There is nothing like optimum capital structure for a firm. The Optimal Capital structure is that Capital Structure at which the weighted Average cost of capital (Ko) is Minimum. It is that combination of Equity and Debt at which the total cost of capital is mini-mum. Trade-off theory argues that there’s an optimal amount of debt of each firm.
At this level of debt, firms can take the most advantage of debts. Debts can be tax shield so that they can save money for firms to reinvest in other projects so as to earn more profits.However, debts can be quite dangerous because highly leveraged firms may face bankruptcy and financial distress costs (no matter they’re direct or indirect) may increase the cost of debt of the company. Therefore, there must be a level of debt that make the benefits of debt and potential danger of debt offset each other. In another word, the marginal revenue of debt equals the marginal cost of debt.
But remember, the real cases are not as easy as we put here.When a firm procures funds from investors or owners, there will be an explicit or implicit promise to pay return to them. The return is paid in terms of interest which is compulsory paid to all investors and owners, but the return paid to owners in the form of dividends is optional. The dividend decision by any firm, like the investment and financing decisions is also taken for maximization of market price of the share.
The term dividend refers to that the portion of profit (after tax) which is distributed among own-ers/shareholders of the firm and the profit which is not distributed is called as retained earnings Dividend Payout Ratio is determined by the dividend policy adopted by the company, and it is im-plemented to decide about the percentage of profits to be distributed by the firm to its own-ers/shareholders. Dividend is always depends on the total profit that a firm acquired after taxes. There are a few factors that affect the Dividend policy of a company.They are Liquidity , Growth Plans and Control Dividend Payout Ratio is also called as DP Ratio which is a mathematical value as DP Ratio = Dividend paid to the Shareholders / Net Profit after tax.
Capital Structural Theories Capital structural theories are designed with a concept of valuation of the firm; it is the earnings of the firm and the investments made by the firm. Capital Structural Theories also used to find the dividend pay-out for its owners/shareholders. Cost of the capital, investment and return on investment (ROI) are a part of dividend policy.The relationship between leverage cost of capital and the value of the firm can be analysed in different ways. Factors determining Capital Structure are minimization of risk, control, flexibility and the profitability of the firm. A firm’s capital structure is a combination of the firm’s liabilities (debts) and the assets (equity and profits).
For Example: A firm with 100 billion as capital structure has 40 billion from equity (shareholders and owners) and the 60 million as debt (Loans and Funding), then the firm is said to be 40% – equity fi-nanced and 60% – debt financed. . Traditional Theories Net Operating Income (NOI) approach is just an opposite of NI approach.
According to the NOI ap-proach, the market value of the firm depends upon the net operating income or profit and the overall cost of capital. NOI approach is based on the argument that the market values the firm as a whole for a given risk complexion. Thus, for a given value of the firm remain the same irrespective of the capital composition and instead on the overall cost of capital.Mathematically Net Operating Income (NOI) is Value of the Firm = Earnings before Tax / Cost of Equity Capital Net Operating Income approach says that an increase in debt proportion of the capital source will always result in increase of the equity proportion of the firm.
Modigliani-Miller Model Modigliani-Miller model which was presented in the year of 1958 on the relationship of leverage, cost of capital and the value of the firm. This is widely used capital structure method to analyze the value of the firm.They have shown that the financial leverage doesn’t matter and the cost of capital and the value of the firm are independent of the capital structure. Modigliani-Miller methods show that there is nothing which may be called as Optimal Capital Structure – to get high valuation of the firm. Modigliani-Miller model is based on following assumptions: 1.
The capital markets are perfect and complete information is available to all the investors free of cost. The implication of this assumption is that investors can borrow and lend funds at the same rate and can move quickly from one security to another, 2.Securities are infinitely divisible; Investors are rational and well informed about the risk-return of all the securities. Modigliani-Miller model says that the total value of the firm is equal to the capitalized value of the operating earnings of the firm. The capitalization is to be made at a rate appropriate to the risk class of the firm.
Growth Plans, are involved in capital structural theories in which a certain amount will be allocated for the growth plans. A finance manager should draw a plan according for the dividend policy.For Example: The firm has $10 million as equity capital and $6 million as debt capital and the firm made a profit (after tax) of $2 million, and the fund allocated to the growth plan was $1 million. For suppose there are 10,000 shareholders in the company and as per capital structural theories some amount will be allocated for the liquidity that is five hundred thousand and the remaining amount should be distributed as Dividends. In this case each shareholder or the owner will receive $50 as dividend.Capital structural theories say that if a firm is in profit and it is looking to expand the business, the profit can be rolled over to the investment option.
In this case there will be no dividends or bonuses issued to the shareholders or the owners. For Example: Low-payout consequences, which is done when the cash gets accumulated the finan-cial manager may be tempted to take on more projects that do don’t meet the minimum rate of return investments. If a firm has $1 million as operating income with 1000 shareholders and firms adopts to take new projects with the profit.Then this may cause unrelated relationship balances between the share-holders and the management of the firm. Optimal Capital Structure: Even though Modigliani-Miller Model says that there is nothing like Opti-mal Capital Structure, but the non-traditional methods say that a firm can attain profits only by im-plementing Optimal Capital Structure. Some firms adopt this capital structure to minimize the risk, flexibility on the investments and the profitability.
The finance manager should be able to identify that optimal point (profit point) for the firm precisely, but not to attempt to track the optimal range for the capital structure. Optimal Capital Structure differs from different firms, Existing Firm and a New Firm. For Example: Existing Firm may require additional capital funds for meeting the requirements of growth, expansion, and diversification or even for working capital management. The decision for a particular source of funds is to be taken in the totality of capital structure, i. e. n the light of the re-sultant capital structure after the proposed issue of capital or debt. The Capital Structure of the new firm is designed in the initial stages of the firm and the financial manager has to take care if many considerations, the present capital structure be designed in the light of a future target capital structure.
Future plans, growth and diversifications strategies should be considered and factored in the analysis, so optimal capital structure greatly influences the divi-dend policy of any firm, depending upon there capital structure.Broadly speaking the dividend policy can be determined by two basic analyses required to find the valuation of the proposed capital structure of the firm, i. e. one from the point of view of profitability and another from view of liquidity. Capital structure will always determine the profits of the firm and the development of the firm. Equity and Debt capital are well managed by the capital structure of the firm. A well designed capital structure will have a very good impact on the dividend policy of the company.