To maintain financial stability, a firm has to maintain an optimum capital structure . This optimum capital structure can be obtained when the market value per share is the maximum. Therefore, the objective of the firm should be taken to select a financing or debt equity mix which will maximise the value of the firm, optimum leverage can be the mix of debt-equity which maximises the value of a company. In order to achieve this goal, the finance managers has to follow the theories of capital structure of corporate enterprises. There are four major theories which explain the relationship between capital structure, cost of capital and value of the firm. They are:
1) Net Income Approach
2) Net Operating Income Approach
3) Modigliani-Miller Approach (MM)
4) Traditional Approach
In order to understand this relationship, following 9 assumptions are need to be made:
(1) The firm employs only two types of capital I.e debt and equity capital
(2) Taxes are not considered
(3) The firm pays its earnings in full as dividend. There is no returned earnings
(4) The firm’s total assets are given and there is no change in the assets
(5)The firm’s total financing remains constant. The firm can change its capital structure by interchanging the source of finance
(6) The operating profit is not expected to change
(7) The business risk remains constant and it is independent of capital structure and financial risk
(8) The firm has a perpetual life. It means the business is a going concern and it has long life
(9) All the investors has the same subjective probability distribution of the future expected operating profit for a given firm
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