Capital structure represents the combination of various sources of funds used to finance the business assets. There are generally two major classifications of sources of finances in this regard i.e. equity based funds and debt based finance. However, in the recent decades a third hybrid sources comprising of both equity and debt are being also in use. Since the composition of capital affects the overall cost of capital known as Weighted Average Cost of Capital or WACC which is weighted average of cost of equity and cost of debt (Friedrich 2005).
Researchers over the past decades have tried to propose, present and explain various theories regarding the capital structure of business, its impacts on business value and/or any other related implications. These theories try to explain the effect of changes that occur in the capital structure (i.e. relative proportion of debt and equity in capital) in terms of weighted average cost of capital and value of business (Friedrich 2005).
Many theories of capital structure have been proposed, however, some of them are discussed here, which are;
Net Income Theory of Capital Structure;
Net Operating Income Theory of Capital Structure;
Traditional Theory of Capital Structure;
Modigliani-Miller theory of Capital Structure;
Trade-off theory of Capital Structure; and
Pecking Order Theory.
These theories are explained one by one alongwith critical analysis of each theory and empirical evidence of these theories is also focused upon in deriving the conclusion.
NET INCOME THEORY OF CAPITAL STRUTURE
The Net income theory of capital structure revolves around the concept of increasing net income of the business which will in turn increase the overall value of the firm’s securities in the market, collectively known as business value and decreasing cost of capital. It proposes that businesses have choice to select that capital structure where proportion of debt is more than the proportion of equity. Such a capital structure will increase the market value of business and reduces the cost of capital. This theory lays foundations upon the common understanding that interest is a tax deductible expense, and therefore, having more proportion of debt brings more tax savings making debt a cheap source of finance. Therefore, after the deduction of interest expense, the company has less tax liability which on overall basis reduces the WACC (Friedrich 2005).
The theory proposes that highly leveraged businesses tend to have more value as compared to businesses whose financial leverage is lower. By taking tax savings generated as a result of high financial leverage and reduced WACC, this theory proposes that increasing financial leverage by increasing debt component will result in maximization of shareholders’ wealth in terms of market price of shares of the business.
Net Income Theory of Capital structure was proposed by David Durand and it is based on the assumptions that the capital requirement remains same and constant. Cost of debt is always less that cost of equity and both remain constant and cost of capital changes inversely with financial leverage (Friedrich 2005).
NET OPERATING INCOME THEORY OF CAPITAL STRUCTURE
Net operating income theory of capital structure is totally different as compared to Net Income theory of capital structure. It negates the idea of maximizing value of business by increasing financial leverage. It proposes that change in debt and equity proportions do not affect overall cost of capital and market value of firm’s securities. Rather, it assumes that under each and every combination of debt and equity, the cost of capital as well as the value of business remains the same.
This theory was suggested by David Durand and is 180 degree opposite to Net Income Theory. This theory proposes that capital structure decision has no effect on total value and the market price of marketable securities of the shares and overall weighted average cost of capital, therefore, nullifying effect of financial leverage of any of these variables (Friedrich 2005).
This theory is based on the assumptions that Cost of capital and Cost of debt are constant, whereas cost of equity changes with the change in debt equity. This theory assumes zero or no tax environment (Friedrich 2005).
TRADITIONAL THEORY OF CAPITAL STRUCTURE
This capital structure approach is a mid way between Net Operating income theory and Net Income theory by David Durand. However, this theory has been divided into three stages or parts in order to understand how it works.
The initial stage suggests that a company with a low financial leverage increases its debt proportion in capital structure in order to increase the market value of the business.
While increasing financial leverage the company reaches a point at which its capital structure becomes optimal. The indicators of such optimal capital structure are lowest weighted average cost of capital and the highest value of business. This is the second stage. The firm tends to remain at this optimal capital structure, since it is in the benefit as well as interest of all stakeholders including management.
If the company further increases the debt proportion in the capital structure beyond this optimal level, the company faces decline in the business value as increased amount of debt capital places the company at a financial risk. Beyond this optimal capital structure, any increase in debt capital will result into increased cost of capital and declined value of business (Friedrich 2005).
