Different theories of capital structure. (PDF) A Comprehensive Review on Capital Structure Theories 2022-10-28

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There are several theories that have been proposed to explain how firms determine their capital structure, or the mix of debt and equity that they use to finance their operations. These theories can be broadly grouped into two categories: trade-off theories and pecking order theories.

Trade-off theories argue that firms carefully balance the benefits and costs of different types of financing in order to achieve an optimal capital structure. One well-known trade-off theory is the traditional trade-off theory, which posits that firms trade off the tax benefits of debt with the financial distress costs of excessive borrowing. According to this theory, firms try to find a balance between the tax savings they receive from the interest payments on their debt and the increased risk of bankruptcy that comes with high levels of debt.

Another trade-off theory is the agency theory, which focuses on the conflict of interest between shareholders and managers. According to this theory, managers may prefer to use debt financing because it allows them to retain control of the firm, while shareholders may prefer equity financing because it aligns the interests of the manager with those of the shareholders. In this case, firms must find a balance between the conflicting preferences of shareholders and managers in order to achieve an optimal capital structure.

Pecking order theories, on the other hand, argue that firms follow a predetermined hierarchy when choosing their financing sources. According to the pecking order theory, firms prefer to use internal funds (such as retained earnings) to finance their operations because these funds are the least costly. When internal funds are not sufficient, firms will turn to external financing, but they will prefer debt financing to equity financing because it is less dilutive to the ownership of existing shareholders.

There are several variations of the pecking order theory, including the asymmetric information theory, which suggests that firms prefer debt financing because it signals to the market that they are creditworthy, and the market timing theory, which posits that firms prefer debt financing when they believe that the market is favorable for raising capital.

Overall, trade-off theories and pecking order theories provide different perspectives on how firms determine their capital structure. While trade-off theories focus on the balancing of benefits and costs, pecking order theories emphasize the importance of the availability and cost of different financing sources. Ultimately, the choice of capital structure is likely to be influenced by a combination of factors, including the firm's financial performance, the tax environment, and the preferences of shareholders and managers.

Theories of Capital Structure

different theories of capital structure

The Review of Financial Studies, 20 5 , pp. Thus, the maximum value under the net income approach is with 100% debt financing. The expected NOI is a random variable ADVERTISEMENTS: 4. 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. Businesses will base their capital structure on various things, including market conditions, management style, and the industry they operate in. According to Chen 2004 , the Pecking Order Theory explains why some companies are reluctant to issue equity to the public as it affects the market value of shares.


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Theories of capital structure

different theories of capital structure

This method can be computed through the formula below. Modigliani and Miller also do not agree with the traditional view. Net Operating Income Approach: ADVERTISEMENTS: Now we want to highlight the Net Operating Income NOI Approach which was advocated by David Durand based on certain assumptions. In essence, aligning with the market timing theory, which Denis 2012 attributes as significant when the managers are working with the interests of the shareholder. Practically, this approach encompasses all the ground between the net income approach and the net operating income approach i.

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Master of Business Administration Resources page: Theories of capital structure

different theories of capital structure

It explains that optimum capital structure has a range where the cost of capital is rather minimised and where the total value of the firm is maximised. Long term, on the other hand, refers to those which can be paid within periods longer than one year, depending on the agreement between the debt owners and the borrowing firms. However, the theory fails to provide an efficient prediction of marginal equity issuance. The profitability of a firm is also based on the debt-equity combination, which is different between firms. In these cases, the levels of borrowing will be low as the management will have the entire decision-making power. Applied Economics, 46 10 , pp.

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Capital Structure Theory: What It Is in Financial Management

different theories of capital structure

An increase in financial leverage Debt Proportion will lead to decline in the weighted average cost of capital WACC , while the value of the firm as well as market price of ordinary share will increase. Also, the firm will not have to give away their financial information when using internal funds, which in most cases, makes them lose their competitive advantage. Risk Principle Due to commitment of fixed payment, debt is a risky source of finance and equity is non-risky source. Illustration: Solution: Thus, from the above table, it becomes quite clear that cost of capital is lowest at 25% and the value of the firm is the highest at Rs 2,33,333 when debt-equity mix is 1,00,000 : 1,00,000 or 1 : 1. Examining the theory of capital structure: signal factor hypothesis. The same can be shown with the help of the following diagram:. However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital, Ko, will remain constant.

