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Sourcing Capital Structure Theory

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Assignment
Sourcing and Managing Funds
Topic-Capital Structure theories
Definition-
What is Capital Structures?
The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirement is also considered to be part of the capital structure. Capital structure or financial leverage deals with a very important financial management question. The question is – ‘what should be the ratio of debt and equity?’ Before scratching our minds to find the answer to this question, we should know the objective of doing …show more content…

• Cost of debt = Kd = R/D
• Value of debt = d = R/Kd
• Equity = Ke = D/P+g
• P value of equity = S = X-KdD/Ke
• Weighted average = Ko =X/V = NOI/V
• Total value of the firm = …show more content…

A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.

High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.
2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital

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