Question
Describe the various Theories of capital structure and discuss the factors influencing pattern of capital structure.
Answer :
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Skip in 10
Capital structure refers to the mix of long-term sources of funds used by a firm, mainly equity, preference shares, retained earnings, debentures, and long-term loans. Decisions relating to capital structure are a crucial part of capital investment and financing decisions because they influence the overall cost of capital, risk, control, and value of the firm. Over time, several theories have been developed to explain how firms should choose their capital structure and whether an optimal combination of debt and equity exists. One of the earliest theories of capital structure is the Net Income (NI) approach. According to this theory, the value of the firm can be increased by increasing the proportion of debt in the capital structure. Debt is considered a cheaper source of finance than equity because interest on debt is fixed and tax-deductible, whereas dividends on equity are not obligatory. As a firm replaces equity with debt, its overall cost of capital declines, leading to an increase in the total value of the firm. The NI approach assumes that the cost of debt and the cost of equity remain constant and that there are no taxes or risk differences. Under this theory, a firm can maximize its value by employing maximum debt in its capital structure. In contrast to the Net Income approach, the Net Operating Income (NOI) approach argues that capital structure is irrelevant in determining the value of the firm. According to this theory, the overall cost of capital remains constant regardless of the debt–equity mix. As the proportion of debt increases, the cost of equity rises due to increased financial risk, offsetting the benefit of cheaper debt. Therefore, the value of the firm depends solely on its operating income and business risk, not on its financing pattern. The NOI approach assumes the absence of taxes and perfect capital markets, and it suggests that there is no optimal capital structure. A more refined view is provided by the Traditional approach, which combines elements of both the NI and NOI approaches. According to this theory, there exists an optimal capital structure at which the overall cost of capital is minimized
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