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Capital Structure | Theories of Capital Structure

Optimal Capital Structure | Theories of Capital Structure

Capital structure

‘The term capital structure means like proportion of the different type of the securities issued by firm the optimal capital structure is the set of proportion maximized the total value of the firm’ (Schells and Helly, 1983:330). Capital structure is the composition of debt and equity that comprises a firms financing of its assets.

Capital structure plays vital role to increase the probability to insure the maximum return to the equity holders and minimum cost of the capital. First of all we most know that what the capital structure is. In general capital structure is the combinations of the long-term sources for funds such as debt ,equity ,preference share etc. ‘Capital represents the funds available to the company for its business. The capital structure refers to the proportions of findings derive form

Debt equity. Capital structure is usually measured by the debt equity ratio or by share holders’ ratio (McGrath, 1949:171).

Both debt and equity are used in large organization. ‘The choice of the amount of debt and equity is made after a comparison of certain characteristics of each kind of the security of internal factors that can external factors that a affects the firms. So the capital structure is that permanent financing of the represented primarily by the long-term debt, prefer stock and common equating the rate of return and the cost of capital, capital structure is sought by using a proportion of debt such that the correct degree of trading on equity leading to financial leverage will cause the highest market value of the ordinary shares (Kuchhal, 1977:388). ‘Capital structure is made up of debt and equity securities which comprise a firm’s finance of its assets. It is the permanent financing of the firm represented by long-term debt plus preferred stock plus net worth (Kulkarni, 1983:363).

Determining a firm’s financial structure means to basic question first how should the firm’s total sources of fund be divided among long term and short term financing. Second what proportion of firms should be financed by debt and equity is made after the comparisons of the certain characteristics of each kind of internal factors related to the firms operation and of external factors that can affect the firms.

Once the financial manager is able to determine the best combination of debt and equity he or she must raise the appropriate amount through best available source. A capital structure with a reasonable proportion of debt and equity capital is called optimal capital structure with a reasonable structure indicator of the optimum capital structure are net profit earning per share and value a firm.

‘As the proportion of debt in the capital structure increase both the cost of equity and cost of debt deign to raise reflecting the increase financial risk but the two do not necessarily raise in the same proportion. Thus with increasing use of dent the overall cost of capital is to fall because the after tax tax of debt is typically cheaper than the cost of equity. After a while the financial markets considers to science for excessive use debt and to much financial risk, completely offsets the advantage of using the lower cost of debt. So they agree with the statement that the judicious mix of long term debt and equity resulting in higher in a higher profiles and stock prices’ (Steven E Bolton Rebort,).

Theories of Capital Structure

The main question facing financial theorist and corporate managers is the relationship between firm’s capital structure and its cost of capital and value. The major Theories are as follows:

  • Net Income (NI) approach
  • Net operating income (NOI)
  • Traditional approach
  • Modigliani-miller (mm) theory

a)     with taxes

b)    without taxes

Optimal Capital Structure

The optimal capital structure is that capital structure or combination of debt and equity that leads to the maximum value of the firm. Optimum capital structure maximizes the value of the company or shareholders wealth and minimizes the company’s cost of capitals. The value will be maximized or the cost will minimum when the marginal cost of each source of the funds is the same. An optimum capital structure would be obtained at those combinations of debt and equity that maximizes that total value of the firm or minimizes the weighted average cost of capital. Optimal Capital Structure can be properly defined as that combination of debt and equity that attains the stated managerial goals maximization of the firms’ market value and which maximizes the firm’s cost of capital. As the existence of an optimal capital structure

Implies the simultaneous optimization of both the cost of capital and firm’s market value occupies central position in the theory of financial management. (phillipparos, 1947:237).The normative objective of the firm of maximizing stockholders wealth is time in the least “expensive ways” (Kreps and watch, 1975:411).

The Optimal Capital Structure may be defined as the relationship of debt and equity securities. This maximizes the value of firm’s equity stock.

It may exit under three situations:

1.     The total value of the firm is maximizations when its equity stock is at maximum value market if debt and preferred stock are not affected by flucation is market values. The values of equity, stock however fluctuates with profits of a firm.

2.     The equity stock value should be maximized on a per share basis so as to ensure to optimal capital structure. The issue of additional share may increase the total value of equity stock but this action may result in a decline in per share value of equity stock and the firms may move away from its optimum capital structure.

3.     The optimum capital structure occurs when a firm’s overall cost of capital is a lowest point.

The optimal capital structure should be balance between risks and return born by equity shareholders.

