Capital Structure Theories and Applications

This paper delves into the aspect of capital structure and encompasses the various theories and applications that will help firms to optimize it effectively. It covers topics like leverage implications of the debt financial choices, trade-off theory of capital structure, capital structure debate, signaling theory, constraining manager’s theory, pecking order hypothesis, and more.

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Running head: CAPITAL STRUCTURE THEORIES AND APPLICATIONS
CAPITAL STRUCTURE THEORIES AND APPLICATIONS
Name of the Student
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Author’s Note

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Table of Contents
Introduction......................................................................................................................................2
Leverage implications of the Debt Financial Choices.....................................................................3
Trade-off Theory of Capital Structure.............................................................................................3
Capital Structure Debate..................................................................................................................5
Signaling Theory.............................................................................................................................9
Constraining Manager’s Theory......................................................................................................9
Pecking Order Hypothesis.............................................................................................................10
Conclusion.....................................................................................................................................11
References......................................................................................................................................12
Appendix........................................................................................................................................15

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Introduction
Every business need funds to execute its business. The objective of the firms is not only
to deploy its products and services into the market but also to ensure that the products and
services are able to acquire more future returns compared to their present valuation. This requires
the possibility of incorporating investment in such a way that the asset value can rise followed by
raising the overall market value of the firm. The funding is being done upon the assets that any
company possess at a particular time. Moreover, it is important to create an optimal mix of the
funding upon the assets as well as the process through which the end consumer obtains the final
product and services. So it is also important that the funding that is being done upon the assets
are able to get optimized based on the functional, operational, managerial efficiencies present in
the firm (Alan & Gaur, 2018). The challenge lies in creating that optimal mix of portfolio based
on the financial management system that a company possess. In fact a firm devotes its excellence
for managing its resources to create the optimal capital structure maintaining the major focus
upon the sales, marketing, logistics and deliverance of the commodities and services that are
produced by any firm and are being deployed in the market to potential customers for
consumption. The economic activity of consumption, distribution, production and exchange of
good and services are thus the important factors that requires the support of effective financing
initiative to optimize their future returns. Thus the funds that are being allocated for the
economic, investment, operating and financial activities need the optimal allocation in order to
get utilized optimally and ensure that the future earning that will come from the present
investment will be higher than the latter. Effective corporate management through maintaining a
credible financial system based on the leverage analysis and optimal capital structure will help in
maximizing the investments that are made upon the assets and keep a balance between the debt

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and the equity of the firm’s financial feasibility ensuring its sustenance for the future. The paper
delves into the aspect of capital structure and encompasses the various theories and applications
that will help firms to optimize it effectively.
Leverage implications of the Debt Financial Choices
Operational, financial, investment as well as other managerial activates that are important
for any organization involved the aspect of financing to execute them in an effective manner. In
order to ensure that the financing activities are being implemented optimally it is important to
focus upon the fact that if the returns from the financing activities are not optimum then the asset
are not optimally utilized for which a firm can’s earn the optimal profit as well as can incur
losses too. Thus there is a presence of risk in the process of financing the activities. The
implication of leverage is associated with the financial decision making of a firm. It is taken
under consideration in the process of effective financial planning so that the financing do not I
cur lower future earnings. For this it may happen that the firm decides to change the proportion
of debt capital invested in its capital structure or increase its fix charges. Leverage results from
the use of borrowed capital as a funding source in order to invest upon the assets of the firm and
ensure that expansion of the values of the firm’s assets takes place followed by generating higher
returns upon the risk capital.
Trade-off Theory of Capital Structure
The trade-off theory of capital structure is based on the exchange between the debt and
equity upon which the managers change the proportion of investment upon the debt or the equity
as per the market condition and the respective fluctuation in the amount of liabilities of the
companies in the market where it operates. In good times the financial leverage makes
everything better and vice-versa though to ensure the right mix of the equity and debt the

4CAPITAL STRUCTURE THEORIES AND APPLICATIONS
effective trade-off is essential to get incorporated within the capital structure of the company.
The only way to increase the value of the firm is (w/c – F). The formulation can be shown as
follows:
V = D + E
The trade - off theory of capital structure was suggested by Mayer in 1984 according to
which an optimal capital structure is important for any firm as it maximizes the value of the firm
as well as balances the cost and benefits for any additional unit of debt as characterized by the
trade – off model of capital structure. Along with that the optimal level of leverage can be
achieved by ensuring balance between the benefits derived from the interest payments and the
cost incurred through the issuing of debt. Notably, the benefits of debt can be of two types, as
follows:
Tax shield benefit – the interest expenses are tax deductible but in case of equity, the dividends
are not exempted from tax.
Added Discipline – It helps the fund managers to think more carefully and avoid any form of
investment that may not be profitable in term of future earning s upon the present investments.
The balance between the cost and benefit is essential due to the reason that the cost of
debt i.e. bankruptcy cost, agency cost and the loss of flexibility are taken under consideration.
The bankruptcy cost takes under consideration the fact that the firms with the greater amount of
risk of experiencing financial distress and found to tend towards borrowing less in comparison to
the firms that possess lower financial distress risk.
The agency cost is on the other hand, arises due to conflict between the shareholders and
that of the management as well as due to conflict between the shareholder and the creditors.
Moreover, the loss of flexibility is that if there exist poor availability of the debt capacity within

