Capital structure theory refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is the composition or ‘structure’ of its liabilities. The capital structure decision affects financial risk and hence the value of the company. The capital structure theory helps us understand the factors most important in the relationship between capital structure and the value of the company.
Assumptions of Capital Structure Theories
The following are assumptions are made to understand theories:
- Firms employ only two types of capital: debt and equity.
- The total assets of the firm are given. The degree of average can be changed by selling debt to purchase shares or selling shares to retire debt.
- The firm has a policy of paying 100 percent dividends.
- The operating earnings of the firm are not expected to grow.
- That there is no corporation or personal taxes.
Capital Structure Theories
There are four major theories or approaches explaining the relationship between capital structure, Cost of capital, and value of the firm. These can be classified into categories as follows:
Net Income (NI) Approach: Net Income Approach was presented by Durand. According to this approach. Capital structure decision is relevant to the valuation of the firm. The cost of debt and cost of equity is assumed to be independent of the capital structure. The theory suggests increasing the value of the firm by decreasing the overall cost of capital which is measured in terms of a weighted average cost of capital. This can be done by having a higher proportion of debt, Which is a cheaper source of finance compared to equity finance.
Assumptions of Net Income Approach
- An increase in debt will not affect the confidence level of the investors.
- The cost of debt is less than the cost of equity i.e ke>kd.
- There are no taxes levied.
The figure shows that the Kd and Ke are constant for all levels of leverage,i.e., for all levels of debt financing. As the debt proportion or the financial leverage increases, the WACC, Ko, decreases as the Kd is less than Ke. This results in an increase in the value of the firm. In the figure, it may be noted that Ko will approach Kd as the debt proportion is increased. However, Ko will never touch Kd as there cannot be a 100% debt firm. Some elements of equity must be there. However, if the firm is a 100% equity firm, then the Ko is equal to Ke. The rate of decline in Ko depends upon the relative position of Kd and Ke.
Net Operating Income Approach(NOI): The Net Operating Income (NOI) approach is opposite to the NI approach. According to the NOI approach, the market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital, WACC. The financing mix or the capital structure is irrelevant and does not affect the value of the firm.
Assumptions of Net Operating Income Approach:
- There are no corporate taxes.
- The debt-equity mix does not affect the overall cost of capital.
- The cost of debt is constant.
- The increase in debt changes the risk perception of the shareholders.
- The overall cost of capital is constant. It depends on business risk which is also constant.