Capital structure theories

The following points will highlight the top four theories of capital structure. Capital Structure Theory 1. Net Income NI Approach: According to NI approach a firm may increase the total value of the firm by lowering its cost of capital.

Capital structure theories

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For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.

In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings.

Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal. In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments.

Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized.

Capital structure theories

MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC.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. 1st Theory of Capital Structure Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital.

Capital Structure and its Theories

Capital Structure Theories – D) Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm. Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches.

Traditional approach confirms the existence of. Modigliani and Miller's Capital-Structure Irrelevance Proposition The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this . Capital Structure Theory # 4.

The Importance of Capital Theory

Modigliani-Miller (M-M) Approach: Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital structure and the valuation of the firm should be explained by NOI (Net Operating Income Approach) by making an attack on the Traditional Approach.

The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from.

Capital structure - Wikipedia