Capital Structure – Meaning and Theories

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.

According to James van Horne, Capital Structure refers to the “Mix of a firm`s permanent long-term financing represented by debt, preferred stock and common stock equity”

It can simply be defined as the relationship between various sources of long-term finance. A major function of a financial manager is to determine the optimal capital structure for a company i.e. optimum mix of debt and equity.

The capital structure decision helps a business to maximize the value of its firm and minimize its overall cost of capital. Therefore, an optimum capital structure refers to the optimum combination of debt and equity, which leads to maximization of firm`s value and minimization of its weighted average cost of capital.

Financial Structure – It may be defined as the extent to which funds are available with a business to finance its business activities and fixed assets.

Financial Structure = Capital structure + Current Liabilities

 

Capital Structure Theories

The Capital Structure decision affects the financial risk and value of the firm. Capital structure theories help us to understand the relationship between the capital structure, cost of capital and value of a firm.

Capital structure theories may be classified on the basis of relevance of capital structure to the valuation of a firm.

(A) Net Income (NI) 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 (Weighted average cost of capital).

According to this approach, a firm must finance its activities more from debt capital and less from equity capital to reduce the overall cost of capital and maximize the value of the firm. 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.

In other words, a change in financial leverage of a firm will lead to a corresponding change in firm`s WACC (weighted average cost of capital) and market value of shares. Therefore a firm must increase its financial leverage (proportion of debt) in order to decrease its WACC and increase the market value of its shares.

Assumptions of NI Approach

  • Corporate taxes do not exist
  • The cost of debt is less than cost of equity i.e. Ke<Kd
  • An increase in debt does not change the confidence of investors in the business

Valuation of a firm according to NI Approach

(1) Value of a firm (V)

V = S + B

Here,

V = Value of the Firm

S = Market value of Equity

B = Market value of Debt

(2) Market Value of Equity (S)

S = NI/Ke

Here,

NI = Earnings available for shareholders

Ke = Equity Capitalization rate

(3) Overall cost of Capital (Ko)

Ko = EBIT/V

 

Statement for valuation of a firm on the basis of NI Approach –

  Particulars Amount
Net Operating Income or Earnings before interest and taxes (NOI or EBIT) XX
Interest on debentures (I) XX
EBIT – I = Earnings available for equity shareholders (NI) XX
  Equity Capitalization Rate (Ke) %
NI/Ke  = Market Value of Equity (S) XX
  Market Value of Debt (B) XX
S + B = Total Value of Firm (V) XX
EBIT/V = Overall Cost of Capital (Ko) %

 

(B) Net Operating Income (NOI) Approach – Contrary to the NI approach the NOI approach suggests that the capital structure decision of a firm is an irrelevant factor to the valuation of a firm i.e. any change in debt or financial leverage of a firm does not affect the market value of its shares.

According to this approach the WACC and total value of a firm are independent and are not affected by any change in financial leverage or capital structure decision. However, it`s market value is dependent upon the operating income and risks associated with the business. As financial leverage can only affect the income earned by debt and equity share holders and not the operating income of a firm, therefore any change in financial leverage or capital structure will not affect the value of a firm.

Assumptions of NOI Approach 

  • Corporate taxes do not exist
  • Overall cost of capital remains constant
  • Cost of debt is constant
  • A change in debt/equity ratio does not affect the overall cost of capital

 

 Valuation of a firm according to the NOI Approach

(1) Value of a firm (V)

V = EBIT/Ko

Here,

V = Value of a firm

Ko = Overall cost of capital

EBIT = Earnings before interests and taxes

(2) Value of Equity (E)

E = V + B

Here,

V = Value of the firm

B = Value of Debt

(3) Equity Capitalization rate (Ke)

Ke = (EBIT – I) / (V + B)

(4) The validity of the NOI approach can be verified by the following formula

Ko = Kd (B/V) = Ke (S/V) 

Here,

Kd = Cost of Debt                          B = Total Debt

Ke = Cost of Equity                       S = Market value of Equity

 

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