The Capital Structure Policy in Perfect Financial Markets Assignment Help

Here Is a List of the Different Capital Structure Theories

The systematic way in which various business activities are financed in the field of Financial Management is referred to as capital structure theory. These business activities are managed using liabilities as well as equities together. It is these capital theories that help in finding out the relationship between equity financing, debts financing as well as market value of the company.

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There have been several theories of capital structure, and in order to properly use funds, it is important for companies to be able to properly adjust to changing environments.

Theories of Capital Structure

Modigliani and Miller’s theory

The earlier theories of capital structure have assumed a lot of things in order to simplify the different problems. One of these assumptions was that costs of debt, as well as cost of equity, are isolated from a capital structure, and the most important figure that needs to be taken into account is income of the firm.

With the help of these assumptions cost of the capital will be decreased by making use of the leverage and firm value will be improved. In this case, the value of equity will remain the same. According to Modigliani and Miller, this cannot be true.

They say that two similar kinds of business which only have differences in their capital structure should be able to able to have same total values. If values would be different, then there would be a lot of problems among individuals and they would try to make these values same.

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Trade-off theory

This is basically a group of theories that are associated with each other and in this theory; it is the decision maker who tries to find advantages and costs of different alternative leverage plans. According to this theory, you can only get benefits of controlling if you are able to achieve an ideal capital structure.

The theory also recognizes tax benefits that you get from payment of your interest. Here there are two important concepts -one is agency cost and the second is the cost of financial distress. This theory mainly states that all businesses are funded by equity as well as debt.

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