Capital Structure Theory

Capital structure theory is a financial approach to fund businesses and raise capital through a combination of equities and liabilities. There are several capital structure theories; each attempts to elaborate on the debt and equity proportion through which a business's capital structure is determined.

Each of the theories defines a different approach, forming a relationship between debt financing, market value and equity financing. These theories are core aspects of corporate finance, explaining how companies use different sources to fund and expand their activities, operations and overall financial stability. The capital structure defined is mentioned on the right-hand side of a company's balance sheet.

Capital structure theory in financial management is the approach through which a company decides on the ratio of debt and equity for the formation of its capital structure. Every firm strives to design the best and optimal capital structure to gain maximum return with minimum risk exposure. Capital structure theories help identify internal and external factors such as market conditions, investors’ nature, tax policies, shareholder demands, company size, age, industry type, level of competition and so on. There is no one theory, but a variety of them play a crucial role in offering concrete foundations for different capital structure approaches to build a stable structure without which the entire company can collapse.

There are four types of capital structure. Debt capital structure refers to when the level of debt financing is high relative to equity. In comparison, equity capital structure is the opposite of debt with a high level of equity capital. Similarly, when the capital structure has both debt and equity financing, it is called a hybrid structure. In contrast, the optimal capital structure is the combination of both, which elevates the company value. Based on the need, objective, planning and prospects, a company decides on the type of capital structure they need to design and which theory should be relevant to approach.

There are many types of capital structure theories based on different aspects, market elements, internal and external factors -

1. Traditional theory - Ezra Solomon gave this theory. It is also called the trade-off capital structure theory. It states that every company should seek a balanced and optimal mix of debt and equity, decreasing the weighted average cost of capital and increasing the value. The main focus of this theory is to increase the debt proportion to a specific limit in the capital structure. 
2. Net income theory - Postulated by David Durand in 1952, he believed that debt has low interest rates and helps in removing the risk factor, assisting in taxation and deducting expenses. It is also referred to as the fixed ''Ke'' theory. In layman's terms, if a company takes on more debt, the capital structure size will increase, and WACC(Weighted average cost of capital) will decline, but it will result in higher firm value.
3. Net operating income theory - David Durand again gave this theory. It is opposite to the net income theory. It states that the overall cost of the equity can remain fixed irrespective of the debt proportion. The theory depicts how any change in the capital structure does not impact a company's market value and WACC.
4. Modigiliani-Miller theory - As the name suggests, this theory was introduced by the collaborative work of two members, Franco Modigiliani and Merton Miller, in the 1950s. Also known as MM capital structure theory. It is based on two conflicting assumptions. The absence of corporate taxes and the presence of corporate taxes. In the former assumption, the firm's value will be equal to the compromised equity amount. In the latter case, the taxes will apply, making the firm's value equal to the indebt firm value plus the product's tax rate and debt value.
5. Pecking order theory - This theory was stated by Stewart Myers and Nicolas Majluf in 1984. According to this theory, managers follow a particular order when it comes to financing. Any manager is likely to begin with the company's retained earnings, then debt, and finally keep equity as a last resort.
6. Agency cost theory - This theory emphasizes the costs linked to the conflicts between stakeholders and managers. It was published in 1976 by Professor William Meckling and Michael Jensen in a paper called Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.
7. Market timing theory - Proposed by Wurgler and Baker, it states that any company's capital structure primarily depends on its past attempts to time the equity market. The theory further suggests that the company issues equity when the market valuations are high and rebuy equity when valuations are low.
8. Signaling theory - This theory suggests that if there is an asymmetry in information, the financing decisions are used as signals to spread the information in the market. In simple terms, if a manager has inside information, their choice of capital structure will automatically reflect the information to the market.

The advantages of capital structure theory are -

• The theories help in calculating and regulating capital structure as required.
• All the theories assist in designing a capital structure with the primary focus of keeping the company value higher than the cost of capital.
• All the approaches help in minimizing risk, and using debt and equity financing effectively.
• Creates a concrete foundation for managers to adopt a particular approach to regulate their capital structure.
• It allows managers to opt for the best possible and optimum use of financing to build a good capital structure.

The disadvantages of capital structure theory are -

• Most of the theories are based on multiple assumptions.
• The capital structure theories most often opt for perfect market conditions and do not account for real-world complexities.
• The pecking order theory specifically relies majorly on internal financing.
• A risk of financial loss always exists with misleading information and unpredictable market timing