Net Income Approach
The net income approach to capital structure theory is based on several assumptions, including:
- The company’s future net income is known. This assumption is not always realistic, as the future is uncertain.
- The cost of debt and equity is known. This assumption is also not always realistic, as the cost of debt and equity can change over time.
- The company’s capital structure is fixed. This assumption is not always realistic, as companies can change their capital structure over time.
- The company’s debt and equity are not perfectly correlated. This assumption is necessary to ensure that the company’s value is not affected by the risk of its debt.
Net Operating Income Approach
The net operating income (NOI) approach to capital structure theory is based on several assumptions, including:
- The company’s future net operating income is known. This assumption is not always realistic, as the future is uncertain.
- The cost of debt and equity is known. This assumption is also not always realistic, as the cost of debt and equity can change over time.
- The company’s capital structure is fixed. This assumption is not always realistic, as companies can change their capital structure over time.
- The company’s debt and equity are not perfectly correlated. This assumption is necessary to ensure that the company’s value is not affected by the risk of its debt.
Trade-off Theory
The trade-off theory to capital structure theory is based on several assumptions, including:
- The company’s debt and equity are priced according to their risk. This assumption is necessary to ensure that the company’s cost of capital is minimized.
- The company’s capital structure is determined by a trade-off between the tax benefits of debt and the risk of bankruptcy. This assumption is necessary to ensure that the company’s value is maximized.
- The company’s capital structure is fixed. This assumption is not always realistic, as companies can change their capital structure over time.
Pecking Order Theory
The pecking order theory to capital structure theory is based on several assumptions, including:
- Companies prefer to finance their operations with internal funds. This assumption is based on the idea that internal funds are cheaper than external funds.
- Companies prefer to use debt before equity. This assumption is based on the idea that debt is less risky than equity.
- Companies only issue equity if they have no other choice. This assumption is based on the idea that equity dilutes the ownership of the existing shareholders.
It is important to note that these are just some of the assumptions that are made in the different approaches to capital structuring. The specific assumptions that are made will vary depending on the approach that is being used.