Capital structure

theories
M.Subashini
 Four major theories

Net income approach (NI)

Net operating income approach(NOI)
Modigilani - miller approach(MM) and
Traditional approach
 Net income approach (NI)

• Suggested by Durand
• Capital structure decision is relevant to the valuation of the firm
• Higher the debt – decline in the overall cost of capital
• Increase in the value of the firm & increase in the value of equity shares of
the company
• Value of the firm(V) = S+B
• Market value of equity(S) = NI/ke
Net operating income (NOI) approach
• It is the opposite of net income approach
• Market value of the firm is not at all affected by the capital
structure changes
• The market value of the firm is ascertained by capitalising the net
operating income at the overall cost of capital (k)
• Value of the firm(V) = EBIT/k
• Value of equity (S) = V - B
 Modigiliani-Miller approach
• Similar to NOI approach
• The value of the firm is independent of its capital structure
• NOI – definitional or conceptual, not provide operational justification
• MM approach supports NOI approach – behavioural justification
• MM approach maintains the weighted average cost of capital , not change
with change in the debt-equity mix
• MM approach – operational justification
 formula
• Unlevered firm :
Vu = profits available for equity shareholders
equity capitalisation rate
(or) Vu = (1-t)EBT
ke
• Levered firm :
Vi = Vu+Bt
 Traditional approach
• It is the intermediate approach is a mid way between the NOI
& NI approach
• NI: accepts- leverage of the firm affects the cost of capital & its
valuation
not subscribe – the value of the firm increases with all degree
of leverage
• NOI: subscribe – the overall cost of capital increases
decrease in the total value of the firm
Thank you