MBA 205

Capital Structure Theories

-Dr A.N.Garg

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Capital Structure
Capital structure refers to the composition or makeup or mix of capital i.e. in what proportion equity share capital, preference share capital, long term loans and debentures have been issued. Capitalization refers to the sum total of all kinds of long term securities i.e. equity share capital, preference share capital and long term loans and debentures. Financial structure refers to all the financial resources, short as well as long term. In nutshell it is the sum total of the liability side of the balance sheet.

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Capital Structure
According to Gerstenberg, capital structure of a company refers to the make-up of its capitalization. There are no ready made rules so far as the proportion of different types of securities is concerned. However, Gerstenberg has given two general principles in this regard. 1)The greater the stability of earnings, the higher may be the ratio of bonds to stock in capital structure. 2)The capital structure should be balanced with a sufficient equity cushion to absorb the shocks of business cycle and to afford flexibility.

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Theories of Capital Structure

Net Income Approach Net Operating Income Approach Traditional Approach Modigliani and Miller Approach

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Net Income Approach

According to this approach, which has been given by Durand, a firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity share by using debt financing. The theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital structure. The basic Assumptions are: The cost of debt is less than the cost of equity. There are no taxes. The risk perception of investors is not changed by the use of debt.

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Net Operating Income Approach

According to this approach, change in capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. The main assumptions are: The market capitalizes the value of the firm as a whole. The business risk remains constant at every level of debtequity mix. There are no corporate taxes.

Traditional Approach

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Traditional view is a compromise between net income and net operating income approach which says that the value of the firm can be increased or cost of capital can be decreased by a judicious mix of debt and equity. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheap source of finance. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of equity shareholders.

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Modigliani and Miller approach

In the absence of Taxes The theory proves that the cost of capital is not affected by the changes in the capital structure. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases.

From the above, it can be seen that MM approach supports Net Operating Income Approach relating to cost of capital and degree of leverage. Assumptions: 1. There are perfect capital markets. 2. Investors can borrow money without any restrictions. 3. Individuals and the firms can borrow at the same terms and conditions. 4. Availability of perfect information. 5. There are no transaction costs. 6. All investors are rational. 7. Business risk is equal among all firms with similaroperating environment. 8. There are no taxes. Operational justification for MM Hypothesis is the arbitrage process of buying a security at a lower price and selling at a higher price in different markets, bringing about equilibrium in the market price of a security.

MM----

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MM----

Limitations of MM Approach: 1. Transaction costs. 2. Personal leverage. 3. Personal capital gearing. 4. Problems of personal leverage. 5. Influence of share prices. 6. Information Access. 7. Corporate taxes.

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When the corporate taxes are assumed to exist

MM later introduced their model with the effect of taxes in two identical firms. They are similar but one firm is levered and the other one is unlevered to find out the advantage of debt. The value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purposes. Levered firm will have greater value. Firm has been advised to use debt up to a certain level only.

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CRITICISMS OF MM APPROACH
The leverage irrelevance theorem of MM is valid if the perfect market assumptions underlying their analysis are satisfied. The real world, however, is characterized by various imperfections:

1. Firms are liable to pay taxes on their income, In addition, investors who receive returns from their investments in firms are subject to taxes at a personal level. 2. Bankruptcy costs can be quite high. 3. Agency costs exist because of the conflict of interest between managers and shareholders and between shareholders and creditors.

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CRITICISMS OF MM APPROACH

4. Managers seem to have preference for a certain sequence of financing. 5. Information asymmetry exists because managers are better informed than investors. 6. Personal leverage and corporate leverage are not perfect substitutes.