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Financial Management - CAPITAL STRUCTURE THEORIES

Introduction of CAPITAL STRUCTURE THEORIES

   Posted On :  20.06.2018 03:01 am

Any business or a company or firm requires capital to acquire assets. These assets could also be obtained with loans from financial institutions.

Introduction
 
Any business or a company or firm requires capital to acquire assets. These assets could also be obtained with loans from financial institutions. The company operates those assets to earn economic returns by fulfilling customer needs.
 
The capital structure decision centres on the allocation between debt and equity in financing the business needs. An efficient mixture of capital reduces the price of capital. The Lesser cost of capital increases net economic returns which ultimately increase business value.
 
An unleveled business uses only equity capital. A levered business uses a mix of equity and various forms of other liabilities.
 
Apart from deciding on a target capital structure, a business must manage its capital structure. Imperfections or opportunities in capital markets, taxes and other practical factors influence the managing of capital structure. Imperfections may suggest a capital structure less than the theoretical optimal.
 
Operation of assets and the business’s financing of those assets jointly dictate its (business) value. Understanding why the current proportion of debt in the capital structure lowers the cost of capital and increases stock price holds attention.
 
Basic characteristics of an unlevered company (total equity and no debt financing). In such a company there are no external creditors. Only the shareholders as a group have a claim on the expected net income and they bear the risk associated with the expected net income.
 
Therefore the total risk faced by such a company is business risk and the risk associated with the tax environment.
 
In a levered company, the creditors are very carefully organized and they have specified claims against a company’s cash flows during normal operations as well as during bankruptcy. Equity holders are always last in line, behind all creditors.
 
The position of each claimant in the line affects the riskiness of their cash flows. Those first in the line claim the most certain cash flows – and their removal of the most certain cash flows increases the risk of the cash flows that remain for those behind them
 
Creditors and equity holders are clever. Claimants further back in the line demand higher returns to compensate themselves for the additional risk they bear. Thus, shareholders require higher returns for the added financial risk of creditors.
 
However, shareholders know another very important facet about debt; they can make money from its use. In fact, the focal point of capital structure theory hinges on shareholders recognizing that debt use can add to their returns. The use of appropriate amount of debt adds value if the company enjoys a tax deduction for interest payments.
 
Thus moving away from entire equity (unlevered) to part equity and part debt (levered) financing will result in the following fruitful journey for the shareholders.

Corporate debt increases – financial risk increase
 
1. Total risk increase since financial risk is increasing
 
2. Equity decreases – the number of shares of stock decreases – the company does not need as much equity financing because debt is replacing equity in the capital structure
 
3. Expected earnings per share increase since fewer shares exist and the expected tax benefits of using debt contribute to the EPS
 
Hence making crucial decision on the capital structure – either entire equity or part equity and part debt financing – is very vital for the development and growth of any business organisation.
 
We shall now make an attempt in various issues connected with the leveraging; theories developed on leveraging and also look at determining the ideal capital structure in practice.
 
Should a business increase or reduce the number of units it is producing? Should it rely more or less heavily on borrowed money? The answer depends upon how a change would affect risk and return.
 
Operating leverage is the name given to the impact on operating income of a change in the level of output. Financial leverage is the name given to the impact on returns of a change in the extent to which the firm’s assets are financed with borrowed money.
 
Despite the fact that both operating leverage and financial leverage are concepts that have been discussed and analyzed for decades, there is substantial disparity in how they are defined and measured by academics and practitioners.
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