Capital Structure Decisions
Introduction: The two principal sources of finance for a company are equity and debt. What should be the proportion of equity and debt in the capital structure of the firm? One of the key issues in the capital structure decision is the relationship between the capital structure and the value of the firm. There are several views on how this decision affects the value of the firm.
Capital structure theories:
There are only two kinds of funds used by a firm i.e. debt and equity.
Taxes are not considered.
The payout ratio is 100%
The firm’s total financing remains constant
Business risk is constant over time
The firm has perpetual life.
Net Income Approach (NI)
According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weightage in the calculation of the cost of capital.
The formula to calculate the average cost of capital is as follows:
Ko = Kd (B/ (B+S)) + Ke (S/(B+S))
Ko is the average cost of capital
Kd is the cost of debt
B is the market value of debt
S is the market value of equity
Ke is the cost of equity
Net Operating income Approach (NOI)
According to this approach:
The overall capitalisation rate remains constant for all levels of financial leverage
The cost of debt also remains constant for all levels of financial leverage
The cost of equity increases linearly with financial leverage
The formula to calculate the cost of capital is Ko=Kd(B/(B+S))+Ke(S/(B+S))
Ko and Kd are constant for all levels of leverage. Given this, the cost of equity can be expressed as follows:
Traditional or Intermediate Approach
This approach is midway between the NI and the NOI approach. The main propositions of this approach are:
The cost of debt remains almost constant up to a certain degree of leverage but rises thereafter at an increasing rate.
The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter.
The cost of capital due to the behaviour of the cost of debt and cost of equity
Decreases up to a certain point
Remains more or less constant for moderate increases in leverage thereafter
Rises beyond that level at an increasing rate.
According to this approach, the capital structure decision of a firm is irrelevant. This approach supports the NOI approach and provides a behavioural justification for it
Additional assumptions of this approach include:
Capital markets are perfect. All information is freely available and there are no transaction costs
All investors are rational
Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk
There are no taxes
This approach indicates that the capital structure is irrelevant because of the arbitrage process which will correct any imbalance i.e. expectations will change and a stage will be reached where further arbitrage is not possible.