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the firm today then they cannot withdraw on it in the future. Based on the Trade – off theory of
capital structure the optimal level can be incorporate as follows:
Thus it can be said that the major objective of the trade – off theory of capital structure is
to incorporate the fact that there is importance of maintaining a balance between the debt and
equity of the firm since it helps the firm to maximize its value. The trade – off theory of capital
structure also incorporates the fact that the optimal capital structure based value of any firm is
directly equal to the firm’s cost as benefit is equal to cost. This invigorates the fact that the
market value of a firm is not affected by its capital structure.
Capital Structure Debate
The debate remains due to the reason in the aspect of capital structure for any firm is that
wither a firm should be structured based on how a firm should be structured upon its liabilities.
This is because of the fact that the firm has to pay back is liabilities and hence the composition of

6CAPITAL STRUCTURE THEORIES AND APPLICATIONS
the capital structure should be debated. Based on the proportion of the firm’s debt and equity it
can be said that a firm that is $ 80 billion in equity and $ 20 billion in debt has a 80 % equity
financed and 20 % debt financed. Thus the firm’s debt to total financing is about 20 % and is
referred to be financial leverage of the firm. This aspect is also related to the components of
capital structure which are equity share capital, preference share capital, retained Earnings,
Borrowed Capital, etc. Equity share capital render the equity shareholders with the basic source
of financing the financial activities that are required for the business to get executed. Hence, the
holders of such share bears the optimum risk associated with the ownership and carries the
dividend at the fluctuating rates depending upon the profitability that the firm earns in the
market.
On the other hand, preference shares carries the dividend at a fixed rate torrential rights over the
equity share based on the returns that is being on over the invested capital is utilised in case of
winding up of the company. Unlike the equity shareholders the voting rights are limited for the
preference shareholders. The part of the profit that is being retained by the company for meeting
the future financial needs as well as ensuring the expansion of the business firm is termed as
retained earnings. It can be considered as the back of the profits. Moreover, capital is of two
types one is debenture and other is the term loans. Debenture is the certificate of loan evidence
regarding the fact that the company is liable to pay this count with an interest at an agreed rate.
While term loan is provided by the financial Institutions like banks at a fixed rate of interest.
Thus the capital structure becomes reserves plus debenture plus preference share and equity
share. Hence capital structure refers to the combination of debt and equity with the company uses
the finance to long term operations. Raising of capital from different sources and using them to
find various assets by and company is the fundamental basis of capital structure which is

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accompanied by certain principles that provide a systematic Framework for investing the capital
and ensure maximum rate of return that is being earned true in curing minimal cost. The total
required capital a b divided into equity share capital as well as preference share capitals and
other than share there is debentures. There are internal factors as well as external factors which
influence the capital structure of any firm. The internal factors comprises of the size of the
business as well as its nature based on the regulatory of generating income constructing an acid
structure based on the age of the firm and desire to retain control for future plans. The operating
ratio as well as trading on equity with the period and purpose of Financing is equally valued
factors which influence the capital structure as a whole. However on the other hand external
factors considered the case of the capital market condition the fluctuations in the investors
perception regarding the investment as well as the statutory requirements taxation policies and
policies that are incorporated by Financial Institutions cost of Financing due to seasonal
variations, nature of market competition and economic fluctuations. The optimal of the best
capital structure is economically viable and financially sustainable for the various form of
securities by mixing proportionately debt and equity with the objective of maximizing the value
of the company and minimizing the cost of capital. Minimizing the cost of capital shoes that
minimum risk is involved in the process and maximum control over the safety simplicity as well
as flexibility is present attractive rules and commensurate to legal requirements. The theories of
capital structure comprises of the net income theory, net operating income theory traditional
theory as well as the Modigliani Miller or M-M theory. The net income theory talks about the
fact that any firm can increase the value of the firm by producing the overall cost of capital and
increasing the proportion of Debt to its capital structure in order to maximize the future earnings
based on the present investment. The theory was propounded by David Durand and is also

