What is Capital Structure Theory? - Definition & Overview

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  • 0:04 What is Capital Structure?
  • 1:36 The Four Capital…
  • 2:09 Net Income Approach
  • 2:48 Net Operating Income Approach
  • 3:19 Traditional Approach
  • 4:07 Modigliani-Miller (MM) Theory
  • 4:44 Lesson Summary
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Lesson Transcript
Instructor: Shelumiel Ryan Abapo

Shelu is a Certified Public Accountant, SAP Business One Consultant, University Professor handling Taxation, Financial Accounting, Cost Accounting and Basic Accounting

In this lesson, learn the main concepts of the competing theories of capital structure. The four theories treat the relationship of a company's worth to its funding very differently.

What Is Capital Structure?

Say you are a manager at JJ Company. You want to expand, but it will require a new plant, hiring new employees, and opening new outlets. How will such expansion be financed? Through debt? Equity? How about a mixture of both?

Capital structure is the mix of owner-supplied capital (equity, reserves, surplus) and borrowed capital (bonds, loans) that a firm uses to finance business operations. Whether to finance through debt, equity, or a combination of both is a result of several factors. These include business risks, management style, control, exposure to taxes, financial flexibility, and market conditions.

In financial management, your goal is to maximize shareholders' wealth - that is, to increase the value of your firm as reflected in the stock price. The value of your company depends on its earnings as well as its weighted average cost of capital (WACC). The WACC is oftentimes referred to as your firm's cost of capital since it indicates the rate of return that equity owners and lenders can expect from the company.

In running JJ Company, you have the option to finance it either through debt or with equity. Hence, in computing for weighted average cost of capital, you will have to separately weigh the cost of the firm's debt and equity by its proportional weight to the total capital. Since WACC is the required return on investors' money, it's often used by management in making long-term decisions, such as mergers and company expansion.

The Four Capital Structure Theories

The capital structure theories explore the relationship between your company's use of debt and equity financing and the value of the firm. We will discuss these theories one by one. 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.
  5. Business risk is unaffected by the financing mix.

Net Income Approach

The first of these theories is the net income approach, which proposes that there is a direct relationship between capital structure and the value of the firm. In other words, JJ Company will be better off if you minimize its cost of capital. Debt is cheaper than equity because you can deduct the interest on the company taxes. Therefore, using more debt makes the cost of capital less. Given that earnings remains constant, such decrease in WACC ups JJ Company's value.

Under this approach, the JJ Company will have maximum value at a point where the WACC is at the minimum - that is, when the firm is 100% debt-financed.

Net Operating Income Approach

The net operating income approach is the opposite of the net income approach. It proposes that there is no relationship between your capital structure and the value of the firm. The more debt, the more risk to shareholders. In effect, the increased shareholders' risk raises the cost of equity. As such, the higher cost of equity nullifies the advantages you have gained from using the cheaper cost of debt. This makes weighted average cost of capital constant. Hence, finance mix is not relevant and does not affect the firm's value.

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