Capital Structure Theories

Capital Structure

Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets. The main objective of financial management is to maximize the value of the equity shares of the firm. Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called as the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm through its cost of capital and can affect the share of the earnings that pertain to the equity
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This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:

1. At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

2. The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:

Value of Equity = Total value of the firm - Value of debt

3. Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

Example:

Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate).

Solution:

EBIT

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