Capital Structure Theories

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Capital Structure theories What Does Capital Structure Mean? The combination of a company's long-term debt, specific short-term debt, common equity, and preferred equity; the capital structure is the firm's various sources of funds used to finance its overall operations and growth. Debt comes in the form of bond issues or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings. Short-term debt such as working capital requirements also is considered part of the capital structure. The capital structure theory helps us understand the factors most important in the relationship between capital structure and the value of the company. Early view: The Early view is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost, of capital can be reduced by the judicious mix of debt and equity capital. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with average. Thus an optimum capital structure exists and occurs when the cost of capital is minimum or the value of the firm is maximum. The cost of capital declines with leverage because debt capital is chipper than equity capital within reasonable, or acceptable, limit of debt. The weighted average cost of capital will decrease with the use of debt. According to the early position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three stages and this can be seen in the following figure. Criticism: 1. The Early view is criticized because it implies that totality of risk incurred by all security-holders of a firm can be altered by changing the way in which this totality of risk is distributed among the various classes of securities.

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