Capital Structure Theories
The word capital structure denotes to an arrangement of funds which a company raises to run its business. A company has all types of sources in an adequate proportion to finance its business. The correct proportion of sources of capital in a company is the result of right financial decision. The objective of a financial decision is to maximise the value of firm which is directly linked with the shareholder’s wealth creation. As per the approaches of capital structure a change in the capital mix would have an impact on firm’s value. There are several approaches and theories for properly understand the concept of capital structure such as net income approach, net operating income approach, traditional approach and Modigliani & Miller approach. In addition to this, in order to determine the optimum capital structure, financial leverage and efficiency of the business is determined on the basis of cost of capital of company. By using the debt and equity portion of the busienss and interest and return available to equity shareholders, company could easily determine the business sustainability and capital leverage in long run.
The capital structure of company is associated with the debt and equity of company. However, in order to determine the optimum capital structure of company is based on the several factors. It is analysed that if company has higher debt capital in its busienss then it will have several benefits such as low cost of capital, high tax deduction. However, high debt funding will also increase the financial leverage but at the same time it will also lower down the overall cost of capital.
It is a process of capitalisation, which consist all the long term resources of capital such as loans, shares, bonds and reserves. It also reflects the proportion of debt and equity in a firm’s capital. Any change in the capital mix of a company changes the proportion of debt and equity in the firm which affects the net income of company. The major reason behind this change is the interest on debt which varies due to the changed level of debt portion of capital. The increase in the interest would decrease the net income and a fall in interest would increase the net income and afterwards the earning per share (Ehiedu, 2014). At the same time the change in EPS also changes the value of firm. To decide the proportion of debt and equity, companies use the measure financial leverage. It helps the company to decide that up to what extent a company should borrow the funds or should employ the debts in its business (Fridson, and Alvarez, 2011). The capital structure helps a company to determine the specified situation of their company and to evaluate its optimal capital structure. It makes a company enable to balance its risk and return. Benefits of setting up optimum capital structure
Factors affecting Optimum Capital Structure
The major benefit of capital structure theory is that it enables the business owners to know about the both debt and equity financing and their profits and consequences for their business. It provides a chance to managers to grow their business to earn more profits. While opting for the right financing option the owner has various thoughts in his mind regarding to the implication of the correct capital structure. These opinions are related to the ownership, controls and future returns. The debt financing allows the owners to keep the entire ownership and control over the business. In this case, owners can manage the operations of business by their own controls. On the other hand, equity financing is an option available for newly established businesses with no proven track records. All in all we can say that every business have their own requirements, according to which they choose their required capital structure (Gibson, 2011). The main benefit of keeping high debt funding in organization is related to tax saving structure. This will allow company to lower down the tax obligation. It is evaluated that the interest payment on the debt funding and to debt holders will be tax deductible expenses for organization. It will eventually reduce the cash outflow and also lower down the cost of capital of company. The low cost of capital of company focuses on the increasing the overall profitability and increasing the overall outcomes in long run (Godwin, and Alderman, (2012).
It is hard to determine the optimum capital structure in the Organizaiton. However, the proportion of the debt and equity capital in busienss is dependent upon the several factors such as nature of the busienss, cost of capital, profitability, efficiency of the business and current investment opportunities available for the organization (Heitger, Mowen, and Hansen, (2007). It is analyzed that if company wants to keep its busienss more sustainable and effective in long run then it will have to focus on managing the cost of capital and financial leverage in long run. It is analyzed that company should focus on reducing the cost of capital if the profitability of the busienss is high (Delen, Kuzey, and Uyar, 2013). On the other hand, if company faces issues related to low profitability then it will first have to keep its busienss safe and secure by keeping the low financial leverage. It will allow company to survive its busienss in long run when the market is sluggish (Higgins, 2012). These different theories such as net income approach, net operating income approach, and traditional approach and Modigliani & Miller approach will be useful for determining the optimum capital structure. The cost of capital and financial leverage both are the imperative factors while determining the capital structure. The firm’s value is determined on the basis of the future estimated cash inflow.