Objectives of optimal capital

  • To maximum return on equity capital
  • To maintain control power
  • To minimize risk
  • To increase flexibility
  • To employ high grade securities

Factors Affecting Capital Structure

Capital structure of different types of firms must consider the many factors managing directories or major shareholders are major determining factors. After overview of the capital stricture of many organizations.

Market conditions

Conditions in the stock and bond markets undergo both long and short term changes. That can have an important an firm’s optimal capital structure for e.g., during the credit crunch in the winter of 1982, there was simply no market at any reasonable interest rate for new long-term bonds rated, low rated combines that needed capital mere forced to go to the stack market of the short-term debt. Action such as this could represent permanent changes in target capital structure of temporary departures from stable targets. The important the type of securities used for a given financing.

Stability of sales and growth rate

Firms which sales a relatively stable can use more debt and incur higher fixed charges then a company with unstable sales. A far as growth rate is concerned other things remaining the same faster growing firms tend to use somewhat more debt then slower growing companies.

Cost of capital

The optimal capital structure should be less costly. Therefore company use the sources having lower cost. Component cost of capital is comprises of using costs and issuing cost. Hence issuing cost of various kinds of securities should also be considered while raising funds. The cost of floating a debt is generally less then the cost of floating equity and hence in may persuade the management to rise debt financing;

Firm’s internal condition

The internal condition of a company also plays an important role on capital structure. According to Brigham’s suppose a firm’s has just successfully completed and R & D programmer and project are not yet anticipated by investors and hence are not reflected in the price of the stock. This company will not materialize and reflected in the stock price at which time it might want to sell an issue of common stock retire the debt and return to its target capital structure.


Interest is deductible expense while dividends are not deductible hence. The higher a firm’s corporate tax rate, the grater, advantage is the advantage is using deft.


The firm’s health high rates of return of investment use relatively little debt. Their high rater of return enabled them to do most of their financing with retained earnings.

Interest rates

A certain point of time when the general level of interest rates is low, the use of debt financing might be more attractive. When interest rate is high, the sales of stock may become more appealing.


The effects of debt versus stock on a management’s control position can influence capital structure. If management has voting control over the company and is not in a position to buy more stock, debt may be a choice debt for new financing. On the other hand, management group that is mot concerned about voting control many decide to use equity rather then debt. An excessive amount of debt can also cause bankruptcy which win mean a loss of control.

Operating leverage

Other things remains the same a firm with less operating leverage is better able to employ financial leverage. Interaction of operating and financial leverage determines the over all affect of a change in sales an operating income and net cash flow.


Capital structure of a firm should be flexible. Then it affects the future financing decision of the company. Therefore the company should compare the benefits and cost of attaining the desired degree of flexibility and balance them properly.

Assets structure

Firms whose assets are suitable as secrecies for loans tend to use debt rather having. General purpose assets, which can be used by many bossiness make a good collateral, where as special purpose assets do not thus real state companies are usually highly leverage where as companies involved in technological research employ less debt.

Legal requirements

The government has also issued certain guideline for the issue of share and debentures. The legal restriction is very significant as these lay down a framework with in which capital structure decision has to be made.

Nature of industry and capital requirement

The patters of capital structure of the industry on which the firm is a part also very important facture affecting determining the capital structure of the firm. The needs and financial condition of a company have to be considered. If growth is only moderate a reinvestment of earnings will serve the purpose.

Assumptions of Capital Structure

The theories of capital structure make certain assumptions, which are given below

  • There are two source of funds used by a firm Debt and equity.
  • There are no corporate taxes.
  • The dividend payout ratio is 100 percent. There is no return earning;
  • The firm life is perpetual;
  • The operation profit is not expected to grow.

All the investors have the same subjective probability distribution of the future expected EBIT for a given firm.

The total finance is fixed. The firm can change its degree of operating leverage either by seeing share and the proceeds to retire departure or by raising more debt and reduce the equity capital.

The business risk is assumed to be constant and independent of capital structure and financial risk.

In the theoretical analysis of capital structure, the following basic symbols have been used.

Cost of debt kd = I/B

Cost of equity = EBIT-I/S or NOI-I/S

Overall cost of capital

Ko = NOI/V or, Ko= kd (B/V)+Ke(s/v)

Value of the firm

V= B+S


B= Total market value of debt

S= Total market value of stock

V=Total market value of firm (B+S)

Ke= Equity capitalization rate

Ko=Overall capitalization rate

I= Total amount of annual interest

EBIT= Earning before interest and tax

I= Total amount of annual interest

EBIT= Earning before interest and tax

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