Recall that accounting-based book values listed on traditional financial statements reflect historical costs. The market-value balance sheet is similar to the accounting balance sheet, but all values are current market values. The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in which arbitrage is expected to work. Due to the existence https://1investing.in/ of imperfections in the capital market/arbitrage will fail to work and will give rise to discrepancy between the market values of levered and unlevered firms. The above assumptions and definitions described above are valid under any of the capital structure theories. David Durand views, Traditional view and MM Hypothesis are tine important theories on capital structure.
What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment. The capital structure of a company determines the best proportion of the debt and equity of that company. Calculating and representing an optimal capital structure with the minimum risk factor is mostly appreciated. Capital structure is very much required for the successful running of a business and to ensure profitable growth in the market. Without a proper capital structure, a company might face several hurdles in the market. Henceforth, a proper structure must be evaluated for which several theories are available to take a reference.
After the deduction of interest, the company has to pay less tax and thus it will decrease the overall cost of capital or the weighted average cost of capital (WACC). The capital structure should be flexible enough that the company can alter the debt-equity ratio whenever there is a need to alter it. For example, banks do not give loans to companies if the debt-equity ratio is high, in that case, it is important to have a flexible capital structure.
The capital structure should be such that it gives maximum return to the shareholders. Maximum use of leverage at minimum cost should be made so as to obtain maximum advantage of trading on equity at minimum cost. The image below demonstrates how the use of leverage can significantly increase equity returns as the debt is paid off over time.
Each of these three methods can be an effective way of recapitalizing the business. Cyclical industries like mining are often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay the debt. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. There were many other options, but once you chose Tesla stock, you no longer had the money available for the other options.
There are several competing capital structure theories, each of which explores the relationship between debt financing, equity financing, and the market value of the firm slightly differently. 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.
Providing a return equal to what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets. The capital structure theory is the approach to determine the value proportion of the capital share to the overall cost of capital for a company to thrive. Assuming that a company has access to capital (e.g. investors and lenders), they will want to minimize their cost of capital. This can be done using a weighted average cost of capital (WACC) calculation.
Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a firm’s capital structure by tracking the D/E ratio and comparing it against the company’s industry peers.
- So, the weighted average Cost of Capital Kw and Kd remain unchanged for all degrees of leverage.
- Thus, it is needless to say that the optimal capital structure is the minimum cost of capital, if financial leverage is one, in other words, the maximum application of debt capital.
- A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known as the weighted average cost of capital (WACC).
- You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments.
- Debt is a cheap source of finance because its interest is deductible from net profit before taxes.
Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Additionally, in times of low interest rates, debt is abundant and easy to access. Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. This approach assumes that companies prioritize their financing strategy based on the path of least resistance.
On the other hand, a company with zero leverage will have a WACC equal to its cost of equity financing and can reduce its WACC by adding debt up to the point where the marginal cost of debt equals the marginal cost of equity financing. In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increased value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital.
Interpretation of Ratios
If, however, Elephant Inc. uses cash (which is financed with debt) to acquire Squirrel Co., it will have increased the amount of debt on its balance sheet. A firm that decides it should optimize its capital structure by changing the mix of debt and equity has a few options to effect this change. Debt investors take less risk because they have the first claim on the assets of the business in the event of bankruptcy.
Dynamics of Debt and Equity
The Net Income Operating Approach, we know, supply proper justification for the irrelevance of the capital structure. In this context, MM support the NOI approach on the principle that the cost of capital is not dependent on the degree of leverage irrespective of the debt-equity mix. According to this approach, there is a relationship between the capital structure and the value of the firm. The firm, by increasing the debt proportion in the capital structure can increase its market value or lower the overall cost of capital (WACC). For example, if Elephant Inc. decides to acquire Squirrel Co. using its own shares as the form of consideration, it will increase the value of equity capital on its balance sheet.
Understanding the Traditional Theory of Capital Structure
It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the cost of capital. So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at its lowest point. Practically, this approach encompasses all the ground between the net income approach and theories of capital structure the net operating income approach i.e., it may be said as intermediate approach. Although the value of the firm Rs. 2,50,000 is constant at all levels, the cost of equity is increased with the corresponding increase in leverage. Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach.
Since equity is costlier than debt, this approach is not desirable and often only done when a firm is overleveraged and desperately needs to reduce its debt. Below is an illustration of the dynamics between debt and equity from the view of investors and the firm. Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million. This equation reminds us that the values of a company’s debt and equity flow from the market value of the company’s assets. In order to produce and sell its products or services, a company needs assets.
It means a change in the capital structure does not affect the overall cost of capital and the market value of the firm. Thus at each and every level of capital structure, the market value of the firm will be the same. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. It refers to how much of each type of funds a company holds as a percentage of its total financing.
David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs. In other words, if a company takes on more debt to leverage investments, its capital structure increases in size and the weighted average cost of capital (WACC) decreases, which results in higher firm value. The cost of capital declines with leverage because debt capital is chipper than equity capital within reasonable, or acceptable, limit of debt. According to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three stages and this can be seen in the following figure.
(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and thereafter rises. So, the weighted average Cost of Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to mention here that as the firm increases its degree of leverage it becomes more risky proposition and investors are to make some sacrifice by having a low P/E ratio. From the above table it is quite clear that the value of the firm (V) will be increased if there is a proportionate increase in debt capital but there will be a reduction in overall cost of capital. So, Cost of Capital is increased and the value of the firm is maximum if a firm uses 100% debt capital.