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
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
Last 30 days 578 views