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
TRADITIONAL APPROACH
01
MODIGLIANI AND MILLER
APPROACH: PROPOSITIONS
WITHOUT TAX AND WITH
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
TRADITIONAL APPROACH
This approach does not define hard and fast
facts. It says that the cost of capital is a
function of the capital structure. The special
thing about this approach is that it believes an
optimal capital structure. Optimal capital
structure implies that at a particular ratio of
debt and equity, the cost of capital is minimum
and value the of the firm is maximum.
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MODIGLIANI AND MILLER
APPROACH (MM APPROACH)
In the Modigliani and Miller (MM) approach, in
the 1960s the two economists included tax
factors into their analysis. They came to the
conclusion that the value of a company with a
higher debt is irrelevant than the value of a
company without debt. The increase was due
to the tax savings from using debt.
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 CAPITAL STRUCTURE THEORY
TRADE OFF THEORY
 Theories suggest that there is an optimal capital
structure that maximizes the value of the firm in
balancing the costs and benefits of an additional
unit of debt, are characterized as models of
tradeoff.
 Optimal level of leverage is achieved by balancing
the benefits from interest payments and costs of
issuing debt.
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MODIGLIANI AND MILLER
APPROACH: PROPOSITIONS
WITHOUT TAX AND WITH TAXES
 Proposition I: It 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 affect 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: 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
PECKING ORDER THEORY
The pecking order theory focuses on
asymmetrical information costs. This approach
assumes that companies prioritize their
financing strategy based on the path of least
resistance. Internal financing is the first
preferred method, followed by debt and external
equity financing as a last resort.
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ASYMMETRY THEORY:
INFORMATION AND SIGNALING
The concept of signaling and information
asymmetry is closely related.
 Asymmetry theory says that the parties
related to the company do not have the same
information about the prospects and risks of
the company.
 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
1. Stability of Sales
A company whose sales are
relatively stable can safely take on
larger amounts of debt and issue
a higher fixed burden compared to
companies whose sales are not
stable.
4. Growth Rate
If other things are considered the
same, then companies that have
faster growth must rely more on
external capital.
2. Asset Structure
Companies whose assets are
sufficient to be used as collateral
for loans tend to use enough debt.
5. Profitability
It is often observed that
companies with very high returns
on investment use relatively small
amounts of debt.
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3. Operating
Leverage
Companies with lower operating
leverage will be better able to
apply financial leverage because
the company will have a lower
business risk.
6. Tax
Interest is a tax deduction, and
this reduction is more valuable for
companies with high tax rates.
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7. Control
The effect of debt compared
to stocks in the position of
control of a company can
affect the capital structure.
10. Market
Conditions
The stock and bond market
conditions experience changes in
the long term and short term that
can provide an important direction
on the optimal capital structure of
a company.
8. Management
Attitude
Management can carry out its
own considerations about the
right capital structure.
11. Internal
Conditions of the
Company
The internal conditions of a
company itself can also affect
the target capital structure.
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9. Attitude of the
Lender and Rating
Agency
Without considering management's
own analysis of the right leverage
factor for the company, the attitude
of lenders and rating agencies will
often influence financial structure
decisions.
12. Financial
Flexibility
Financial flexibility or the
ability to raise capital with
reasonable terms is in poor
condition.
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Thank you!
Any questions?

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