Benefits of Optimum Capital Structure
The capital structure theories are required to find out an adequate financing method for the activities of business. This systematic method explores the link between market value of firm and the debt/equity financing. There are several approaches given by different economist which help us to know that how the capital structure of a company affects its overall value. Out of these theories, according to net income approach the value of firm and its capital structure are relevant terms (Krantz, and Johnson, 2014). This theory was given by Durand. It says that if the debt ratio in capital structure increases, it gives a fall to weighted average cost of capital. However, it is hard to determine the optimum capital structure on this basis of this theory. It means any change in leverage also brings a change in overall cost of capital of the firm i.e. value of firm. The assumption of this approach says that the cost of equity is higher than the cost of debt and the use of debt also decreases the levy of taxes. As per this approach an increase in debt portion of capital will not influence the investor’s confidence (Mwangi, and Murigu, 2015). The main strength of this theory is to identify the stakeholder’s influence on the capital structure. The net operating income approach was also given by Durand but it consist an opposite concept from the net income approach. As per this approach, the strengthen of this theory is to determine the estimated cost of capital. The overall cost of capital of a company is independent and change in debt will not change the firm’s value or the market price of shares. As per this approach the increase in debt also enhance the cost of equity. For balance the higher risk factor in case of highly debt levered company, the holders of equity share also expect higher returns which results an increase in cost of equity capital (Baker, Jabbouri, and Dyaz, 2017). This uncertainty is the one of the weakness of this theory. Apart from these two approaches the third approach of capital structure i.e. traditional approach believes that at a specified ratio of equity and debt, the firm’s value is Maximum and the cost of capital is Minimum. That particular capital structure is called as optimal capital structure (Robb, and Robinson, 2014). Nonetheless, the optimum capital structure is varied at different times on the basis of the several factors. For instance, if the profitability of company is going down then company will have to increase the equity capital by lower down the debt funding. It is analyzed that company could have higher debt funding when the available earnings before interest and tax are enough to cover interest payment. That particular point of capital structure is the result of a mix of debt and equity. The theory says that the firm’s value increases up to a specified level of debts and afterwards it seems to remain stable or if the borrowings are too much then it begins to fall down. Due to the overleveraging, such fall in the firm’s value happens. The next approach of capital structure popularly known as MM approach is somehow similar to the Durand’s given net operating approach (Nikolai, Bazley, and Jones, 2009). It also believes that the cost of capital of a company is independent and not relevant to the value of the firm. The MM approach works on two propositions. One of the proposition says that the value of firm rely on the expectation of future earnings (Bessler, and Schneck, 2016).
Net Income Approach
This will allow company to determine the value of the firms on the basis of the future earning of the company. For instance, if company is going to have a certain amount of earning in the future then by using the present value of the money, company could easily determine the estimated value of the capital (Owens, 2018). On basis of this approach the structure of capital is irrelevant to the firm’s value. Second proposition of MM approach states that however, the financial leverage helps to boost the expected future earnings of a firm but it has no role in the increase of value of firm. It believes that the increased earnings are the result of change in expected rate of return (Sinha, 2012). The difference between MM approach and net operating income approach is that the MM approach has an operational justification for the point that the cost of capital of a company is independent but the net operating income approach does not have any justification for that particular point. Apart from all these theories, the trade-off theory of capital structure was also an idea of balancing the benefits and costs of financing (Brigham, and Ehrhardt, 2013). The theory helps the corporates to choose the adequate quantity of debt and equity options while deciding its capital structure. However, the main weakness is to establish eh linkage between the both. As per this theory the company should focus on the mix of capital options which provides equilibrium between the cost and benefits to the company (Vogel, 2014). All these discussed theories of capital structure assists the corporates to find the best mix of capital to enhance its market value and to reduce the cost of capital of its business and at the same time maintain the optimum capital structure (Bragg, 2012). For instance, if company maintains higher debt funding in its business then it will have to face high financial risk. There are several benefits and losses associated with the debt funding. The main advantage of the debt funding in the busienss is related to keeping the cost of the raised capital low. If company could manage higher debt funding in its business then it will have low cost of capital and increased financial leverage. Many companies such as One Tel, HIH insurance and other big companies have failed to survive in the market due to their inability to pay to its creditors. It has been analyzed that if company keeps lower debt capital in its busienss then it will have to face high cost of capital which will hamper the profitability and efficiency of the company in long run. On the other hand, if debt funding is high in busienss then it will negatively impact the financial leverage and keep be more risky for the Organizaiton to sustain its busienss in case of sluggish market condition (Robb, and Robinson, 2014). The sustainability of the business is determined on the basis of the capital structure and financial leverage faced by company in long run. If company uses high debt funding then it will allow company to not to dilute the ownership in long run.
