Capital Structure Theories

Capital structure is the major part of the firm’s financial decision which affects the value of the firm and it leads to change EBIT and market value of the shares. There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure is to maximize the value of the firm and to reduce the cost of capital.

There are two major theories explaining the relationship between capital structure, cost of capital and value of the firm.

Traditional Approach

It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt. Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and when reaching the minimum level, it starts increasing with financial leverage.

Assumptions

Capital structure theories are based on certain assumption to analysis in a single and convenient manner:

• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.

Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm.

According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm.

Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.

where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt

Market value of the equity can be ascertained by the following formula:
S = NI/Ke

where
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate

Net Operating Income (NOI) Approach

Another modern theory of capital structure, suggested by Durand. This is just the opposite to the Net Income approach. According to this approach, Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital structure changes.

According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital.

• NI approach is based on the following important assumptions;
• The overall cost of capital remains constant;
• There are no corporate taxes;
• The market capitalizes the value of the firm as a whole;

Value of the firm (V) can be calculated with the help of the following formula

V= EBIT/Ko

where,
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market. In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structures of the firm.

Modigliani and Miller approach is based on the following important assumptions:

• There is a perfect capital market.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.

Value of the firm can be calculated with the help of the following formula:

V = EBIT / Ko x (l - t)

where
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
t = Tax rate