A company’s growth rate is an important factor to consider when determining its optimal capital structure. Rapidly growing firms typically require more capital to finance their growth, and may therefore use higher levels of debt. Companies with slower growth rates may not require as much capital and may prefer a lower debt to equity ratio. The traditional approach is a blend of the first two capital structure theories.

We know that cost of capital and the value of the firm are practically the product of financial leverage. For degree of leverage before that point, the marginal real cost of debt is less than that of equity beyond that point the marginal real cost of debt exceeds that of equity. That is, at this stage the cost of capital would be minimum which is expressed by the letter ‘A’ in the graph. If we draw a perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm. The same is possible continuously by lowering its cost of capital by the use of debt capital. In other words, using more debt capital with a corresponding reduction in cost of capital, the value of the firm will increase.

By understanding these theories, traders and investors can evaluate the value of a stock and determine the optimal capital structure for a company, helping them make informed decisions about buying, holding or selling the company’s shares. The traditional approach is a compromise between the net income and net operating income approaches, as it advocates for a mix of debt and equity. Increased debt or leverage will lower the WACC and increase business value, but only up to a certain point.

Starting from assumption of perfect capital market of capital structure, four major theories emerged over the years as modern theories of capital structure. Peaking order theory argued that there is no defined optimum capital structure rather firms will always resort to internal source of financing (retain profit) then debt (borrowed fund) and finally Equity financing (issuing of new shares). Trade-off theory argued that managers would prefer leverage financing because of the set-off between tax benefit, bankruptcy cost, and agency cost. Market timing theory also, argued that fluctuations in share price influence capital structure of a firm and consequently the financing decision of the firm. They further explain that firms issue shares when shares are overpriced and buyback when they are undervalued hence they concluded that the main determinant of capital structure is the stock returns. Credit Rating hypothesis which is believed to be an extension of trade-off theory concluded that any firm closer to the credit rate, will prefer less debt composition as compare to firms not closer to the credit rate change.

These theories outline the relationships between the capital structure and the valuation of a company. Debt financing involves borrowing money from lenders or bond investors, such as banks, or other financial institutions. The borrower agrees to pay back the principal amount borrowed plus interest over a specified period of time.

Net Operating Income Approach

The optimal capital structure, according to the traditional approach, is where the market value of a company is at its maximum and the WACC is at its minimum. With the net income approach, the company has lowered its cost of capital to the lowest point with 100% debt financing, which maximizes the value of the company. Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. At that optimal structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal real cost of equity in equilibrium. Market conditions, including interest rates and investor sentiment, can also impact a firm’s capital structure decisions.

This can help to determine the most cost-effective and suitable financing mix for the company. For example, a company taking the traditional approach seeks to find the ideal amount of debt and equity to finance operations. It looks to find the amount of each that will make the WACC the lowest possible point while the company value is at its maximum. Thus, any additional debt or additional equity would increase its WACC and lower its business value. The weighted average cost of capital (WACC) is a key figure in determining the value of a company.

Are there alternative theories of capital structure?

The trade-off model assumes that there is an optimal capital structure where the benefits of debt and equity financing are balanced, and that a company should aim to achieve this optimal balance. However, the optimal capital structure may differ for each company depending on factors such as industry, business risk, and tax environment. So, according to MM, the total value of a firm is absolutely unaffected by the capital structure (debt-equity mix) when corporate tax is ignored. Using debt or equity does not matter in the valuation, according to the Modigliani-Miller theory. That is, even if financial leverage increases a company’s earnings, an increase in the required rate of return offsets the change. Managers and investors have the same information in this theory, and any effects from transaction costs and taxes are ignored.

So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at its lowest point. Practically, this approach encompasses all the ground between the Net Income Approach and the Net Operating Income Approach, traditional approach capital structure i.e., it may be called Intermediate Approach. From the above table it is quite clear that the value of the firm (V) will be increased if there is a proportionate increase in debt capital but there will be a reduction in overall cost of capital.

Principles of Managerial Finance Chad J. Zutter; Scott B. Smart

Assumptions of the traditional approach to capital structure are illustrated in the figure below. For example, the Modigliani-Miller theory is similar to the net operating approach. The company with a large debt load will have the same value as a company with no debt, per this theory. The company’s value is based on its operating income and not its capital structure. Under, NOI approach since
overall cost of capital is constant, thus, there is no optimal capital
structure rather every capital structure is as good as any other and so every
capital structure is optimal. According to some critics the arguments which were advocated by MM, are not valued in the practical world.

