Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. In this simplified view, the weighted average cost of capital WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.
In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Competing capital structure theories explore the relationship between debt financingequity financing and the market value of the firm.
Traditional Approach According to the traditional theorya company should aim to minimize its weighted average cost of capital WACC and maximize the value of its marketable assets. This approach suggests that the use of debt financing has a clear and identifiable limit.
Any debt capital beyond this point will create company devaluation and unnecessary leverage. Managers and financial analysts are required to make certain assumptions under the traditional approach.
For example, the interest rate on debt remains constant during any one period and increases with additional leverage over time. The expected rate of return from equity also remains constant before increasing gradually with leverage.
This creates an optimal point at which WACC is smallest before rising again. Other Approaches One popular alternative to traditional capital structure theory is the Modigliani and Miller approach. The MM approach has two central propositions.
The first says that capital structure and company value have no direct correlation; instead, the firm's value is dependent on expected future earnings. The second proposition then asserts that financial leverage increases expected future earnings but not the value of the firm.
This is because leverage-based future earnings are offset by corresponding increases in the required rate of return.
The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance.
Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.- 25 - CHAPTER 2 THE THEORY OF CAPITAL STRUCTURE INTRODUCTION. The study of capital structure attempts to explain how listed firms utilise the mix of various. In the past, several significant theories of capital structure in financial management have emerged.
But before we discuss these theories you should know what is capital structure. A firm’s Capital structure is the relative proportions of debt, equity, and other securities in the total financing of its assets.
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. This is often referred to as the tradeoff theory. Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure.
At that optimal structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal Real cost of equity in equilibrium. Capital Structure Theories – D) Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm.
Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches. Traditional approach confirms the existence of. Hence, optimum capital structure in this case is considered as Equity Capital Rs.
1,00, and Debt Capital Rs. 1,00, which bring the lowest overall cost of capital .