In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the wacc falls as a company gears up. Thus, it is needless to say that the optimal capital structure is the minimum cost of capital, if financial leverage is one, in other words, the maximum application of debt capital. Capital structure and its 4 important theories ni, noi. Capital structure wharton finance university of pennsylvania. Based on the proportion of finance, wacc and value of a firm are affected. Capital structure theories capital structure tax rate.
Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. Chapter iii concepts and theories of capital structure and profitability. January 2006 the theory and practice of corporate capital structure liability strategies group 7 introduction this paper this paper provides an overview of current capital structure theory together with a detailed analysis of the results of a recent corporate capital structure survey. Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital. Further research on the theory of capital structure uses modigliani. Find materials for this course in the pages linked along the left. B net operating income noi approach contrary to the ni approach the noi approach suggests that the capital structure decision of a firm is an irrelevant factor to the valuation of a firm i. It is important to keep in mind that what counts for a positive science is the development of theories that yield valid and meaningful predictions about ob. Capital structure is the proportion of all types of capital viz. Bahadur institute of management sciences, university of mysore, india available online at. The agency theory examines the duties and conflicts that occur between parties who have an agency relationship. In this approach, there is no search for an optimal capital structure. Tradeoff theory, pecking order theory and market timing theory wan shahdila shah shahar1, wan shahzlinda shah shahar2, nor fadilah bahari3. But literatures emphasis onfixed assets management, accounting and financial reporting, working capital management, capital structure management, accounting information.
The capital structure theory and its practical implications for firm. Structure theories capital structure capital structure is the proportion of debt and preference and equity shares on a firms balance sheet optimum capital structure is that at which the weighted average cost of capital is minimum and thereby maximum value of the firm traditional approach the traditional approach argues that moderate degree of debt can lower the firms overall. Theories of capital structure in practice it is difficult to specify an optional capital structure indeed, managers even feels uncomfortable about specifying an optional capital structure range. Finance, kellogg graduate school of management, northwestern university. Capital structure management capital structure strategy. The theory of capital structure wiley online library. Agency relationships occur when one party, the principal, employs another party, called the agent, to perform a task on their behalf. Capital structure and its 4 important theories ni, noi, traditional. Financial management practice involves various aspects. Meaning of capital structure capital structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations. Further, the mm model adds a behavioural justification in favour of the noi approach personal leverage assumptions o capital markets are perfect and. Given the plethora of forces and issues that capital structure. Financial management fm capital structure duration.
Lecture notes financial management sloan school of. Static tradeoff theory the horizontal base line in figure 17. Capital structure theories free download as powerpoint presentation. The capital structure theories explore the relationship between your companys use of debt and equity financing and the value of the firm. The data set excludes listed firms from finance, insurance, and investment sectors. Cash management and marketable securities 196 chapter9. It is the employment of an asset source of finance for which. Capital structure describes the amount of debt a company uses as opposed to equity, and it is often measured with the ratio of debt to equity. So it relates to the arrangement of capital and excludes shortterm borrowings. Theories of capital structure explained with examples. Theories of capital structure ppt capital structure. The study of capital structure attempts to explain how listed firms utilise the mix of various forms of securities in order to finance investment. Thus, financial managers worry primarily about whether their firms are using too little or too much debt, not about the precise optimal amount of debt. The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share eps are maximized.
Effect of financial management practices on profitability. The concept capital structure the term capital structure is a widely known terms in the finance world, many scholars have given their own version in terms of definitions since the. Optimum capital structure f9 financial management acca. As gearing up continues, the cost of equity increases to include a financial risk premium and the wacc reaches a minimum value. Capital structure is still a puzzle among finance scholars.
The business risk is assumed to be constant and independent of capital structure and financial risk. The above assumptions and definitions described above are valid under any of the capital structure theories. The more debt a company has, the more it has to pay creditors for the use of those funds. Capital structure theory focuses on how firms finance assets. In comparison the pecking order theory implies firms preference to internal finance over external finance and debt over equity. Concept of capital structure in their attempt to maximise the overall value, firms differ with respect to capital structures. Firm financial management in central and eastern europe marian rizov licos center for transition economics, katholieke universiteit leuven abstract. Cost of capital 50 capital structure theories 50 traditional approach 51 assumptions 51 comments 53 net income ni approach 53. Introduction a business invests in new plant and equipment to generate additional revenues and income, which is. This decision in a private enterprise is directed towards the achievement of maximization of the shareholders wealth or value of the firm. Based on this theory, there is an optimal capital structure that maximizes the firm value by balancing between debt tax shield and increase in bankruptcy and financial distress costs brealey and. The theory proves that the costs of capital is not affected by changes in the capital structure or say that the debtequity mix is irrelevant in the determination of the total value of a firm. According to this approach the wacc and total value of a firm are independent and are not. In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and.
Capital structure theory class 01 by cma sumit rastogi sir skip navigation. In the capital structure of a company, broadly, there are mainly two types of capital i. The goal of this chapter is to discuss the various theories that help to explain the determination of capital structure. Financial management, india, capital structure, theories, theories of capital structure.
But neither of these two theories provide a complete description why some firms prefer debt and others prefer equity finance under different. List of capital structure theories theories of capital structure static tradeoff theory, pecking order theory, modified pecking order theory with graphs 1. The optimal capital structure for a company is one that offers a. An empirical test of capital structure theories for the. Capital structure management a companys capital structure refers to the combination of its various sources of funding. Capital structure theories in financial management. In financial management, it is a significant term and it is a very important decision in business. Capital structure theories introduction capital structure decision is a significant decision in financial management. Agency theory in financial management mba knowledge base.
Most companies are funded by a mix of debt and equity, including some shortterm debt, some longterm debt, a number of shares of common stock. Financial management has become a vital part of the business concern and they are concentrating more in the field of financial management. Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production. The following are the important scope of financial management. Proceeding of the 2nd international conference on management and muamalah 2015 2nd icomm 16th 17th november 2015, eisbn. The capital structure puzzle is unravelled and a clear. Capital structure theories c modigliani miller model mm mm approach supports the noi approach, i. Financial management practice play significant role for economic development of nations. Agency theory is often described in terms of the relationships between the various interested parties in the firm. The capital structure of a company is made up of debt and equity securities that comprise a firms financing of its assets.
372 761 1069 26 273 1415 53 441 1020 125 718 657 1135 1252 714 915 1555 583 908 863 1261 454 1231 29 476 1055 1138 1408 850 978 919 264