Capital structure and approaches to capital structure

This document has been incorporated in the comprehensive version of International Convergence of Capital Measurement and Capital Standards: This report presents the outcome of the Basel Committee on Banking Supervision's "the Committee" work over recent years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. Following the publication of the Committee's first round of proposals for revising the capital adequacy framework in Junean extensive consultative process was set in train in all member countries and the proposals were also circulated to supervisory authorities worldwide.

Capital structure and approaches to capital structure

In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Competing capital structure theories explore the relationship between debt financingequity financing and the market value of the firm.

Traditional Approach According to the traditional theorya company should aim to minimize its weighted average cost of capital WACC and maximize the value of its marketable assets.

This approach suggests that the use of debt financing has a clear and identifiable limit. Any debt capital beyond this point will create company devaluation and unnecessary leverage. Managers and financial analysts are required to make certain assumptions under the traditional approach.

For example, the interest rate on debt remains constant during any one period and increases with additional leverage over time. The expected rate of return from equity also remains constant before increasing gradually with leverage. This creates an optimal point at which WACC is smallest before rising again.

Other Approaches One popular alternative to traditional capital structure theory is the Modigliani and Miller approach.

The MM approach has two central propositions.

Capital Structure and its Theories

The second proposition then asserts that financial leverage increases expected future earnings but not the value of the firm. This is because leverage-based future earnings are offset by corresponding increases in the required rate of return. The pecking order theory focuses on asymmetrical information costs.

Capital structure and approaches to capital structure

This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.Ravi Bhagavatula. Ravi is the Founder and a Managing Partner at Excelsior Capital Partners.

He has more than two decades of experience in deal sourcing, deal execution, asset management, operations consulting and C-level management. The capital structure of a company is the way a company finances its assets.

A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a . If someone tells you, “I work in Debt Capital Markets (DCM)”, you might immediately think: Bond.

Investment-grade bond. Or, you might not think of anything at all, since there’s much less information about the debt markets than there is about the equity markets.

Everyone can recall famous IPOs. Advanced Approaches Capital Framework Implementation. The Advanced Approaches capital framework requires certain banking organizations to use an internal ratings-based approach and other methodologies to calculate risk-based capital requirements for credit risk and advanced measurement approaches to calculate risk-based capital requirements for operational risk.

Note: This document has been incorporated in the comprehensive version of International Convergence of Capital Measurement and Capital Standards: A Revised Framework, including the elements of the Accord that were not revised during the Basel II process, the Amendment to the Capital Accord to Incorporate Market Risks, and the paper on The Application of Basel II to Trading.

Capital Structure Theories and its different approaches put forth the relation between the proportion of debt in the financing of a company’s assets, the weighted average cost of capital (WACC) and the market value of the company.

Capital Structure Theory - Modigliani and Miller (MM) Approach