Theories of capital structure

I have already discussed the meaning of capital structure. Today I will discuss the different theories of capital structure.

1.)    Net income approach: this theory is given by Durand. As per the theory the value of firm can be increased and its cost of capital can be reduced by increasing proportion of debt in its capital structure. The approach is based upon following assumptions:-

a)      Cost of debt < cost of equity as interest rate are usually lower than dividend rates.

b)      there are no taxes

      V (value of firm) = S (market value of equity share) + D (market value of debentures)

                            Or

                                       V= EBIT/KO

2.)    Net operating income approach: this theory is also given by Durand. This theory is totally opposite to the net income approach. As per this approach with the change in capital structure there is no change in the value of firm and cost of capital. It means if debt-equity mix is 80:20, 40:60:, 60:40 the cost of capital(ko) remains the same. There is nothing like optimal capital structure. The approach is based upon following assumptions:-

a)      there are no taxes

b)      risk is same at all the levels of debt equity mix.

c)      ko remains constant.

d)      ko = kd

                  V= EBIT/KO

This theory has been criticized on the grounds that ko and kd cannot remains constant at all the levels.

3.)    Traditional approach (intermediate approach): it is a balance between two above discussed approaches. As per this theory of capital structure, initially the value of the firm can be increased as well as cost of capital can be decreased by using more debt as debt is a cheaper source of funds than equity. But after a particular point of time, the cost of equity start increasing.

4.)    Modigliani and miller approach:

In the absence of taxes (net operating income approach): according to this approach the debt equity mix is irrelevant in determining the value of the firm. It is because with the increase in the use of the debt the cost of equity increases. This theory of capital structure assumes:

a)      there are no taxes

b)      there is a perfect market

c)      investors act rationally

d)      no transaction cost

e)      all earning goes to the shareholders

      In the presence of taxes (net income approach): according to this approach cost of capital will decrease and value of the firm increase with the use of debt due to taxes. The optimal capital structure can be achieved by maximizing the debt in the equity.

                            V= EBIT/KO

                                                 =200000/25%

                So value of firm   = 800000

If there are taxes than (1-t)

                           V= EBIT/KO (1-t)

                                                 =200000/25% (1-10%)

                So value of firm   = 720000

Therefore above are the different theories of capital structure.

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