Theory of Extreme Capital Structure - Essay Example

Therefore, capital structure can be defined as the arrangement of capital. In order to analyse capital structure, we need to highlight the difference between capital structure and financial structure. The terms are interchanged in some circles to mean the same, but they are not quite the same. Financial structure is the sum of all the means the firm uses to fund its activities. Therefore, financial structure comprises of net worth and liabilities of the company i.e. short and long term. The capital structure on the other hand is financial structure excluding short term borrowing.

Capital structure has already been seen as two-fold, with the finance and asset structure. The source of capital is what determines what asset will be purchased. The structure of capital is categorised as follows: 1. According to sources: The structure may either be simple or complex. A simple structure consists of a single source while the complex is where the sources are more than one. (Although retained earnings is not considered an additional source). This mode is only possible under the fund concept because it is rare for a firm to have one asset, invalidating the asset concept. 2. According to sources This is broadly categorised into internal and external sources.

Internal sources comprise of share capital (bonus issue), capital reserve, and reserve and surplus. On the hand the external sources include share capital (bonus issue excluded), share premium, forfeited shares, long term and short-term liabilities and debentures. 3. According to ownership This is either ownership capital or creditorship (debt) capital. Ownership capital includes equity share capital and retained earnings while creditorship comprises of debentures, long-term and short-term liabilities.

It is agreed by all accountants where preference shares should be grouped as they have the both elements of ownership and debt. 4. According to cost behaviour This classifies the assets as either fixed cost or variable cost, depending on their expense implications. The fixed cost capital include preference share, long term debt and debentures whereas variable cost capital include equity share and short term liabilities. Firms have different capital structures depending on industry, company type, and proportion of capital contribution.

The theories of capital structure try to ask the pertinent questions in leveraging, valuation, and financial balance. This involves evaluating how a firm can affect its total valuation factoring debt and equity, how debt affects the firm’s position. This is by use of accounting ratios 1  Where  is the firm’s debt yield, assuming the element of perpetuity of debt 2.  [E=EBIT-I] Where we assume 100% dividend payout and the firms earning are constant with no element of growth. Therefore, the earnings/price ratio gives the market discount rate, which equals the present value of the series of expected future dividends at the existing market value of the share. 3.  Where  is the firm’s overall capitalisation rate.

It computation is normally the weighting of the cost of capital as shown below + The theories of capital structure try to explain the relationship between capital, leverage and the firm’s value. What we want to know is what happens to , and when the degree of leverage (D/V) increases or how is the value of capital