Capital structure refers to the mix of firm ‘s capitalization and includes long terms sources of  fund such as ,preference share ,equity share ,retained earning and debentures. Form a corporate view ,equity represents a more expensive and permanent source of capital. The mix of debt and equity by a company to finance its overall operations and growth. The composition of a firm’s financing consists of equity preference and debt. Short terms debts is also consider to be part of capital structure.                                                           Key Takeaways;                                                                                               1.Capital structure refers company origin his fund for overall growth and operations.                                                                                              2. Equity aries for ownership right in a company with risk.                     3. Debt-to-equity ratio useful for riskiness company borrowing parties.

Optimal Capital Structure;

The theory of optimal capital deals with the issue of right mix equity and debt in long term capital structure of a company. This theory states that if company takes on debt, the value of firm increases up to a point, beyond that point if debt continue to increase then the value of firm start decreasing. Those company use balance ratio of debt and equity they have high leverage ratio, and a other side if  a company use high equity and debt they have low leverage ratio.            That said, a high leverage ratio can also lead to higher growth rates where a low leverage ratio can also lead low leverage ratio can lead lower growth rate.                                                                                                   Optimal capital structure should hold some features:                                             1.Flexbilty: structure should be flexible so that company may able to rise fund or reduce fund whenever its required.                                         3. Control: It should reduces the rise of dilution of control.                           3. Profitability: Maximization of profitability by using leverage minimum cost.                                                                                                                              Optimal capital ratio=Debt : Equity                                                                                                                                                   –                                           2 : 1


Capital structure relevance theory

-Traditional approach

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-Net Income approach

Capital structure irrelevance theory

-Net operating income approach

– Modiglani Miller Model .

Assumption in capital structure theories

-Firm has perpetual life

-There is no personal or cooperative tax

-100 % pay out ratio.

– Cost of debt less than cost of equity.

-There is only two sources of funds debt and equity.

-The firm earn operating profits and it is expected to grow. (No losses)                                                                                             –          –   –        -Business risk is consent and is not affected by  financing mix decision.

Capital structure relevant theory

Net income  approach : It is given by David Durand.

-It state a relationship between leverage, cost of capital and value of firm.

-Relationship between capital and value of firm.

-It state that value of firm increase by increasing more debt proportion leverage and over all cost capital will decrease.          –   —       -More debt leverage > increase value of firm > decrease  overall cost of capital of firm.

-Assumption are cost of debt (Kd) and cost of equity (Ke) are constant. (Kd = Ke =k)

-Approach suggest higher degree of debt of leverage better it is the value of the firm would be higher. A firm can increase its value by just increasing the debt proportion in capital structure.                        Value of firm (V)= S+D                                                                                           S =Market value of equity , D=Market value of debt                                                  Market value of equity = NI/K,    NI=earning available for shareholder                Ke = equity capitalisation rate

Traditional approach : It said that both NI or NOI approach is unrealistic.

-It takes a midway between the NI ( value of a firm in increase by increasing debt ) and NOI ( value of a firm remain constant.)                   -As per this firm should make a balance use of both debt or equity to achieve a optimal capital structure.                                                                   –WACC will be minimum & value of firm will be maximum.

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-Assumption are cost of debt and cost of equity is constant. ( KD = KE) the use of leverage beyond the limit have adverse effect and increase over all cost of capital of a firm and thus result in decrease in value of the firm.


Net operating income approach :

-Opposite to NI approach

-Market value of firm depends on the operating profit or EBIT and overall cost of capital. (WACC)

-Financing mix or capital structure is irrelevant and does not affect the value of a firm.

-Assumption are cost of debt and overall cost of capital are constant.(Ke=ko=k)

-As the debt proportion or the financial leverage the risk of the share holder also increase and the cost of equity also increase so value of firm remains the same.                                                –                                     -Not consider ko to be  constant there is no optimal capital structure rather every capital structure is good as any other & every capital structure is good as any other & every capital structure is optimal one.                                                                                                                         -Value of equity = value of firm-value of debt                                                                          – NOI mans earning before interest and  tax.                                                            – As result the division between debt and equity is irrelevant.


Modigilani and Miller approach :

-Capital structure no effect on the value of firm.

-Restate NOI approach added it to the behavioural justification for there model.

-Assumption are market are perfect, securities are infinitely divisible, investor are rational, no tax , personal leverage and cooperate leverage perfect substitute.

-It argues that if two firm are alike in all respect that they different in respect of there financing pattern and there market value, than the investor develop tendency to sell the overvalued firm and by the share of undervalue firm this pressures will continue till the two firm have same  market value.                                                                                  –It follow the arbitrage process :  If refers to taking to understanding by a person of tow related action or step simultaneously in order to drive some benefit buying by speculator in one market and selling the same at same time in other market.

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-The arbitrage process has been used by MM to testify their hypothesis of financial leverage cost of capital and value of firm.          The Trade -off theory :

-The trade- off theory of capital structure refers the idea that a company chooses how much debt and how much equity finance to use by balancing the cost and benefits.                           – The trade- off theory of capital structure basically entails offsetting the cost of debt against the benefits.                                                                                                                                                                                         –This theory primarily deals with the two concepts cost of financial distress and agency cost. An important purpose of the trade off theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly equity.                                       – It state that there is an advantage to financing with debt, the tax benefits of debt and  there is a cost of financing with debt, the cost financial distress including bankruptcy cost of debts and non bankruptcy cost, like suppliers demanding bondholder etc.

Packing order theory :                                                                      –This theory is based on  asymmetric information  which refers to a situation in which different parties have different information. In a firm manager will have better information than investors.                                          –This theory state that firms prefer to issue debt when they positive about future earnings. Equity is issued when they are doubtful and internal finance is insufficient.

So briefly under this theory rules are

Rule 1: Use internal financing debt.                                                                                Rule2: Issue debt next.                                                                                                   Rule3: Issue of new equity shares at last.

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