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Capital Structure Theories

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Capital Structure

Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firmís assets. The main objective of financial management is to maximize the value of the equity shares of the firm. Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called as the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm through its cost of capital and can affect the share of the earnings that pertain to the equity shareholders.


Introduction to Capital Structure Theories

There are 4 basic Capital Structure theories. They are:
  • Net Income Approach
  • Net Operating Income Approach
  • Modigliani-Miller (MM) Approach and
  • Traditional Approach

Generally, the capital structure theories have the following assumptions:
  • There are no corporate taxes (this assumption has been removed later).
  • The firms use only 2 sources of financing namely perpetual debts ad equity shares
  • The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms.
  • The total assets are given which do not change and the investment decisions are assumed to be constant.
  • Business risk is constant over time and it is assumed that it is independent of the capital structure.
  • The firm has a perpetual life.
  • The firmís earnings before interest and taxes are not expected to grow.
  • The firmís total financing remains constant. The firmís degree of leverage can be altered either by selling shares and to retire the debt using the proceeds or by raising more debt and reduce the equity financing.
  • All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm.

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