This theory is based on the assumptions that value of business changes positively with changes in financial leverage until it reaches a limit (referred to as optimal capital structure), after that it changes inversely. It also assumes that cost of debt is less that cost of equity (Friedrich 2005).
THE MODIGLIANI-MILLER THEORY
The theory proposed by F. Modigliani and M. Miller is identical to operating income theory, and in the original proposition they proposed that in the absence of taxes, cost of capital and business value of the firm will not be affected by the capital structure changes. The theory laid two main propositions i.e. cost of capital and business value are independent of the capital structure and hence business value can be arrived at by capitalizing expected net operating income by appropriate discount rate for the risk class. Secondly, the increase in debt increases the financial risk which in turn increases cost of equity in the manner to offset low cost advantage of debt. Therefore, overall cost of capital remains the same (Miller 1988).
However, the assumptions upon which Modigliani and Miller based their theory were quite numerous. Existence of perfect market (where investors are free to sell and buy shares, can borrow funds at same rates for individuals and for companies, have rational behavior, have complete information with no transaction costs), classification of firms into homogenous risk clases having same degree of financial risk, same expectation of net operating income in all the investors, 100% dividend payout ratio with zero retention, zero taxes or null taxes (which was removed later) were the main assumptions of MM theory. The theory also tried to explain arbitrage and reverse arbitrage process (Miller 1958).
TRADE OFF THEORY OF CAPITAL STRUCTURE
The main proposition of Trade off theory of capital structure is that the choice of capital structure by a firm is dependent upon the comparative costs and benefits of the two sources of finance. A balance is sought to be maintained between dead-weight costs of bankruptcy and the benefits arising out of tax saving. However, agency costs are also sometimes made part of the balance. This theory takes into account the fact that generally corporations are financed both by equity and debt, and it compares the advantages and disadvantages of debt to arrive at optimum capital structure (Murray Z. Frank 2008).
PECKING ORDER THEORY OF CAPITAL STRUCTURE
Pecking order Theory was proposed by Stewart C. Myers in 1984 and states firm’s sources of finance are prioritized from internal financing (retained earnings etc) to equity in accordance with the principle of least effort or least resistance. Therefore, internal funds are used first, then debt is used and equity is opted for in the last. This theory may not explain optimal capital structure of the firm but tries to explain the way in which sources of finance are discharged (Murray Z. Frank 2008).
Since, a brief summary of the theories regarding capital structure have been give, now the empirical evidence regarding the applicability of these theories in real life scenarios is to be considered. The income approaches (either Net Income or Net Operating Income approach) arrive at the business valuation by discounting benefits (net incomes) of the business by appropriate discount factor to arrive at Net present value (Friedrich 2005).
As far as MM Theory is concerned, it is difficult to determine the extent to which this theory has affected capital markets, however, a general perception about this theory is that it is used to promote debt financing. However, this perception is not exact. This theory based on the assumptions, violations of which can change the result (J. Miles 1980). In practice, generally, emphasis is put on the result and not on the assumptions leading to misunderstanding. However, if the assumption of risk profile in low gearing and high gearing being same, is removed, the results under this theory change almost to opposite (Miller 1988).
However, when the empirical evidence of trade-off theory is considered it is criticized often. Some researchers such as Miller labeled this as akin to balance horse and rabbit content in a stew of one horse and one rabbit (E. Fama 2002). Taxes cannot be ignored as they exist almost everywhere, whereas, bankruptcy is rare. If the proposal of Trade-off theory is accepted then every firm will tend to have higher debt level which is almost against the reality. However, in spite of these criticisms, it remains one of the main corporate capital theory in financial world (Murray Z. Frank 2008).
When pecking order theory is considered, empirical evidence regarding this theory has not been found enough by many researchers to arrive at the result that any priority is given to a specific source of finance regarding capital structure (Murray Z. Frank 2003). Some researchers have promoted that it is a common practice in reality whereas many other such as Fama and French, Myers and Shyam-Sunder conclude that some features of data get explained by pecking order theory and some by trade-off theory (E. Fama 2002). Goyal and Frank further criticize that this theory fails to prove itself (Murray Z. Frank 2003).