Net Operating Income Approach
The firm value is determined on the basis of undertaken busienss structure and invested capital in the assets of organization. It is determined that in financial management, capital structure theory is referred to systematic approach to finance the busienss activities by combining the equity and debt portion in the particular manner. The capital structure and value of firm has an indirect relationship (Sinha, 2012). The value of the firs is based on the capital, assets and liabilities shown in the books of accounts of company. The main impact on the value on firm would be from the high financial leverage and cost of capital. The debt and equity capital portion in the capital structure are the main part which influence the cost of capital and financial leverage of the busienss (Vogel, 2014). It is analyzed that company should establish the proper equilibrium in its costing of the capital and financial leverage by undertaking the nature of the busienss, undertaken business functioning and market condition of organization. The change in proportion of components of capital also affects the value of firm. The relation between the capital structure and financial firm’s value both are interrelated to each other. Capital structure has different theories to determine the relationship between the capital structure and value of firm. All these approaches have their own views and assumptions regarding such relationship (Warren, and Jones, 2018). The capital structure has a significant impact on the value of firm because it affects the performance of the firm and the performance of business is the main determinant of firm’s value. There are several theories which are given to determine how well company could manage its busienss. Company could increase its overall profitability and efficiency by setting equilibrium between the debt funding and profitability of company. The Modigilani- Millar and Gordon capital structure model will also be the helpful theory to determine the accurate cost of capital which company will have to pay to its investors for their capital in business (Warren, Reeve, and Duchac, 2011). There are several companies such as HIH insurance, One Tel and Dick Smith that have gone into liquidation due to the winding up and liquidation of company. A firm with unbalanced capital structure cannot perform better and it results into negative returns. The above discussed report proves that the value of firm affects with the variation in capital structure. The firm value and capital structure both are interrelated to each other and if company wants to create value on its investment then it will have to first focus on evaluating the influencing internal and external factors which might negatively and positively impact the busienss growth, leverage and profitability of business (Yahoo finance, 2017).
Traditional Approach
Conclusion
There are several information and theories have been analyzed which focuses on the capital structure and how company could manage its business in long run. On the basis of the above discussed report, financing decision plays a significant role in building an adequate capital structure for a business. The capital of a company has both debt and equity portions. To find out the right proportion of these two variants, business owners go with the approaches of capital structure. If the management decides to have higher debts in their business then it will get the benefit form interest expenses as it reduces the taxable income. But at the same time it increases the interest liability of the company. Hence, it is mandatory for a company to find an equilibrium point between the equity and debts to form an optimal capital structure. After analysing all the details and case study, it could be inferred that company should focus on determining the optimum financial leverage which it could have in its busienss. However, higher financial leverage in busienss process will make difficult for the busienss to survive when the market is unstable and reflecting low profitability for organization. Now in the end, it could be inferred that company should first determine its busienss policies, market condition, financial position and liquidity as well while deciding the debt and equity portion in the capital structure of organization. Now in the end, it could be inferred that capital structure of company should be dependent upon cost of capital and profitability of company.
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