Financial Management - CAPITAL STRUCTURE THEORIES
Capital structure theories
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A company can raise the required finance through two principal sources, namely equity and debt.
Capital structure theories
A company can raise the required finance through two principal sources, namely equity and debt.
Therefore, a question should arise - what should be the proportion of debt and equity in the capital structure of the company? This can be put in a different manner – what should be the financial leverage of the company?
The company should decide as to how to divide its cash flows into two broad components – a fixed component earmarked to meet the debt obligation and the balance portion that genuinely belongs to the equity shareholders.
Any financial management should ensure maximization of the shareholders’ wealth. Therefore an important question that should be raised and answered is what is the relationship between capital structure and value of the firm? Or what is the relationship between capital structure and cost of capital?
As cost of capital and firm value are inversely related, this assumes greater importance. If the cost of capital is very low, then the value of the company is maximized and if the cost of capital is very high, then the value of the company is minimized.
Some question this relationship; according to them there is no relationship whatsoever between capital structure and value of the company. Others agree that the financial leverage has a positive impact and effect on the value of the firm up to a point and it would be negative thereafter. However some strongly hold the view that greater the financial leverage, greater the value of the firm, when other things remain equal.
A company can raise the required finance through two principal sources, namely equity and debt.
Therefore, a question should arise - what should be the proportion of debt and equity in the capital structure of the company? This can be put in a different manner – what should be the financial leverage of the company?
The company should decide as to how to divide its cash flows into two broad components – a fixed component earmarked to meet the debt obligation and the balance portion that genuinely belongs to the equity shareholders.
Any financial management should ensure maximization of the shareholders’ wealth. Therefore an important question that should be raised and answered is what is the relationship between capital structure and value of the firm? Or what is the relationship between capital structure and cost of capital?
As cost of capital and firm value are inversely related, this assumes greater importance. If the cost of capital is very low, then the value of the company is maximized and if the cost of capital is very high, then the value of the company is minimized.
Some question this relationship; according to them there is no relationship whatsoever between capital structure and value of the company. Others agree that the financial leverage has a positive impact and effect on the value of the firm up to a point and it would be negative thereafter. However some strongly hold the view that greater the financial leverage, greater the value of the firm, when other things remain equal.
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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