Approaches to Determine Capital Structure Homework Help
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The way a firm manages its finances by distributing its fund to meet debts and manage the equity by shareholders is termed as Capital Structure. It is a combination of principles like finance, accounts, economics and growth. The finance for Capital Structure comprises of senior debt, sub – ordinate debt, common equity, hybrid securities and preferred equity. It helps a corporation to have an overall understanding about the funding that it generally uses to invest for its financial activities and progress. A link can be studied between these components, displayed in a balance sheet using Approaches to Determine Capital Structure Homework Help. It can also be referred to as debt–to–finance ratio because a firm usually maintains a general ratio of the investment done by equity–finance and the debt–finance. This ratio may vary according to the company strategies to manipulate the actual capital cost to as low as possible. Capital Structure can help to differentiate companies as low–geared companies (equity-finance dominated) or high–geared companies (debt–financed dominated). A high leverage ratio and aggressive capital structure are always desirable to the shareholders, which is obtained when the firms promote more debt–finance than equity–finance assets.
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Approaches to determine capital structure
There are four approaches for the determination of a capital structure. The approaches are mentioned in Approaches to Determine Capital Structure Homework Help.These are
• Net Income Approach(NI) – In order to increase the value of the firm, the overall cost of the assets,measured in terms of Weighted Average Cost of Capital (WACC) should be decreased. This can be achieved by having a greater share of debt investment in the funds. For further insights into approaches to determine capital structure, go through Approaches to Determine Capital Structure Homework Help.
• Net Operating Income Approach (NOI) – NOI approach is completely opposite from NI approach. It suggests the overall capitalization rate would remain same for any share of debt. If the debt is increased, the cost of equity also increases and WACC remains constant. Value of equity can be determined by deducting the value of debt from total value of the firm.
• Traditional approach- An optimal structure of capital exists when the market value of the assets are maximized due to minimization of the WACC. The asset value rises up to a certain increase in debt capital but it begins to fall down after a certain value. For more information on the topic, refer Approaches to Determine Capital Structure Homework Help.
• Modigliani and Miller’s theory- The changes in the company’s capital structure shouldn’t affect the WACC and it should remain constant, further implying the capital structure is irrelevant of company’s stock price. This theory identifies the benefit of taxes that come from interest payments.
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