Capital Structure Concepts
Capital structure is combination of sources of funds in which we can include two primary sources' proportion. One is Debt and other is Share Capital. All four theories are just explaining the effect of changing the ratio of these sources on the complete cost of capital and total value of business firm.
First Concept of Capital Structure:
Name of Theory = Net Income Theory of Capital Structure
This theory gives the idea for increasing market value of business firm and decreasing overall cost of capital. A business firm can select a degree of capital structure in which debt is more than equity share capital. It will be accommodating to enhance the market value of business firm and decrease the value of overall cost of capital. Debt is relatively low because its interest is deductible from net profit before taxes. After deducting interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.
For instance, if you have equity debt mix is 50:50 except for, if you heighten it as 20:80, it will heighten the market value of business firm and its positive impression on the value of per share.
High debt content mixture, of equity debt mix ratio, to a very great extent called financial leverage. Increasing of financial leverage will be assertive for maximizing the business firm's value.
Second Concept of Capital Structure:
Net Operating income Concept of Capital Structure
Net operating income theory or approach does not admit the idea of increasing the financial leverage under NI approach. It refers to alter the capital structure does not affect overall cost of market and capital value of business firm. At each one and every level of capital structure, market value of business firm will be same.
Third Concept of Capital Structure:
Traditional Theory of Capital Structure
This hypothesis capital structure is mix of net income approach and net operating income approach of capital structure has three stages which investor should comprehend:
In the first stage which is to a very great extent initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm.
In second stage, after increasing debt in equity debt mix, company acquires the position of optimum capital structure, where weighted cost of capital is minimum and market value of business firm is maximum. And then there is no need to further increase in debt in capital structure.
Company can acquires loss in its market value because increasing the amount of debt in capital structure after its optimum level will by all odds increase the overall cost of capital and cost of debt.
Fourth Concept of Capital Structure:
Modigliani and Miller Concept
MM theory or approach is fully opposite of traditional approach. This approach states that there is no relationship among cost of capital and capital structure. Thus, there will no effect of increasing debt on cost of capital.
Value of business firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other components which have been pushed aside by traditional theory of capital structure.
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