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A company’s capital structure is its financial structure minus current liabilities, which leaves the business’s mix of long-term funding. Capital structure is made up of fixed assets, such as debt, permanent holdings, and long-term investments. How to structure permanent finance is the primary focus of several types of capital structure theory. These theories include the independence hypothesis, the dependence hypothesis, and several moderate theories that balance between independence and dependence.
Most businesses strive to reach an optimal capital structure, which is a mix of funding sources that minimizes the cost of raising capital to fund new ventures. Optimal capital structure theory is unique to each business, so different businesses subscribe to different theories. Financial analysts use a number of elements when determining capital structure. These often include common stock values, expected cash dividends, equity, debt, and earnings.
The independence capitol structure theory is generally considered an extreme hypothesis. This position figures that a company’s cost of capital and common stock prices are independent of the business’s choice of financial leverage. According to the independence theory, no amount of debt financing can affect the price of the company’s stock. To record assets and liabilities under this system, accountants use a valuation approach known as net operating income, or NOI.
Dependence hypothesis is the opposite of the independence capital structure theory, and is also usually considered an extreme idea. This theory supposes that greater financial leverage indefinitely lowers the company’s cost of capital. It is assumed that market trends capitalize or discount common stockholder’s expected earnings in relation to the demand for the company’s stock. Earnings become synonymous with net income and accountants value using this net income, or NI approach.
In truth, most business situations call for a capital structure theory that combines or moderates these two extreme theories. The independence theory is flawed because too much financial leverage may eventually cause a company to go bankrupt or fail. Dependence capital structure theory is fallible because debt financing can, and often does, increase the value of outstanding stock.
Moderation often comes in the form of a tax shield, which moderates debt financing by allowing for debt failures and protecting stock investors by using tax code as a cost-saving shield. This keeps the cost of capital somewhat independent of leverage, while still acknowledging that debt may affect stock prices. Financial managers can attempt to control debt by using debt capacity calculations that figure the maximum proportion of debt that can be handed by the company’s capital structure.