The degree of leverage is plotted along the X-axis whereas Ke, Kw and Kd are on the Y-axis. It reveals that when the cheaper debt capital in the capital structure is proportionately increased, the weighted average cost of capital, Kw, decreases and consequently the cost of debt is Kd. Net Income approach is one of the two approaches used to determine the optimal capital structure for a firm, the other being the Net Operating Income approach.

Net Income Approach

(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a certain level and thereafter increases rapidly. Under this approach, the most significant assumption is that the Kw is constant irrespective of the degree of leverage. The segregation of debt and equity is not important here and the market capitalises the value of the firm as a whole. The availability of financing can also influence a company’s capital structure. Companies with easier access to debt financing may be more likely to use higher levels of debt, while those with limited access to debt financing may be forced to use more equity. The nature of a business can significantly influence the choice of capital structure.

Companies with stable, predictable earnings streams are better able to support higher levels of debt. In contrast, businesses with unpredictable earnings or cyclicality may prefer to maintain a lower debt to equity ratio. In order to raise capital for business needs companies have two types of financing.

This capital structure will also correspond to the point where the WACC is minimized. Under the Net Income approach, the optimal capital structure is one that maximizes the firm’s overall value by minimizing the weighted average cost of capital (WACC). This is achieved by selecting the right combination of debt and equity to fund the firm’s operations.

• In this paper, we apply the trade-off theory of capital structure to Microsoft.
• While buying securities, this cost is involved in the form of brokerage or commission etc. for which extra amount is to be paid which increases the cost price of the shares and requires a greater amount although the return is same.
• Capital structure refers to the mix of different types of capital that a company uses to finance its operations and growth.
• The company’s value is based on its operating income and not its capital structure.
• In other words, the cost of borrowing funds is comparatively less than the contractual rate of interest which allows the firm regarding tax advantage.

You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. The Net Operating Income Approach, supplies proper justification for the irrelevance of the capital structure. In Income Approach, supplies proper justification for the irrelevance of the capital structure. All the earnings remaining after payment of debenture interest are distributed as dividends among the
Shareholders. By taking on debt, a company may be required to make regular interest payments and adhere to certain financial covenants. Let’s calculate the value of STAR S.E. Inc. for all variants of capital structure.

The cost of equity, is determined from the level of shareholder’s
expectations. Thus, the
shareholders would now, expect a higher rate of return from the shares of the
company. Thus, each change in the debt equity mix is automatically set-off by a
change in the expectations of the shareholders from the equity share capital. Modigliani and Miller, thus, argue that financial leverage has nothing to do
with the overall cost of capital and the overall cost of capital is equal to
the capitalisation rate of pure equity stream of its class of risk. Thus,
financial leverage has no impact on share market prices nor on the cost of
capital. The traditional theory of capital structure says that a firm’s value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing.

At first, the weighted average cost of capital declines with leverage because the rise in ke
does not offset entirely the benefit of use of cheaper debt funds. As a result, the weighted average
cost of capital (ko), declines with moderate use of leverage. After a point, however, the increase in ke
more than offsets the use of cheaper debt funds in the capital structure, and ko begins to rise. Hence, the traditional position implies that the cost of capital is not independent of the
capital structure of the firm and that there is an optimal capital structure.

The WACC is also known as the company’s cost of capital and is a representation of the required rate of return that equity and debt holders expect. Thus, the advantage of debt
is set off exactly by increase in equity capitalisation rate. Thus, due to the market imperfection, after tax cost of capital function will be U-shaped. In answer to this criticism, MM suggested that the firm would adopt a target debt ratio so as not to violate the limits of level of debt imposed by creditors. This is an indirect way of stating that the cost of capital will increase sharply with leverage beyond some safe limit of debt.

So, Cost of Capital is increased and the value of the firm is maximum if a firm uses 100% debt capital. When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital structure for the firm and, at this point, the market price per share is maximised. A company with an optimal capital structure is likely to have a higher credit rating, as it is better able to manage its debt obligations. This can make it easier and less expensive for the company to access debt financing in the future.