The Important Theories of Capital Structure are given below:
1. Net Income Approach:
According to this approach, a firm can minimise the weighted average, cost 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 reduces the overall cost of capital by increasing the proportion of debt in its capital structure. This approach is based upon the following assumptions:
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(i) The cost of debt is less than the cost of equity
(ii) There are no taxes.
(iii) The risk perception of investors is not changed by the use of debt.
The line of argument in favour of net income approach is that as the proportion of debt financing in capital structure increases, the proportion of a cheaper source of funds increases.
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This results in the decrease in overall (weighted average) cost of capital leading to an increase in the value of the firm. The reasons for assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than dividend rates due to element of risk and the benefit of tax as the interest is a deductible expense.
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. 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
(i) The market capitalises the value of the firm as a whole and
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(ii) The business risk remains constant at every level of debt equity mix.
The reasons propounded for such assumptions are that the increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of debt remains constant with the increasing proportion of debt as the financial risk of the lenders is not affected.
Thus, the advantage of using the cheaper source of funds, i.e., debt is exactly offset by the increased cost of equity.
3. The Traditional Approach:
The traditional approach, also known as Intermediate approach, is a compromise between the two extremes of net income approach and net operating income approach.
According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Thus, optimum capital structure can be reached by a proper debt-equity mix.
Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt.
Thus, overall cost of capital, according to this theory, decreases upto certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases or rises beyond a certain point. Even the cost of debt may increase at this state due to increased financial risk.
4. Modigliani and Miller Approach:
M & M hypothesis is identical with the Net Operating Income approach it taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income Approach.
(a) In the absence of taxes:
The theory proves that the cost of capital is not affected by changes in the capital structure or says that the debt-equity mix is irrelevant in the determination of the total value of a firm.
The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases. This increase in cost of equity offsets the advantage of the low cost of debt.
Thus, although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The theory emphasises the fact that a firm’s operating income is a determinant of its total value. The theory further propounds that beyond a certain limit of debt, the cost of debt increases (due to increased financial risk) but the cost of equity falls thereby again balancing the two costs.
In the opinion of Modigliani & Miller, two identical firms in all respects except their capital structure cannot have different market values or cost of capital because of arbitrate process.
In case two identical firms except of their capital structure have different market values or cost of capital, arbitrate will take place and the investors will engage in ‘personal leverage’ (i.e., they will buy equity of the other company in preference to the company having lesser value) as against the corporate leverage’; and this will again render the two firms to have the same total value.
The M & M approach is based upon the following assumptions:
(i) There are no corporate taxes.
(ii) There is a perfect market.
(iii) Investors act rationally.
(iv) The expected earnings of all the firms have identical risk characteristics.
(v) The cut-off point of investment in a firm is capitalisation rate.
(vi) Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates.
(vii) All earnings are distributed to the shareholders.
(b) When the corporate taxes are assumed to exist:
Modigliani and Miller, in their article of 1963 have recognised that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum capital structure can be achieved by maximising the debt mix in the equity of a firm.