THEORIES OF CAPITAL STRUCTURE

 THEORIES OF CAPITAL STRUCTURE

1. Net Income Approach:   David Durand

2. Net Operating Income Approach: David Durand

3. The Traditional view (intermediate approach) : Ezra Solomon

4. Modigliani and Miller hypothesis : Modigliani and Miller

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Net income Approach.

 According to this approach, a firm can minimise the weighted average of capital and increase the value of the firm-as well as market price of equity shares by using debt financing to the maximum possible extent.

 The theory propounds that a company can increase its value and decrease the overall cost of capital by increasing the proportion of debt in its capital structure.

Assumptions

(1)The cost of debt is less than the cost of equity

(ii) The risk perception of investors is not changed by the use of debt.

(iii) There are no taxes

On the other hand, 

if the proportion of debt financing in the capital structure is reduced or say when the financial leverage is reduced, the weighted average cost of capital of the firm will increase and the total value of the firm will decrease. 

The Net Income (NI) Approach showing the effect of leverage on overall cost of capital has been presented in the following figure.

The total market value of a firm on the basis of Net Income Approach can be ascertained as below

V=S+D

V= Total market value of a firm

S= Market value of equity shares

Earnings Available to Equity Shareholders (ND)/ Equity Capitalisation Rate

D= Market value of cebt

and, Overall Cost of Capital or Weighted Average Cost of Capital can be calculated as

Ko=EBIT/V

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2) Net Operating Income Approach. This theory as suggested by Durand is another extreme of the effect of leverage on the value of the firm it is diametrically opposite to the net income approach 

According to this approach, change in the capital structure of a company does not affect the market value of the firm, and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the debt equity mix is 50 50 or 20 80 or 0.100. Thus, there is nothing as an optimal capital structure and every capital structure is the optimum capital structure. This theory presumes that

(1) the market capitalises the value of the firm as a whole.

 (ii) the business risk remains constant at every level of debt equity mix, 

(ii) there are no corporate taxes

According to the Net Operating Income (NOI) Approach, 

the financing mix is irrelevant and it does not affect the value of the firm. The NOI approach showing the effect of leverage on the overall cost of capital has been presented in the following figure.

The value of a firm on the basis of Net Operating Income Approach can be determined as below:

EBIT/Кo

V=value of a firm

EBIT=-Net operating income or Earnings before interest and tax Ko} = Overall cost of capital

3) The Traditional Approach

1. This approach, which is also known as intermediate approach, has been popularised by Ezra Solomon.

2. It is a compromise between the two extremes of Net Income Approach and NetOperating Income Approach.

3. According to this approach, cost of capital can be reduced or the value of the firm can

be increased with a judicious mix of debt and equity.

 4. This theory says that cost of capital declines with increase in debt capital upto a

reasonable level, and later it increases with a further rise in debt capital.

The Traditional View

The way in which the overall cost of capital reacts to changes in capital structure can be divided into three stages under traditional position.

Stage I

In this stage, the cost of equity (Ke) and the cost of debt (Kd) are constant and cost of debt is less then cost of equity. The employment of debt capital upto a reasonable level will cause the overall cost of capital to decline due to the low cost advantage of debt.

Stage II

Once the firm has reached a reasonable level of leverage, a further increase in debt will have no effect on the value of the firm and cost of capital . This is because of the fact that a further rise in debt capital increases the risk to equity shareholders which leads to a rise in equity capitalization rate (Ke). The risk in cost of capital exactly offsets the low-cost advantage of debt capital so that the cost of capital remains constant.

Stage (III)

If the firm increases debt capital further and furtherbeyond reasonable level, it will cause an increase in risk to both equity shareholders and debt holders, because of which both cost of equity and cost of debt start rising in this stage. This will in turn will cause an increase in overall cost of capital

4) Modigliani and Miller hypothesis : Modigliani and Miller

The Modigliani-Miller theorem states that a company's capital structure is not a factor in its value. Market value is determined by the present value of future earnings, the theorem states. The theorem has been highly influential since it was introduced in the 1950s.

The Assumptions of M.M. Hypothesis are:

 (i) Perfect capital markets;

(ii) Investors are rational;

(iii) There are no transaction costs;

(iv) Securities are infinitely divisible;

(v) No investor is large enough to influence market price of securities;

(vi) There are no floatation costs.

2. There are no taxes. Alternatively, there are no differences in tax rates between capital gains and dividends

3. A firm has a fixed investment policy which will not change over a period of time. Financing of new investments will not change in the required rate of return

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