Capital structure Theories describe the relationship between capital structure, cost of capital and the value of the firm.
Capital structure is the mix of long-term sources and it includes equity capital, preference shares and long-term debt capital. The capital structure must be decided in a way that it protects the owner’s interest by assuming an optimal return continuously.
Assumptions of Capital Structure Theories
- There are only two sources of finance i.e. debt and equity.
- There are no taxes.
- Entire earnings are distributed as dividends; the dividend payout ratio is 100%.
- There are no retained earnings.
- The company has an infinite life.
- The operating profit (EBIT) is given and is not expected to grow.
- Total assets of the company are given and are not expected to change.
- Business risk is constant over time and is independent of capital structure and financial risk.