The mixed of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the option of capital structure. The firm’s is considered optimum when the market value of share is maximised.
The assets of a Company can be financed either by increasing the owner’s claim or the creditors claims. The owner’s claims increase when the firm raise funds by issuing ordening share or by relating the earning. Creditors claims increased by borrowing.
1) The various means of financing represent the financial structure of a company. Short term borrowing an excluded from the list of methods of financing the firm’s capital structure of the enterprise.
2) It is used to represent the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserve and surplus (retained earning).
3) Capital structure decision is a significant management decision. It influences the shareholder’s return and risk.The market value of the share may be affected by the capital structure decision.
The company will have to plan it’s capital structure initially at the time of its promotion.Whenever funds have to be raised to finance investments , a decision is involved.
4) A demand for raising funds generator a new structure since a decision has to be made as to the quantity and forms of financing.
5) The decision will involve an analysis of the existing capital structure and the factor, which will govern the decision at present.
6) The company’s policy to retain or distribute earning affects the owners claims. Shareholders’ equity position is strength and by retention of earnings. Thus , the dividend decision has a learning of the company. The new financing decision of the company may affect its debt equity mix.
The debt equity mix has implication for the shareholders’ earning and risk, which in turn will affect the cost of capital and the market value of the firm.
Understanding of capital structure.
This decision should be examined from the point of its impact on the value of the firm. If capital structure decision can affect a firm’s value then it would like to have a capital structure, which maximizes.
it’s market value however those exist conflicting theories on the relationship between capital structure and the value of a firm.
Theory of capital structure
Capital structure is relevant is the net income (NI) approach.
1) Modigliani and Miller(mm) theory-The traditionalists believe that its affects the firm’s value modigliani and miller (mm), under the assumption of perfect capital markets and no taxes.
2) Theory of capital structure is relevant is the net income (NI) approach. The net income approach a firm that finance its assets by equity and debt is called a levered firm. On the other hand,a firm that uses no debt and finances its assets entirely by equity is called an uncovered firm.
3) The firm’s overall cost capital is the weighted average cost of capital(WACC). There is an alternative way of calculating wacc(),wacc is the weighted average of costs of call of the firm’s securities.
WACC= cost of equity×equity weight+cost of debt × debt weight
The traditional view has emerged as a compromise to the extreme position taken by NI approach. Like the NI approach it does not assume constant cost of equity with financial leverage and continuously declining WACC.
A judicious mix of debt and equity capital on increase the value of the firm by reducing the weight average cost of capital up to certain level of debt.
Optimum capital structure
A firm has an optimum capital structure that occurs when WACC is minimum as thereby maximising the value of the firm.
WACC declines with moderate level of leverage since low-cost debt is replaced for expensive equity capital. Financial leverage. Resulting in risk to shareholder will cause the cost of equity to increase.
Traditional theory assume that at moderate level of leverage, the increase in the cost of equity is more than affect by the lower cost of debt funds are cheaper than equity funds Carries the clear implication that the cost of debt plus the increased cost of equity is more than offset of debt plus to increased cost of equity to increase.
The uncertain that debt fund are cheaper then equity funds carries the clear implication that cost of debt plus the increased cost of equity before debt financing.
WACC= cost of equity×weight of equity +cost of debt ×weight of debt