THEORIES OF CAPITAL STRUCTURE

There are mainly four theories in capital structure which are follow:

• Net Income Approach
• Net operating income approach
• Traditional approach
• Modigliani and Miller approach

Net Income Approach:

This approach has been suggested by Durand. According to this approach, a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. i.e. If the degree of financial leverage increases, the weighted average cost of capital will decline with every increase in the debt content in total capital employed, while the value of firm will increase. Reserve will happen in a converse situation.

The total market value of firm (V) under the NI approach is determined with the help of the following formula

V = S + D

V= Total market value ; S= Market Value equity share ; D= Market value of debt

Net Operating Income approach:

The approach has been suggested by Durand. According to this approach, the mkt value of the firm is not affected by the captial structure changes. The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital which is constant.

Traditional Approach:

This approach is also known as intermediate approach as it takes a midway between NI & NOI. According to this approach the use of debt up to a point is advantageous. It can help to reduce the overall cost of capital and increase the value of the firm, beyond this point, the debt increases the financial risk of shareholders. As a result, cost of equity also increases, the benefit of debt is neutralized by the increased cost of equity. Thus up to a point, the content of debt in capital structure will be favorable. Beyond that point the use of debt will adversely affect the value of the firm. At the point the capital structure is optimal and the overall cost of capital will be the least.

Modigliani and Miller approach:

Modigliani and Miller have explained the relationship between cost of capital, capital structure and total value of the form under two conditions

(a)When there are no corporate tax

The MM, approach is identical to NOI approach, when there are no corporate taxes. MM argues that in the absence of taxes the cost of capital and value of the form are not affected by capital structure or debt equity mix. They gave a simple argument in support of their approach.

(b)When there are corporate tax

MM agreed that the capital structure will affect the value of the firm and the cost of capital when taxes are applicable to corporate income. If a firm uses debt in its capital structure, the cost of capital will decline and market value of the firm will increase. This because interest is detectable expenses for tax purpose and therefore, the effective cost od debt is less than the contractual rate of interest. A levered firm can therefore have more earnings to its equity shareholder than an unlevered firm. This make debt financing advantageous and value of the levered firm will be higher that of an unlevered firm.

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