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CAPITAL STRUCTURE THEORY

ADVANCED FINANCIAL MANAGEMENT

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CAPITAL STRUCTURE THEORY

DEFINITION

In financial management, capital structure theory


refers to a systematic approach to financing
business activities through a combination of equities
and liabilities.

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CAPITAL STRUCTURE COMPONENT

FOREIGN CAPITAL OWNER’S EQUITY

Foreign capital or debt is one of the Own capital or equity is long-term


external financing sources used by capital obtained from the owner of the
companies to finance their funding company or shareholders.
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CAPITAL STRUCTURE THEORY
MODIGLIANI AND MILLER
APPROACH: PROPOSITIONS
TRADITIONAL APPROACH WITHOUT TAX AND WITH
01 04 TAXES

MODIGLIANI AND MILLER


APPROACH (MM APPROACH) PECKING ORDER
02 05 THEORY

ASYMMETRY THEORY:
INFORMATION AND
TRADE OFF THEORY
SIGNALING
03 06

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CAPITAL STRUCTURE THEORY

MODIGLIANI AND MILLER


TRADITIONAL APPROACH APPROACH (MM APPROACH)

This approach does not define hard and fast In the Modigliani and Miller (MM) approach, in
facts. It says that the cost of capital is a the 1960s the two economists included tax
function of the capital structure. The special factors into their analysis. They came to the
thing about this approach is that it believes an conclusion that the value of a company with a
optimal capital structure. Optimal capital higher debt is irrelevant than the value of a
structure implies that at a particular ratio of company without debt. The increase was due
debt and equity, the cost of capital is minimum to the tax savings from using debt.
and value the of the firm is maximum.

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CAPITAL STRUCTURE THEORY

MODIGLIANI AND MILLER


APPROACH: PROPOSITIONS
TRADE OFF THEORY WITHOUT TAX AND WITH TAXES

 Theories suggest that there is an optimal capital  Proposition I: It says that the capital structure is
structure that maximizes the value of the firm in irrelevant to the value of a firm. The value of two
balancing the costs and benefits of an additional identical firms would remain the same and value
unit of debt, are characterized as models of would not affect by the choice of finance adopted
tradeoff. to finance the assets. The value of a firm is

 Optimal level of leverage is achieved by balancing dependent on the expected future earnings. It is

the benefits from interest payments and costs of when there are no taxes.

issuing debt.  Proposition II: It says that the financial leverage


boosts the value of a firm and reduces WACC. It is
when tax information is available.
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CAPITAL STRUCTURE THEORY

ASYMMETRY THEORY:
PECKING ORDER THEORY INFORMATION AND SIGNALING

The pecking order theory focuses on The concept of signaling and information
asymmetrical information costs. This approach asymmetry is closely related.
assumes that companies prioritize their  Asymmetry theory says that the parties
financing strategy based on the path of least related to the company do not have the same
resistance. Internal financing is the first information about the prospects and risks of
preferred method, followed by debt and external the company.
equity financing as a last resort.
 Signaling theory is a model where the capital
structure (use of debt) is a signal conveyed
by managers to the market for investors
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FACTORS THAT CAN INFLUENCE CAPITAL STRUCTURE
DECISIONS
3. Operating
1. Stability of Sales 2. Asset Structure
Leverage
A company whose sales are Companies whose assets are Companies with lower operating
relatively stable can safely take on sufficient to be used as collateral leverage will be better able to
larger amounts of debt and issue for loans tend to use enough debt. apply financial leverage because
a higher fixed burden compared to the company will have a lower
companies whose sales are not business risk.
stable.
4. Growth Rate 5. Profitability 6. Tax

If other things are considered the It is often observed that Interest is a tax deduction, and
same, then companies that have companies with very high returns this reduction is more valuable for
faster growth must rely more on on investment use relatively small companies with high tax rates.
external capital. amounts of debt.

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9. Attitude of the
8. Management Lender and Rating
7. Control Attitude Agency
The effect of debt compared Management can carry out its Without considering management's

to stocks in the position of own considerations about the own analysis of the right leverage
factor for the company, the attitude
control of a company can right capital structure.
of lenders and rating agencies will
affect the capital structure. often influence financial structure
11. Internal decisions.
10. Market Conditions of the 12. Financial
Conditions Company Flexibility
The stock and bond market The internal conditions of a Financial flexibility or the
conditions experience changes in company itself can also affect ability to raise capital with
the long term and short term that
the target capital structure. reasonable terms is in poor
can provide an important direction
condition.
on the optimal capital structure of
a company.

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Thank you!
Any questions?

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