This document discusses theories of capital structure. It summarizes five approaches: [1] Net Income Approach, which suggests that increasing debt lowers cost of capital and increases firm value; [2] Net Operating Income Approach, which argues cost of capital remains constant as debt increases; [3] Traditional Approach, which believes in an optimal capital structure that minimizes cost of capital; [4] Modigliani-Miller Approach, which has two propositions - capital structure does not affect value without taxes, but leverage increases value with taxes. The document provides brief overviews of each theory.
This document discusses theories of capital structure. It summarizes five approaches: [1] Net Income Approach, which suggests that increasing debt lowers cost of capital and increases firm value; [2] Net Operating Income Approach, which argues cost of capital remains constant as debt increases; [3] Traditional Approach, which believes in an optimal capital structure that minimizes cost of capital; [4] Modigliani-Miller Approach, which has two propositions - capital structure does not affect value without taxes, but leverage increases value with taxes. The document provides brief overviews of each theory.
This document discusses theories of capital structure. It summarizes five approaches: [1] Net Income Approach, which suggests that increasing debt lowers cost of capital and increases firm value; [2] Net Operating Income Approach, which argues cost of capital remains constant as debt increases; [3] Traditional Approach, which believes in an optimal capital structure that minimizes cost of capital; [4] Modigliani-Miller Approach, which has two propositions - capital structure does not affect value without taxes, but leverage increases value with taxes. The document provides brief overviews of each theory.
Capital Structure Capital structure is the proportion of all types of capital viz. equity, debt, preference, etc. It is synonymously used as financial leverage or financing mix. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm. Financial leverage is how a business firm employs borrowed money or debts. In financial management, it is an important term, and it is a crucial decision in business. In a company’s capital structure, broadly, there are mainly two types of capital, i.e., Equity and Debt. Out of the two, debt is a cheaper source of finance because the interest rate will be less than the cost of equity, and the interest payments are a tax-deductible expense. Net Income Approach Durand suggested this approach, and he favored the financial leverage decision. According to him, a change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases, and hence the value of the firm increases. Net Operating Income Approach Durand also provides this approach. It is the opposite of the Net Income Approach if there are no taxes. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate that has no relation to the debt- equity ratio. If tax information is given, it recommends that WACC reduces with an increase in debt financing, and the firm’s value will start increasing. Traditional Approach This approach does not define hard and fast facts, and it says that the cost of capital is a function of the capital structure. The unique thing about this approach is that it believes in an optimal capital structure. Optimal capital structure implies that the cost of capital is minimum at a particular ratio of debt and equity, and the firm’s value is maximum. Modigliani and Miller Approach (MM Approach) It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed two propositions. Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not affect the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes. Proposition II: It says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.