In Financial Management book, you would read the topic theories of capital structure. Here, I have made these theories simplified. I hope, you can study these theories here and use these theories as reference. We all know that capital structure is combination of sources of funds in which we can include two main sources’ proportion. One is share capital and other is Debt. All four theories are just explaining the effect of changing the proportion of these sources on the overall cost of capital and total value of firm.
If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. First 50 represent the share capital and second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure in simple and clean words. 1st Theory of Capital Structure Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital.
A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.
High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm’s value. 2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same. 3rd Theory of Capital Structure
Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: Ist Stage In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum.
So, no need to further increase in debt in capital structure. 3rd Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. 4th Theory of Capital Structure Name of theory = Modigliani and Miller MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor’s expectations. Investors’ expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure. Traditional Approach The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm.
This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases. Example: Let us consider an example where a company has 20% debt and 80% equity in its capital structure. The cost of debt for the company is 9% and the cost of equity is 14%. According to the traditional approach the overall cost of capital would be: WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity) ? (20% x 9%) + (80% x 14%) ? 1. 8 + 11. 2 ? 13%
If the company wants to raise the debt portion in the capital structure to be 50%, the cost of debt as well as equity would increase due to the increased risk of the company. Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost of capital would be: WACC = (50% x 10%) + (50% x 15%) ? 5 + 7. 5 ? 12. 5% In the above case, although the debt-equity ratio has increased, as well as their respective costs, the overall cost of capital has not increased, but has decreased. The reason is that debt involves lower cost and is a cheaper source of finance when compared to equity.
The increase in specific costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a cheaper source, namely debt. Now, let us assume that the company raises its debt percentage to 70%, thereby pushing down the equity portion to 30%. Due to the increased and over debt content in the capital structure, the firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be: WACC = (70% x 15%) + (30% x 20%) ? 10. 5 + 6 ? 6. 5% This decision has increased the company’s overall cost of capital to 16. 5%. The above example illustrates that using the cheaper source of funds, namely debt, does not always lower the overall cost of capital. It provides advantages to some extent and beyond that reasonable level, it increases the company’s risk as well the overall cost of capital. These factors must be considered by the company before raising finance via debt. _____________________________________________________________ Net Income (NI) Approach Net Income theory was introduced by David Durand.
According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.
Assumptions of NI approach: * There are no taxes * The cost of debt is less than the cost of equity. * The use of debt does not change the risk perception of the investors ————————————————- Net Operating Income Approach Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares.
This approach also says that the overall cost of capital is independent of the degree of leverage. Features of NOI approach: * At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate. * The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm – Value of debt Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital. Example: Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12. 5%.
Procurement plan for emergency euipments
Procurement plan for emergency euipments.
The topic explains what its needed to be done really, so it consist of emergency medical advice(EMA) for a population of 20,000 people (like a small state). i want diagrams to make it explanation more understandable. The currency must be in pounds sterling.
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