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Financial Management - CAPITAL STRUCTURE THEORIES

Capital Structure and Value of a Firm

   Posted On :  20.06.2018 03:33 am

We know that there are two main sources of finance available for a company (or a firm) such as debt and equity.

Capital Structure and Value of a Firm
 
We know that there are two main sources of finance available for a company (or a firm) such as debt and equity. However it is difficult to arrive at the exact or at least optimum proportion of debt and equity in the capital structure of a company. Therefore, ascertaining the level of financial leverage is the primary task to be performed.
 
The main objective of financial management is to maximize the owners’ (share holders’) wealth and value. The key issues are the relationship between capital structure and cost of capital.
 
We know given a certain level of earnings, the value of the company is maximized when the cost of capital is minimized. In the same vein the value of the company is minimized when the cost of capital is maximized. Therefore the value of the company and the cost of capital are inversely related.
 
There are many different arguments and view points as to how the capital structure influences the value of the company. Some argue that financial leverage (use of debt capital) has a positive effect on the company value up to a point and negative thereafter. On the other extreme, few contend that there is no relation between capital structure and value of the company. Many strongly believe that other things being equal, greater the leverage, greater will be the value of the company
 
The capital structure of a company will be planned and implemented when the company is formed and incorporated. The initial capital structure would therefore be designed very carefully.
 
The management of a company would set a target capital structure and the subsequent financing decisions would be made with a view to achieve the target capital structure. The management has also to deal with an existing capital structure. The company will need to fund or finance its activities continuously. Every time a need arises for funds, the management will have to weigh the pros and cons of the various sources of finance and then select the advantageous source keeping in view the target capital structure.

Thus capital structure decisions are a continuous one and they have to be made whenever the company needs additional finance. Now let us explore the relationship between the financial leverage and cost of capital which is a contested issue in financial management.
 

Assumptions

 
The relationship between a capital structure and cost of capital of a company can be better established and appreciated by considering the following assumptions
 
1. There is no incidence of corporate / income / personal taxes
 
2. The company distributes all its earnings in a year by way of dividends to its shareholders
 
3. The investors have uniform subjective probability distribution of operating income (EBIT) for each company
 
4. The operating income is expected to remain same – no growth or no decline – over a period of time
 
5. Capital structure can be changed by a company without incurring transaction costs with ease and comfort and instantaneously
 
The idea behind the above assumptions is to keep aside the influence of tax, dividend policy, risk perception, growth and market imperfections so that the influence of financial leverage on cost of capital can be studied and sustained with greater clarity and focus
 
Taking into the above assumptions, cost of debt, Rd can be arrived at as under



= Annual interest charges divided by Market value of debt
 
If we assume the debt is perpetual, and then Rd would become the cost of capital, when the company pays out 100% of its earnings and when the earnings also remain constant for ever, then Re, the cost of equity would be



= Equity earnings divided by Market value of equity

When the market value of the company V is equal to Debt plus Equity, then Ra combined capitalization rate of the company would be



= Operating income divided by Market value of the firm 

Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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