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Capital Structure Theories

different theories of capital structure

However, the future developments may address the problems are creating a framework for capital structures that may prove practical. No existence of tax. Anwar and Sun 2015, p. Abstract The beginning of the study of financing mix is after the Modigliani and Miller theorem and its unrealistic assumptions under which the source of finance does not impact the capital structure of the firm. The team follows the six-sigma approach to achieve the benchmark of zero error in its publications and research platforms. Also read You may like watching the Video PPT of the content. This information is validated by their willingness to take expensive reorganization of their capital structure.

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Theories of Capital Structure (explained with examples)

different theories of capital structure

JEL classification numbers: G35 In order to reveal the corporate finance peculiarities, we conduct a panel data study on companies located in European emerging Czech, Poland, Slovakia, Hungary and Romania and developed countries United Kingdom, France, Spain, Italy and Germany. Yet, other researchers have used the Pecking Order Theory to back their arguments. Asset distribution, therefore, means the shareholders will be able to get their returns when the firm has paid off all its debts and liabilities and not become liable in case the profits are not enough to pay off the debts of the firms and pay the shareholders. This money may be borrowed over either short term or longer term periods. Therefore, capital structure comes about because of the availability of preferred finance sources. The firm operating income EBIT is assumed to be constant. Lastly the study recommends to financial managers to consider these determinants as yardstick in their capital structure decisions, regulatory authorities in East Africa stock Market such as East African securities regulatory authority EASRA to formulate policies relating to securities markets by taking into consideration these findings and also to researchers to conduct future researches after incorporating other variables like corporate governance structure, financial flexibility, credit rating etc.

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The Importance of Capital Structure

different theories of capital structure

It should however, be noticed that their propositions are based on the following assumptions: 1. Alternatively, maybe, it is better to use retained profits to finance. This is their proposition I and can be expressed as follows: According to this proposition the average cost of capital is a constant and is not affected by leverage. Also, they are more likely to turn their surplus earnings to liquid reserves Serrasqueiro and Caetano 2015, p. The empirical literature is going to revolve around relevant empirical studies that have been done on the capital structure of different firms. Make sure you include all the helpful materials so that our academic writers can deliver the perfect paper.

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Capital Structure and its 4 Important Theories

different theories of capital structure

For this reason, the tax rate and the level of debt have to be equal. The beneficiaries include researchers, senior corporate managers, financial managers and investors within the universities and industries. It may not be the easiest way to build company capital structure, which is why loans or small business funds can be a less complicated option—although the application process may be more involved, requiring a business plan and an outline of expenses. Higher proportion of debt and accordingly higher risk is not recommended. MM Hypothesis: The Modigliani — Miller Hypothesis is identical with the net operating income approach, Modigliani and Miller M. The traditional approach can graphically be represented as under taking the data from the previous illustration.


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Evaluation of Capital Structure Theories

different theories of capital structure

Bradley and Roberts 2015 contradict by stating that using convertible debts mitigates asset substitution so that the lenders can always change their bonds to equity is the shareholders choose to make risky investments. As a result, the weighted average cost of capital remains constant and the total of the firm also remains constant as average changed. Yazdanfar and Ă–hman 2015 argue that a firm can increase its asset value by increasing its debts. According to Kumar and Rao 2015, p. It assumes that the gain which a company gets by infusion of debt is negated by the rise in the required rate of return by the stockholders.

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Theories of Capital Structure

different theories of capital structure

HSBC Holdings PLC, HSBA: LSE financials — FT. It is found from the above, the average cost curve is U-shaped. Moreover, the theory fails to consider the issue of informational asymmetry that is required for balancing between debt and equity. This is because there are no floatation costs when it comes to using internal funds. Lesson Summary Capital structure is the breakdown of how a company finances its operations.

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