What are the theories related to Capital Structure?

Capital Structure: It is a proportion of the capital raise through debt, equity or wholly debt or wholly equity to finance company's assets.

Theories of Capital Structure:

1.       Net Income

2.       Net Operating Income

3.       Trade Off

4.       Pecking Order

5.       Modigliani and Miller

6.       Market Timing

Net Income: According to this theory debt finance is cheaper than other sources of finance, more debt capital in a company lesser the total cost of capital because the interest is tax deductible and it reduces the burden of tax so, that’s why the weighted average cost of capital is less.

Assumptions:

·         Cost of debt < cost of equity

·         No tax

·         Use of debt does not change the risk of investors.

Net Operating Income: According to this theory increase or decrease in the debt of a company does not affect the value of a firm/company. Because it does not affect the operating income of a company or firm it affects only debt holder or equity holder. The total value of the firm or weighted average cost of capital is independent from changes in capital structure. But increases in debt increases financial risk. It is also known as traditional approaches. 

Assumptions:

·         Value of equity determine after subtracting interest on debt and dividend of preference shareholders.

·         Cost of capital remains constant.

·         Increasing the cost of debt increasing the risk perception of cost of equity.

Trade Off: In this theory debt and equity are uses to finance the assets of a company/ firm until the cost of its less than its benefits or both are same.

Pecking Order: According to it companies uses internal sources to finance its assets like retained earnings, selling short term securities. If further capital is required then company issues debt capital like debenture, bond, and long term securities and at last company uses equity capital like shares, preference share to finance company’s assets.

Modigliani and Miller: This theory is proposed by two professors Modigliani and Miller and their assumptions are:

·         No tax

·         No transaction cost

·         Equivalence borrowing cost for investors and companies.

·         No bankruptcy cost

·         No effect of debt on earnings before interest and tax

·         The investors and companies have same information.

It states that the change in capital structure does not affect the value of a firm/company. The value of a company/firm only affected by expected future earnings of a company/firm. There are two assumptions: without taxes and with taxes

·         No Taxes:

•  It states that the earnings are distributed equally among shareholders and debt holders.

•  With increase in debt the risk of equity shareholders get higher so, there is increase in cost of equity in comparison to cost of debt.

            With Taxes: In reality tax is applicable on company’s earnings. The interest on debt is tax deductible, but it is not in the case of dividend on equity. So, that’s why the company uses both the source of finance to lower the WACC.

Market Timing: According to this theory companies issues such securities whose market value are more and buy back when the value of the securities are less.

Factors to determine the capital structure:

·         Cost of financing: At the time of financing the capital structure if the cost of debt is less than the cost of equity, then company will choose to raise capital through debt otherwise shares or equity.

·         Type of investors: Company is always considering its investors interest at the time of rising capital to finance its assets. For risk taking investors it issues equity and debenture while issues bond.

·         Related company: If a related company has higher earnings than their capital structures act as a factor to determine the capital structure.

·         Cost of equity: If a company’s earnings are higher at that time the shareholders demands more profit than the cost of equity is higher than the cost of debt. So, in that case limited debt capital is raised by the company.

·         Cash requirement: If the company has enough cash for the day to day requirement, then it raises capital through debt otherwise it uses shares.

·         Control: If the company wants more control over management remain in their hands it raises capital through debt or loan, otherwise it uses equity.