As companies grow and continue to operate, they must decide how to fund their various projects and operations as well as how to pay employees and keep the lights on. While sales revenues are key sources of income, most companies also seek capital from investors or lenders as well. But what is the right mix of equity stock sold to investors and bonds sold to creditors? Capital structure theory is the analysis of this key business question.
The net income approach, static trade-off theory, and the pecking order theory are three financial principles that help a company choose its capital structure. Each plays a role in the decision-making process depending on the type of capital structure the company wishes to achieve. The pecking order theory, however, has been empirically observed to be most used in determining a company's capital structure.
Key Takeaways
- Capital structure refers to the mix of revenues, equity capital, and debt that a firm uses to fund its growth and operations.
- Several economists have devised approaches to identify and optimize the ideal capital structure for a firm.
- Here, we look at three popular methods: the net income approach, static trade-off theory, and pecking order theory.
The Net Income Approach
Economist David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change incapital costs. In other words, if there's an increase in the debt ratio, capital structure increases, and theweighted average cost of capital(WACC) decreases, which results in higher firm value.
The Net Operating Income Approach, also proposed by Durand, is the opposite of the Net Income Approach, in the absence of taxes. In this approach, WACC remains constant. It postulates that the market analyzes a whole firm, and any discount has no relation tothedebt-to-equity ratio. If tax information is provided, it states that WACC reduces with an increase indebt financing, and the value of a firm will increase.
In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It's important to remember, however, that this approach assumes anoptimal capital structure. Optimal capital structure implies that at a certain ratio of debt and equity, the cost of capital is at a minimum, and the value of the firm is at a maximum.
Static Trade-off Theory
The static trade-off theory is a financial theory based on the work of economists Modigliani and Miller in the 1950s, two professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. This proposition states that in perfect markets, the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets.
According to Modigliani and Miller, value is independent of the method of financing used and a company's investments.Themade two propositions:
- Proposition I:This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
- Proposition II:This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.
With a static trade-off theory, since a company's debt payments are tax-deductible and there is less risk involved in taking out debt over equity, debt financing is initially cheaper than equity financing. This means a company can lower its weighted average cost of capital through a capital structure with debt over equity.
However, increasing the amount of debt also increases the risk to a company, somewhat offsetting the decrease in the WACC. Therefore, static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.
Pecking Order Theory
The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity.
This pecking order is important because it signals to the public how the company is performing. If a company finances itself internally, that means it is strong. If a company finances itself through debt, it is a signal that management is confident the company can meet its monthly obligations. If a company finances itself through issuing new stock, it is normally a negative signal, as the company thinks its stock is overvalued and it seeks to make money prior to its share price falling.
The Bottom Line
There are several ways that firms can decide what the ideal capital structure is between cash coming in from sales, stock sold to investors, and debt sold to bondholders. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability.
FAQs
The net income approach, static trade-off theory, and the pecking order theory are three financial principles that help a company choose its capital structure. Each plays a role in the decision-making process depending on the type of capital structure the company wishes to achieve.
What are the principles of capital structure decision? ›
The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital). In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value.
What determines a company's capital structure? ›
Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.
What are the factors determining capital structure of a company? ›
However, coping with these factors is relatively easier than significant factors. Earnings stability, state regulations, intensity of competition, growth period, credit history, cash flow, corporate tax rates, and other financial information are necessary factors.
Which financial structure is capital structure? ›
The Capital Structure is a part of the Liabilities section of the Balance Sheet. The Financial Structure includes all the items in the Liabilities section of the Balance Sheet. Capital Structure has a narrower scope compared to Financial Structure. Financial Structure has a broader scope compared to Capital Structure.
What are the principles of capital structure policy? ›
The net income approach, static trade-off theory, and the pecking order theory are three financial principles that help a company choose its capital structure. Each plays a role in the decision-making process depending on the type of capital structure the company wishes to achieve.
What are the four primary factors influence capital structure decisions? ›
Answer and Explanation:
- Size of the company. ...
- Tax exposures of the company. ...
- Business risks. ...
- Financial Flexibility.
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity.
How should a company decide on their prospective capital structure? ›
Businesses should also consider balancing risk and reward when deciding on an optimal capital structure. To determine the optimal capital structure, companies should assess the costs and benefits of different financing sources, such as debt, equity or other alternative forms of capital.
How do you choose the optimal capital structure? ›
Optimal capital structure is determined by a debt-to-equity ratio, which should equal around 1 for most companies. The ratio equation is liabilities/equity, which means a company needs to know its liabilities, which are things like loans and other expenses, like wages and warranties, and equity.
Answer: Working capital, or networking capital, has several determinants, including nature and size of business, production policy, the position of the business cycle, seasonal business, dividend policy, credit policy, tax level, market conditions and the volume of businesses.
How to determine target capital structure? ›
To develop a target capital structure, a combination of three approaches is suggested:
- Estimate the current capital structure. ...
- Review the capital structure of comparable companies. ...
- Review senior management's approach to financing.
Capital structure is the mix of debt and equity on a company's balance sheet. It shows how much of a company is financed by creditors and owners, and also provides insights into the company's cost of capital—how much the capital in the business is costing the owners.
What financial statement shows capital structure? ›
What Is Capital Structure? Capital structure represents debt plus shareholder equity on a company's balance sheet. Understanding it can help investors size up the strength of the balance sheet and the company's financial health. That, in turn, can aid investors in their investment decision-making.
What are the four types of capital structure? ›
The types of capital structure are equity share capital, debt, preference share capital, and vendor finance. In addition, it ensures accurate funds utilization for business. The right capital structure level decreases the overall capital cost to the highest level. Also, it increases the public entity's valuation.
What are the assumptions of capital structure? ›
The capital structure theories use the following assumptions for simplicity: 1) The firm uses only two sources of funds: debt and equity. 2) The effects of taxes are ignored. 3) There is no change in investment decisions or in the firm's total assets. 4) No income is retained.
What are the principles of capital budgeting decision? ›
Capital budgeting typically adopts the following principles: decisions are based on cash flows, not accounting concepts such as net income; the timing of cash flows is critical; cash flows are based on opportunity costs.
What do capital structure decisions include? ›
CAPITAL STRUCTURE DECISIONS ARE long-term decisions involving the acquisition, retention, and redemption of funds at various time periods. We draw from economics the definition of long run, where all sources contributing to capital can be changed, and short run, where at least one source of capital is fixed.
What is a capital structure decision example? ›
For instance, a company may have a capital structure of 60% equity and 40% debt, indicating that 60% of its funds are raised through equity, and 40% through debt.
What are the approaches of capital structure decision? ›
However, several capital structure theories provide different approaches; the four most important ones are the net income theory, net operating income theory, traditional theory, and Modigliani-Miller theory.
