Introduction To Capital Structure Theory

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Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets. Financial management aims at maximizing the value of the equity shares of the firm. To achieve this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. This form of capital structure is called as the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm and can affect the share of the earnings of the equity shareholders.

Capital Structure Theories

There are 4 basic Capital structure theories. They are
1. Net Income Approach: According to this approach change in financial leverage would lead to change in the cost of capital.

2.Net Operating Income Approach: This approach is just opposite of net income approach. It says that weighted average cost of capital remains constant.

3.Modigliani-Miller (MM) Approach: The MM approach has two central propositions. The first says that capital structure and value of the firm have no direct correlation; instead, the firm’s value is dependent on expected future earnings. The second proposition states that financial leverage increases expected future earnings but not the value of the firm.

4.Traditional Approach: The traditional theory aims at minimizing the \weighted average cost of capital (WACC) and maximizing the value of its marketable assets. This approach suggests that the use of debt financing has a clear and identifiable limit.

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