8CAPITAL STRUCTURE THEORIES AND APPLICATIONS
known as fixed "ke" theory. This is due to the fact that debt is generally a cheapest source of
funding interest rates are lower than the dividend rates due to
1. Elimination of risk and
2. The benefit of tax is implemented as interest is deductible expenses from income for income
tax purpose.
The total value of the firm (V) = S + D
Where S = market value of the Shares = (EBIT – I)/ Ke = E/ Ke
D = Face Value = Market value of the Debt
E = the amount of earning s available for the Equity Shareholders
Ke = Equity Capitalization Rate or the Cost of Capital
Thus the capitalization rate K0 = EBIT/V
Where V = value of the firm
K0 = Capitalization rate or the Overall cost of capital
The Modigliani – Miller Theory was propounded by Merton Miller and Franco Modigliani
which was based upon two approaches, namely the absence of corporate taxes and when
corporate taxes exists. In absence of the corporate tax the value of the firm (V) and the
capitalization rate (K0) are found to be independent of the capital structure. However, the debt to
equity mix of the Firm in determining the total value of the firm. This is due to the reason that
the increase in the use of Debt as a source of finance “Ke” is found to rise and the advantage of
the low cost Debt is being offset by the equal amount of rise in “Ke”. In case two identical firm
with different capital structure can possess same cost of capital or market value due to the
arbitrage process. Thus the M-M theory is based upon the assumption of perfect capital market
with no transactional cost and a class of homogeneous risk where the expected EBIT of all the

9CAPITAL STRUCTURE THEORIES AND APPLICATIONS
firm are found to possess identical characteristics of risk. There is also 100 percent distribution
of the earnings to the shareholders and the amount of corporate tax is nil. However, when the
“V”, “K0” are being constant with the rise in debt within the capital structure and does not found
to hold good corporate taxes. They are found to recognize the “V” and “K0” with decrease of
which there is a corresponding rise in thee the amount of debt within the capital structure. Value
of the unlevered firm Vu = ((EBIT (1-T))/ Ke. The value of the levered firm = VL = Vu + Dt. Here
the value of the firm Vu = Value of the undelivered Firm, VL = Value of the levered firm
(Öztekin, 2015).
Signaling Theory
The changing the security prices results inter volatility after the announcement effect
which causes drastic price changes and result in companies as well as government to option
select leak or hint of announcement before that actually get orchid 9 surprise dance 2015
standard signal effect the signaling is a contract theory what idea is that one party that is age
incredibly Convent some information regarding itself to that of the another which is the principle
and price signal is conveyed to the consumer as well as the producers wire ads for product and
services which provides the increase in the prices (Mason & Harrison, 2017). The process of
dividend signaling suggest that mean in company announce and increase in its dividend payout
then it is an indication of positive future prospects and hence the theory directly relates its tie up
with Game Theory for managers investment potential are most likely to provide signals. It is the
act of referring to the various market signals which indicates the initiation of trading positions.
Based on the technical analysis and the signaling approach shades gates initiated form signal in
price series. On the other hand debt signaling that is stocks future performance with any

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announcement that is being made regarding death about company’s initiative to take death under
consideration in order to finance is capital structure.
Constraining Manager’s Theory
The constraints manager's theory is often regarded as the theory of constraints that is
property applicable to managing business operations within an organization. It helps in
determining the best way for an organization through which we can achieve its goals by reducing
the operating expenses as well as mitigating the risk involving inventory and increase the output.
It is an overall management philosophy introduced by Goldratt that help in clearing
organizations continually in the process of achieving goals to the concept of managing business
and helps the manager to incorporate a common language in financing as well as strategizing
organizational objectives. It also states that any system contain Ashok. That prevent from
achieving goals and is also known as the bottleneck or constraint for financial analysis and
returning value for an organization based on the management philosophy. The motion of the
constants manager's is involved in the operational business for maximizing the output national
goals of the business factor that restricts from one achieving its goal in the context of financial
management. It is the methodology abide by which the weakest ring in the chain can improve the
performance of the system.
Pecking Order Hypothesis
The pecking order hypothesis postulates that the cost of Financing increases with
the asymmetric information present in the market. Refinancing comes under 3 sources which are
internal funds debt and new equity. 10 the form of that a Farm chooses can act as a signal of its
need for external Financing. Eastern this theory a company should prefer to finance itself first

11CAPITAL STRUCTURE THEORIES AND APPLICATIONS
internal it through retained earnings and if the source of Financing is unavailable can a company
should finance itself to debt
The theory is useful in describing the behavior of two parties with it be an individual or
organization that have access to different kind of information where does information has the
ability to influence the market. This process has one part is that must use weather and how to
communicate through the signal or information that are being exchanged and the other party is
the receiver that must choose how to interpret the signal. It interpret the extent up to which
reports its financial performance and reveals its characteristic that mining the practice of the
financial disclosure.
Conclusion
It can be concluded that if the value from the financial review leveraging then the risk
associated with the process will not have a negative effect. The ideal financial leverage company
to 10 return based on its equity and increases because deliveries increases the stock volatility by
increasing the level of risk which is increases the returns. The attribution of too much risk
decrease liver is for the equity investors which it benefits to the EPS increases the default risk
potential investors and spook existing investors causing the demand and the price for the stock to
decline.
.Capital structure is a relation between the debt and equity of securities of the firm that helps in
financing its assets and covering up its liabilities. It is the long term source of the funds
employed in the business enterprise for permanently financing the long term debts, preferred
stocks as well as the net worth of the firm.

12CAPITAL STRUCTURE THEORIES AND APPLICATIONS
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Appendix