure. Finally, it explains key capital structure theories including the net income approach, net operating income approach, traditional theory, and Modigliani-Miller hypotheses on the irrelevance and relevance of capital structure.

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Dhiraj Sharma
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81 views20 pages

Capital Structure: Meaning and Theories Presented by Namrata Deb 1 PGDBM

The document summarizes various theories related to capital structure. It defines capital structure as the way a corporation finances its assets through a combination of equity, debt, or hybrid securities. It then discusses features of a good capital structure, assumptions of capital structure theories, and factors determining capital structure. Finally, it explains key capital structure theories including the net income approach, net operating income approach, traditional theory, and Modigliani-Miller hypotheses on the irrelevance and relevance of capital structure.

Uploaded by

Dhiraj Sharma
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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CAPITAL STRUCTURE

MEANING AND THEORIES

Presented by
Namrata deb
1st PGDBM
REFERENCES:
 SHARMA AND SHASHI. K. GUPTA
 I. M. PANDEY
 PRADEEP KUMAR
MEANING:

In finance capital structure refers to the


way a corporation finances its assets
through some combination of equity, debt,
or hybrid securities. A firm's capital
structure is then the composition or
'structure' of its liabilities. For example, a
firm that sells $20 billion in equity and $80
billion in debt is said to be 20% equity-
financed and 80% debt-financed.
FEATURES OF A GOOD CAPITAL
STRUCTURE
1. PROFITABILITY: capital structure of a
company should be most advantageous
2. FLEXIBILITY: capital structure should be
flexible to meet the changing conditions
3. CONSERVATISM: the debt capacity of
the firm should not be exceeded
4. CONTROL: should involve minimum risk
of loss of control of the company.
ASSUMPTIONS:

1. Firms employ only two types of capital:


debt and equity.
2. Degree of leverage cannot be changed.
3. The corporate or personal taxes do not
exist.
4. Operating earnings of the firm are not
expected to grow.
FACTORS DETERMINING CAPITAL
STRCTURE
1. FINANCIAL LEVERAGE OR TRADING
ON EQUITY:
the use of long term fixed interest
bearing debt and preference share
capital along with equity share capital
2. Growth and stability of sales:
If the sales of the firm are expected to
remain stable or if the rate of growth of
sales is on the increase, the firm will be
more willing to raise a higher level of debt.
3. Cost of capital:
Cost of capital is the minimum return
expected by its suppliers. Capital structure
should provide for minimum cost of capital.
4. Cash flow ability to service debt:
A firm that is able to generate larger and
more stable cash flow can employ more
debt in its capital structure.
5. Nature and size of a firm:
6. Control : the greater the willingness to
control, more debt is included.
7. Flexibility : more the percentage of
redeemable p.shares and debenture more
the flexibility.
8. Requirements of investors:
Three types of investors are there- bold
investors, cautious investors, less cautious
investors
9. Capital market conditions:
Choice of securities influenced by market
conditions
10. Asset structure:
More amount of fixed assets more the
amount of debt
11. Purpose of financing:
Productive or non-productive purpose
12. Period of finance:
For short term finance debt or preference
share is used whereas for permanent
finance equity is preferred.
13. Costs of floatation:
cost of floating a debt is less than cost of
floating an equity
14. Personal considerations:

15. Corporate tax rate:


Companies prefer debt financing to get tax
deductions on interest
16. Legal requirements:
CAPITAL STRUCTURE
THEORIES
NET INCOME APPROACH:
The essence of net income approach is that the firm can
increase its value or lower its overall cost of capital by
increasing the proportion of debt in the capital structure.
It considers the following assumptions:
 It does not change the risk perception of the investors.
 Debt capitalization rate is less than equity capitalization
rate
 Corporate income tax does not exist.
NET OPERATING INCOME APPROACH

According to this approach market value of


the firm is not affected by the capital
structure changes
Market value is found out by
capitalizing the overall or weighted
average cost of capital.
TRADITIONAL THEORY
 This theory was propounded by Ezra Solomon. It
is also known as the intermediate approach
and is the compromise between the two
extremes of net income and net operating
income approaches.
 According to this theory the firm can decrease
the overall cost of capital or increase the total
value of the firm by increasing the debt
proportion in its capital structure to a certain
limit. Because debt is a cheap source of raising
funds as compare to equity
THE MODIGLIANI MILLER
HYPOTHESIS (theory of irrelevance)
M&M hypothesis is identical to net
operating income approach if taxes are
ignored.
The theory proves that the cost of capital is
not affected by the changes in the capital
structure or that the debt equity mix is
irrelevant in the determination of the total
value of the firm
Assumptions :
 There are no corporate taxes
 There is a perfect market
 Investors act rationally
 Expected earnings of all firms have same
risk characteristics
 Risk of investors depend on the random
fluctuation of expected earnings
 All earnings are distributed to all share
holders.
M&M hypothesis( theory of relevance)

M&M hypothesis is identical to net income


approach if corporate taxes are taken into
account.
the value of the firm will change along
with the changes in the debt-equity
proportion because of the deductibility of
interest charges for tax purposes.
M&M hypothesis with corporate and
personal taxes
A firm should aim at minimizing the total
taxes i.e., both corporate taxes of the firm
and personal taxes of the investors while
deciding about the borrowings.
ANY QUERIES?

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