Theories of Capital Structure

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Every business requires an investment, and it requires a capital structure to raise a profitable investment for that particular business. It determines the ratio between the debt and equity of the company. It should be planned so that the company can attain the maximum profit with minimum risk factors. In contrast, several factors affect the capital structure, including the market conditions, nature of investors, taxation policies, etc. 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.

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Capital structure

When it comes to business terms and conditions, the capital structure is one of the basic foundations in this field. It is defined as the equilibrium between the debt and a company’s equity. Without a stable structure, the business will collapse.

Every business or company requires the investment or financial support for its long-term operations. Understanding this financial aid and the procedure of step-by-step investments in the industry is known as the capital structure. Calculating the capital structure and preparing the plan depends upon the type of the business. The evaluation of structure must be maintained in such a way so that the ROI is always higher.

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Factors affecting the capital structure

Various factors might affect the evaluation of the structure; these factors are categorised into two groups, internal factors and external factors.

1. Internal factors: The capital structure of a business or a startup depends upon its size, theme, and nature. The firm’s age and the plan also play an active role in determining the same. However, in official terms, the trading on equity and the period or purpose of financing are significant factors affecting any business’s capital structure.
2. External factors: The external factors consist of those policies and documentation, that the owner cannot control. The external factors include the taxation policy, economic fluctuation in the market, and the level of competition. Several other factors include the nature of the investor, capital markets condition, and the financial institutions’ policy. Based on the type of business, the seasonal variation in the market also affects the capital structure significantly.

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Importance of Capital structure

Calculating and managing a capital structure is required for growing a business. Several salient features need to be considered while creating the structure. Some of these are:

• A capital structure must be designed in a way so that the value of the company is higher than the cost of capital
• The perfect evaluation assures the most economical and safe ratio between different policies
• Those structures are more preferred if they provide the minimum risk factor
• An optimal capital structure must be straightforward and flexible according to the market conditions
• It must involve rules, terms, and conditions which are attractive and efficient
• An optimal capital structure must correlate with all legal requirements to prevent the hassle

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Theories of capital structure

A business requires the most beneficial capital structure. So, many capital structure theories are available to take as a reference; amongst them, we will discuss the four most essential ones:

• Net income theory:

This theory was postulated by David Durand, who put forward the idea of increasing the proportion of debt in the overall capital structure. According to him, debt is a fund source because it has a lower interest rate, eliminating the risk factor and playing a significant role in deducting expenses for income tax. This theory is also called the “Fixed ‘Ke’ theory.”

• Net operating income theory:

Also known as the irrelevant theory, it was also postulated by David Durand. It depicts that the company’s market value is not affected by changes in the capital structure. The overall cost of equity can remain fixed no matter the proportion of debt.

• Traditional theory:

The traditional theory was postulated by Ezra Solomon. The assumptions of this approach are quite related to the net income theory. The main principle behind this theory was to increase the proportion of debt to a certain limit in the capital structure.

• Modigliani-Miller theory:

This theory came into existence by correlating the ideas of two co-members, Franco Modigliani and Merton Miller. This theory had two further assumptions.

1. 1.  Absence of Corporate taxes: According to Modigliani-Miller’s theory, in the absence of the corporate tax, the value of the creditworthy firm will be equal to that of the amount of equity compromised.
   2. Presence of corporate taxes: In the case where taxes are applied, the value of the creditworthy firm is equal to the value of the indebted firm summed up with the product of the tax rate and the value of debt.

Conclusion

The capital structure of a company determines the best proportion of the debt and equity of that company. Calculating and representing an optimal capital structure with the minimum risk factor is mostly appreciated. Capital structure is very much required for the successful running of a business and to ensure profitable growth in the market. Without a proper capital structure, a company might face several hurdles in the market. Henceforth, a proper structure must be evaluated for which several theories are available to take a reference.

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