CAPITAL

STRUCTURE
THEORIES
Presented By:
Ram Krishan Sharma
MBA (F&C) ||nd Sem.
Roll No. 52
 CAPITAL
STRUCTURE
▪ Capital Structure means a combination of all long-term sources of
finance. It includes Equity Share Capital, Reserves and
Surplus, Preference Share capital, Loan, Debentures and other such
long-term sources of finance.
• A company has to decide the proportion in which it should have
its own finance and outsider’s finance particularly debt finance.
▪ Based on the proportion of finance, WACC and Value of a firm are
affected.
▪ There are four capital structure theories for this, viz. net
income, net operating income, traditional and M&M approach.
• Capital structure is the proportion of all types of capital viz.
equity, debt, preference etc. It is synonymously used as financial
leverage or financing mix.
• Capital structure is also referred to as the degree of debts in the
financing or capital of a business firm.
• The approaches to Capital Structure are :
• Net Operating Income Approach

•
NET OPERATING INCOME
APPROACH (NOI)
• This approach was put forth by Durand and totally differs from the Net
Income Approach.
• Also famous as traditional approach, Net Operating Income Approach
suggests that change in debt of the firm/company or the change in leverage
fails to affect the total value of the firm/company.
• As per this approach, the WACC and the total value of a company are
independent of the capital structure decision or financial leverage of a
company.
• As per this approach, the market value is dependent on the operating
income and the associated business risk of the firm. 
•  Both these factors cannot be impacted by the financial leverage. Financial
leverage can only impact the share of income earned by debt holders and
equity holders but cannot impact the operating incomes of the firm.
NET OPERATING INCOME
APPROACH (NOI)
•  Both these factors cannot be impacted by the financial leverage.
Financial leverage can only impact the share of income earned by
debt holders and equity holders but cannot impact the operating
incomes of the firm.
• Therefore, change in debt to equity ratio cannot make any change
in the value of the firm.
•
FEATURES OF NET OPERATING
INCOME APPROACH
▪ The overall capitalization rate remains constant irrespective of the degree
of leverage. At a given level of EBIT, the value of the firm would be
“EBIT/Overall capitalization rate” .
▪ Value of equity is the difference between total firm value less value
of debt i.e. Value of Equity = Total Value of the Firm – Value of Debt.
▪ WACC (Weightage Average Cost of Capital) remains constant; and
with the increase in debt, the cost of equity increases. An increase in
debt in the capital structure results in increased risk for shareholders.
As a compensation of investing in the highly leveraged company, the
shareholders expect higher return resulting in higher cost of equity
capital.
TRADITIONAL APPROACH
▪ The traditional approach to capital structure suggests that there exist an
optimal debt to equity ratio where the overall cost of capital is the minimum
and market value of the firm is the maximum.
▪ On either side of this point, changes in the financing mix can bring positive
change to the value of the firm. Before this point, the marginal cost of debt is
less than a cost of equity and after this point vice-versa. 
▪ 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.
▪ While Net Income Approach and Net Operating Income Approach are
the two extremes Approach are the two extremes, traditional approach,
advocated by Ezta Solomon and Fred Weston is a midway approach also
known as “intermediate approach”.
ASSUMPTION TO
TRADITIONAL APPROACH
▪ The rate of interest on debt remains constant for a certain period and
thereafter with an increase in leverage, it increases.
▪ The expected rate by equity shareholders remains constant or increase
gradually. After that, the equity shareholders starts perceiving a
financial risk and then from the optimal point and the expected rate
increases speedily.
▪ As a result of the activity of rate of interest and expected rate of return,
the WACC first decreases and then increases. The lowest point on the
curve is optimal capital structure. 
MODIGLIANI AND MILLER
APPROACH
(MM APPROACH)
▪ The Modigliani and Miller approach to capital theory, devised in the
1950s, advocates the capital structure irrelevancy theory. This suggests
that the valuation of a firm is irrelevant to the capital structure of a
company. 
▪ The fundamentals of the Modigliani and Miller Approach resemble
that of the Net Operating Income Approach. 
▪ Modigliani and Miller advocate capital structure irrelevancy theory,
which suggests that the valuation of a firm is irrelevant to the capital
structure of a company. Whether a firm is highly leveraged or has a
lower debt component in the financing mix has no bearing on the
value of a firm.
ASSUMPTIONS TO
MODIGLIANI & MILLER
APPROACH
▪ There are no taxes.
▪ Transaction cost for buying and selling securities, as well as the
bankruptcy cost, is nil.
▪ There is a symmetry of information. This means that an investor will
have access to the same information that a corporation would and
investors will thus behave rationally.
▪ The cost of borrowing is the same for investors and companies.
▪ There is no floatation cost, such as an underwriting commission,
payment to merchant bankers, advertisement expenses, etc.
▪ There is no corporate dividend tax.
MM APPROACH PROPOSITIONS
WITHOUT TAX
▪ PROPOSITION 1
With the above assumptions of “no taxes”, the capital structure does not
influence the valuation of a firm. In other words, leveraging the company does
not increase the market value of the company. It also suggests that debt holders
in the company and equity shareholders have the same priority, i.e., earnings
are split equally amongst them.
▪ PROPOSITION 2
It says that financial leverage is in direct proportion to the cost of equity. With
an increase in the debt component, the equity shareholders perceive a higher
risk to the company. Hence, in return, the shareholders expect a higher return,
thereby increasing the cost of equity. A key distinction here is that Proposition
2 assumes that debt shareholders have the upper hand as far as the claim on
earnings is concerned. Thus, the cost of debt reduces.
MM APPROACH PROPOSITIONS
WITH TAX
▪ This theory is also called ‘The trade off theory of leverage’.
▪ The Modigliani and Miller Approach assumes that there are no taxes, but
in the real world, this is far from the truth. Most countries, if not all, tax
companies. This theory recognizes the tax benefits accrued by interest
payments. 
▪ The interest paid on borrowed funds is tax deductible. However, the same
is not the case with dividends paid on equity. In other words, the actual
cost of debt is less than the nominal cost of debt due to tax benefits
▪ This approach with corporate taxes does acknowledge tax savings and
thus infers that a change in the debt-equity ratio has an effect on the
WACC (Weighted Average Cost of Capital).
THANK YOU!