Easy Explanation Notes with Examples

Understanding Capital Structure Theories


In corporate finance, capital structure theories examine the relationship of equity financing and debt financing with the market value of a company. In other words, these theories describe how the market value of the company may increase though an optimal combination of equity and debt structure (capital structure).

Net Income Approach

The theory (suggested by David Durand) states that a company may increase market value by lowering its cost of capital, at this point capital structure of the company will be optimal and share price will be at the maximum limit. This is based on the assumptions that after utilizing debt financing, the risk perception of equity holders will not be changed resulting in less cost of equity than debt and there are no taxes.

Net Operating Income Approach

This theory was also propagated by David Durand, opposite to the net income approach. It states that value of a company is irrelevant to capital structure decisions; rather it is ascertained by capitalizing net operating income at the overall cost of capital which assumes to stay constant. So there will be no optimal capital structure because the value of company stays constant.

Traditional Approach

Traditional Approach states that the capital structure affects valuation and cost of capital but like the net income approach its cost of capital does not remain the same. So there will be optimal capital structure when the market value of a company is maximized and weighted average cost of capital is minimized.

Modigliani and Millers (MM) Approach

In the 1950s, Modigliani and Millers develop new approach similar to the net operating income approach which states that value of a company is independent of its capital structure rather it is determined by earning power. The key difference between two approaches that the net operating income does not provide operational evidence for the irrelevance of capital structure, however, Modigliani and Millers Approach does.

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