Financial Management :Capital Structure
The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value of the firm. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both If average affects the cost of capital and the value of the firm, an optimum capital structure would be obtained at that combination of debt and equity that maximizes the total value of the firm (value of shares plus value of debt) or minimizes the weighted average cost of capital
Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is synonymously used as financial leverage or financing mix. Capital structure is also referred as the degree of debts in the financing or capital of a business firm. It is believed that with the change in capital structure, the value of a firm can be influenced. There are four approaches to this, viz. net income, net operating income, traditional and M&M approach.
The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value of the firm. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both If average affects the cost of capital and the value of the firm, an optimum capital structure would be obtained at that combination of debt and equity that maximizes the total value of the firm (value of shares plus value of debt) or minimizes the weighted average cost of capital
Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is synonymously used as financial leverage or financing mix. Capital structure is also referred as the degree of debts in the financing or capital of a business firm. It is believed that with the change in capital structure, the value of a firm can be influenced. There are four approaches to this, viz. net income, net operating income, traditional and M&M approach.
- Net Income Approach: This approach was suggested by Durand and he was in the favour of financial leverage decision. According to him, change in financial leverage would lead to change in cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of the firm.
- Net Operating Income Approach: This approach is also provided by Durand but it is totally opposite to the Net Income Approach. It says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses firm as a whole which discounts at a particular rate which is not related to debt-equity ratio.
- Traditional Approach: This approach is not defined hard and fast facts but it says that cost of capital is a function of the capital structure. The special thing about this approach is that it believes an optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of firm is maximum.
- Modigliani and Miller Approach (MM Approach):It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed two propositions.
- Proposition I: It says that the capital structure is irrelevant to the value of a firm. Value of two identical firms would be same and it would not be affected by the mode of finance adopted to finance the assets. Value of a firm is dependent on the expected future earnings.
- Proposition II: It says that the financial leverage boosts the expected earnings but it does not increase the value of the firm because the increase in earnings is compensated by the change in the required rate of return.
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