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Capital Structure Theory:

• Net Income Approach ( N I Approach)


• Net Operating Income Approach (NOI Approach)
• Traditional Theory or Approach.
• Modigliani – Miller Model (M – M Model)
Assumptions
1) The firm employs only two types of capital- debt and equity – there are no pref. shares
2) There are no corporate tax. This assumption is removed later.
3) The firm pays 100% of its earnings as dividend and hence there are no retained earnings.
4) The firms total assets are given and they do not change i.e. the investment decisions are
assumed to be constant.
5) The firms total financing remains constant. The firm can change its capital structure
either by redeeming the debenture by issue if share or by raising more debt and reduce
the equity share capital
6) The operating profit (EBIT) are not expected to grow
7) The business risk remains constant and is independent of capital structure and financial
risk
8) All investors have the same subjective probability distribution of the future expected
operating earnings for a given firm.
9) The firm has a perpetual life
Net Income Approach:
This approach is proposed by David Durand. According to this approach a higher debt
content in the capital structure (use of leverage) will result in decline in the overall or weighted
average cost of capital. This will increase the value of the firm which in-turn increases the value
of equity shares of the company. Thus significance of this approach is that, a firm can lower its
cost of capital continually and increase its total valuation by the use of debt funds. Therefore
with increased use of leverage, overall cost of capital declines and total value of the firm rises.
Thus, NI approach indicates that change in the capital structure causes a corresponding changes
in the overall cost of capital as well as the total value of the firm.
Assumptions of NI Approach
1) There are no corporate taxes
2) The cost of debt is less than cost of equity
3) The debt content does not change the risk perception of the investors.
Value of the firm under NI Approach
V=S+B
V = Value of the firm
S = Mkt value of equity
B = Mkt value of Debt
Mkt value of equity = S = NI/Ke

S = mkt value of equity


NI = Earnings available to equity share holders
Ke = Equity capitalization rate
Net Operating Income Approach (NOI Approach)
This approach is also suggested by David Durand. This is just opposite of NI approach.
According this approach total value of the firm remains unaffected by its capital structure. Any
change in leverage will not lead to any change in total value of the firm and the mkt price of the
shares as well as the overall cost of capital is independent of the degrees of leverage.
Assumptions of NOI Approach
1. The overall cost of capital (k) remains constant for all degree of debt equity mix or
leverage.
2. The market capitalizes the value of the firm as a whole and therefore, the split between
debt and equity is not relevant.

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3. The use of debt having low cost increases the risk of equity shareholders. This results in
increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by
increase in the equity capitalization rate.
4. There are no corporate tax
Value of the firm = V = EBIT / K
V = value of the firm
K = Overall cost of capital
Value of Equity = S = V – B
S = Value of equity
V = Value of firm
B = Value of debt
Traditional Approach
The traditional approach or the intermediate approach is a midway between NI and NOI
approaches. According to this approach, upto a certain point, a firm can, by increasing
proportion of debt in its capital structure reduce cost of capital and raise market value of the
stock. Beyond that point, further induction of debt will increase the cost of capital and decrease
the market value of the stock. Thus, through a judicious mix of debt and equity the firm can
minimize overall cost of capital and maximize value of stock. At this level of debt equity mix,
the capital structure will be optimum.
Modigliani – Miller Approach ( M – M Approach)
According to M – M Model cost of capital and value of the firm remain unaffected by
leverage employed by the firm. They are of the opinion that any rational choice of debt and
equity would result in the same cost of capital under their assumptions and that there is no
optimal mix of debt and equity financing. Thus, M – M approach maintains that the weighted
average cost of capital does not change with change in the debt equity mix or capital structure
of the firm.
Main Propositions of the Theory:
1. The overall cost of capital (k) and the value of the firm (v) are independent of the capital
structure – k & v are constant for all levels of debt equity mix.
2. The cost of equity (ke) is equal to capitalization rate of the pure equity stream plus a
premium for the financial risk. The financial risk increases with more debt content in the
capital structure. As a result, the ke increases in a manner to off set exactly the use of a
less expensive source of funds represented by debt.
3. The cut off rate for investment purposes is completely independent of the way in with an
investment is financed.
Assumptions of M – M Approach:
1. Capital Markets are perfect which means investors are free to buy and self securities, they
can borrow without any restrictions on the same terms on which the firm can borrow,
they are well informed and behave rationally. There are no transaction cost.
2. The firm can classified into homogeneous risk classes. All firms within the same class
will have the same degree of business risk.
3. All investors have the same expectations of a firms net operating income (EBIT) with
which to evaluate the value of any firm
4. The dividend pay out ratio is 100%
5. There are no corporate taxes
Limitations:
1. Rates of interest are not the same for individuals and the firms.
2. Home made leverage is not perfect substitute for corporate leverage.
3. Transaction costs involved.
4. Institutional restrictions
Corporate taxes frustrate M – M Hypothesis

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