There are several theories and approaches to capital structuring. Some of the most common theories include:
- Modigliani-Miller Theory: This theory states that the value of a company is not affected by its capital structure. This is because the cost of equity will increase as the company uses more debt, and the cost of debt will decrease as the company uses more equity. These two effects will offset each other, and the overall value of the company will not change.
- Trade-off Theory: This theory states that there is an optimal capital structure for a company. This optimal capital structure is the one that minimizes the company’s cost of capital. The trade-off theory argues that there are two factors that affect the cost of capital: the risk of the company and the amount of debt that the company uses. As the company uses more debt, its risk will increase, and its cost of capital will also increase. However, the company will also be able to save money on interest payments. The trade-off theory argues that there is an optimal level of debt that minimizes the company’s cost of capital.
- Pecking Order Theory: This theory states that companies prefer to finance their operations with internal funds, then debt, and then equity. The pecking order theory argues that companies are reluctant to issue equity because it dilutes the ownership of the existing shareholders. Companies will only issue equity if they have no other choice.
These are just some of the most common theories and approaches to capital structuring. The optimal capital structure for a company will vary depending on the specific factors that affect the company.
Here are some of the additional things to keep in mind about the theories/approaches on capital structuring:
- The theories on capital structuring are not always accurate. The real world is more complex than the theories, and there are many factors that can affect the value of a company.
- The theories on capital structuring are just guidelines. Companies should use the theories as a starting point, and then adjust their capital structure based on their specific circumstances.
- The theories on capital structuring are constantly evolving. As new research is conducted, the theories on capital structuring may need to be revised.