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Theories of capital structure

Different theories have been developed by different authors. The important theories

Are :


(i) Net income approach

(ii) Net operating income approach

(iii) Traditional approach

(iv) Modigliani and Miller approach.

(i)- Net Income Approach


According to NI approach, a firm can minimize the weighted average cost of capital and

it can increase the value of the firm as well as market price of the equity shares by using

more debt content in the company.


This ·approach is based upon the following assumptions.

• The cost of debt is less than the cost of equity.

• There are no corporate taxes.

• The debt content of the firm does not change the risk perception of the investors.


(ii) Net Operating Income Approach


This theory was suggested by Durand. It is entirely opposite to the NI approach. According to this approach, change in the capital structure of the company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. Its implication is that the overall cost of capital remains the same whether the debt equity mix is 50 : 50, or 30 :70 or 10 : 90. Under this approach, all the structures are optimum capital structures. It is based on the following assumptions like

• The market capitalises the value of the firm as a whole.

• The business risk remains constant at each and every level of debt-equity mix.


(iii) Traditional Approach


This approach is also known as Ezra Solomon’s approach. It is the intermediate approach between the net income approach and net operating income approach. According to this  approach, the value of the firm can be increased initially. The cost of capital can be decreased

by using more debt as the debt is a cheaper source of funds than equity. The optimum capital structure can be reached by an appropriate debt equity mix.


(iv) Modigliani and Miller Approach


The Modigliani-Miller approach is similar to the net operating income approach. Under this approach, the value of a firm is independent of its capital structure . . Simply, MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structure of the firm. The argument is based on a simple switching mechanism which is closely called arbitrage.


In the expression of Modigliani and Miller, two firms, identical in all respects except their capital structure, cannot have different market values or cost of capital because of arbitrage process. In case they have different market values or cost of capital, arbitrage will take place and the investors will engage in personal leverage as against the corporate leverage and this will again render the two companies having the same value.


Modigliani and Miller Approach is based on the following assumptions :


(i) There are no transaction costs.

(ii) All the investors are free to buy and sell securities.

(iii) There are no corporate taxes (But this assumption has been removed later).

(iv) There are no retained earnings. However, the dividend pay out ratio is 100%

(v) Borrowings are riskless.


Balanced or Optimum Capital Structure


Optimum or balanced capital structure means an ideal combination of borrowed and owned capital that may achieve the maximisation of market value per share and decrease the cost of capital when the real cost of each source of funds is the same.


Characteristics of a Balanced Capital Structure


(i) Profitability

(ii) Solvency

(iii) Conservatism

(iv)  Effective Control

(v)  Economy

(vi  Attraction to the Investors

(vii) Ease and Simplicity

(viii) Minimum Remuneration.