Any business or a company or firm requires capital to acquire assets. These assets could also be obtained with loans from financial institutions.
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
An unleveled business uses only
equity capital. A levered business uses a mix of equity and various forms of
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
moving away from entire equity (unlevered) to part equity and part debt
(levered) financing will result in the following fruitful journey for the
debt increases – financial risk increase
1. Total risk increase since financial risk is
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
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
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
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.
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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