Meaning of capital structure capital structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations. The same may be achieved if an optimal capital structure is designed for the. Aswath damodaran 3 the objective in decision making n in traditional corporate finance, the objective in decision making is to maximize the value of the firm. The traditional school, at one extreme, argues that there is an optimum capital structure at. Theories of capital structure ppt capital structure cost of capital. It is the employment of an asset source of finance for which. Managers should also be watchful and aware of windows of opportunities in which they can maximize the corporations growth. 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. Capital structure means a combination of all longterm sources of finance. Capital structure theories and its different approaches put forth the relation between the proportion of debt in the financing of a companys assets, the weighted average cost of capital wacc and the market value of the company.
Most businesses strive to reach an optimal capital structure, which is a mix of funding sources that minimizes the cost of raising capital to fund new ventures. Your discussion must identify the conflicts and similarities between theories. The four theories treat the relationship of a companys worth to its funding very differently. A companys capital structure refers to how it finances its operations and growth with different sources of funds, such as bond issues, longterm. Powerpoint slide on theories of dividend compiled by dr. This tells us that capital structure decision is irrelevant to cost of capital and. Capital structure theories capital structure theories a net income approach ni net income approach proposes that there is a definite relationship between capital structure and value of the firm. Capital structure, a reading prepared by pamela peterson drake 4. A companys capital structure points out how its assets are financed. Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital. The theory of capital structure milton harris and artur raviv abstract this paper surveys capital structure theories based on agency costs, asymmetric information, productinput market interactions, and corporate control considerations but excluding taxbased theories. In this approach to capital structure theory, the cost of capital is a function of the capital structure. Capital structure theories click now to get solution. Capital structure is the mix between owners funds and borrowed funds.
Theories of capital structure essays, research papers. While net income approach and net operating income approach are the two extremes approach are the two extremes, traditional approach, advocated by ezta solomon and. Capital structure theories may be classified on the basis of relevance of capital structure to the valuation of a firm. In this lesson, learn the main concepts of the competing theories of capital structure. Capital market conditionin the lifetime of the company, the market price of the shares has got an important influence. Meaning of capital structure capital structure refer to the proportion between the various long term source of finance in the total capital of firm a financial manager choose that source of finance which include minimum risk as well as minimum cost of capital. Theories of capital structure ppt capital structure. A company has to decide the proportion in which it should have its own finance and outsiders finance particularly debt finance. Capital structure chapter 15 and chapter 16 contents i. List of capital structure theories theories of capital structure static tradeoff theory, pecking order theory, modified pecking order theory with graphs 1. During the depression period, the companys capital structure generally consists of debentures and loans. Capital structure theories capital structure cost of. Capitalstructure is the most essential real time news and analysis service in the european distressed space.
Chen 2011 stated among the theories are static trade off theory which derived by modigliani and miller 1963 was the earliest and most recognized which explains the formulation of. The proportion of debt, preference and equity shares on a firms balance sheet. When a company finances its operations by opening up or increasing capital to an investor preferred shares, common shares, or retained earnings, it avoids debt risk, thus reducing the potential that it will go bankrupt. Static tradeoff theory the horizontal base line in figure 17. Bahadur institute of management sciences, university of mysore, india available online at.
If there is a change in the present capital structure of the company, will there be a. This presentation is an overview of capital structure theories. This theory is diametrically opposite to net income approach. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. Theories of capital structure explained with examples. Capital structure is the mix of financial securities used to finance the firm. Its important to remember, however, that this approach assumes an optimal capital structure. Introduction to capital structure theories there are 4 basic capital structure theories. From a technical perspective, the capital structure is the careful balance between equity and debt that a business uses to finance its assets, daytoday operations, and future growth. Given three types of firms or scenarios of firms the model can be summarized as follows.
In the mainstream of the academic field of finance, the modigliani and millers 1958 proof of capital structure irrelevance theory, has been praised as the cornerstone of modern scientific finance. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. Assumptions and definitions to understand relationship between financial leverage n cost of capital. The value of a firm is defined to be the sum of the value of the firms debt and the firms equity. The capital structure of a firm influences its cost of capital wacc, and thus directly affects the value of the firm. Hi guys, i am sharing with you this excellent ebook on financial management in pdf format. Capital structure is the proportion of all types of capital viz. I will also share the lecture notes on this subject. In the end, glazer and israel recognize this weakness and claim that their results cannot be considered as a capital structure theory.
The capital structure or combination of debt and equity at which the wacc is minimum and it leads to maximum value of the firm what is capital structure. Ensure your discussion is not dominated with textbook description of the subject. Generally, an ebook can be downloaded in five minutes or less. Optimal capital structure theory is unique to each business, so different businesses subscribe to different theories. A net income ni approach durand presented the net income approach which suggested. Chapter iii concepts and theories of capital structure and profitability. However, the capital structure irrelevance theory is based on a set of assumptions, which are both unrealistic and contradictory to the main assumption of the mainstream academic finance. The capital structure of a firm is the mix of different sources of finance used by the firm to finance its operations. Capital structure theories explain the relationship between the cost of capital and capital structure. Top 4 theories of capital structure with calculations.
This ebook is highly recommended for mba or management students. Capital structure theories help us to understand the relationship between the capital structure, cost of capital and value of a firm. This paper surveys literature on five theories of capital structure theories from modigliani and miller research paper at 1958 to halov and heider at 2004. When cost of capital is lowest and the value of the firm is. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. The capital structure puzzle is unravelled and a clear. The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the wacc and maximizes value.
The following points will highlight the top four theories of capital structure. What are the different types of capital structure theory. When the stock is traded and markets are viewed to be efficient, the objective is. It includes equity share capital, reserves and surplus, preference share capital, loan, debentures and other such longterm sources of finance. As one can see, there are many aspects one needs to consider when determining a firms capital structure and this essay only slightly begins to. Capital structure and its 4 important theories ni, noi. This paper surveys capital structure theories based on agency costs, asymmetric information, productinput market interactions, and corporate control considerations but excluding tax. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. According to ni approach a firm may increase the total value of the firm by lowering its cost of capital. Normally, a capital structure theory should combine various basic finance factors together. Financial management ebook,lecture notes,pdf download for. Capital structure theory a free powerpoint ppt presentation displayed as a flash slide show on id.
Debt and equity the total assets are given and do not change. The goal of this chapter is to discuss the various theories that help to explain the determination of capital structure. It is accurate, well informed, breaks more stories than its peers and provides an ability to track the new issue high yield and leveraged loans universe which is. Capital structure decision is relevant to the valuation of the firm. Capital structure theories the debate on optimal capital structure that leads to maximum market valuation and minimum cost of capital is perennial. Theories of capital structure ppt free download as powerpoint presentation.
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