CAPITAL STRUCTURE

THEORIES

SUBMITTED BY
J.JAYASUBANILA
1911041
INTRODUCTION

Capital structure is the mix of owner-supplied capital (equity, reserves, surplus) and
borrowed capital (bonds, loans) that a firm uses to finance business operations. Whether to
finance through debt, equity, or a combination of both is a result of several factors. These
include business risks, management style, control, exposure to taxes, financial flexibility, and
market conditions.

The capital structure theories explore the relationship between your company's use of debt
and equity financing and the value of the firm. In financial management, capital
structure theory refers to a systematic approach to financing business activities through a
combination of equities and liabilities. There are several competing capital structure theories,
each of which explores the relationship between debt financing, equity financing, and
the market value of the firm slightly differently.

The following are the theories which we are going to see

 Net Income
 Net Operating Income
 Traditional
 Modigliani & Miller (MM)
 Pecking Order Theory
 CAPITAL STRUCTURE THEORIES

NET INCOME APPROACH

Net Income Approach was presented by Durand. The theory suggests increasing value of the
firm by decreasing the overall cost of capital which is measured in terms of Weighted
Average Cost of Capital. This can be done by having a higher proportion of debt, which is a
cheaper source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where the weights are the amount of capital raised from each source.

According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value
of the company. The Net Income Approach suggests that with the increase in leverage
(proportion of debt), the WACC decreases and the value of firm increases. On the other hand,
if there is a decrease in the leverage, the WACC increases and thereby the value of the firm
decreases.

ASSUMPTIONS OF NET INCOME APPROACH

Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources of
finance like Prefrence Share Capital and Retained Earning.
 All companies have uniform dividend pay out ratio; it is 1.
 There is no flotation cost, no transaction cost and corporate dividend tax.
 Capital market is perfect, it means information about all companies are available to all
investors and there are no chances of over pricing or under pricing of security. Further it
means that all investors are rational. So, all investors want to maximize their return with
minimization of risk.
 All sources of finance are for infinity. There are no redeemable sources of finance.

EXAMPLE

Consider a fictitious company with below figures. All figures in USD.

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

Cost of Equity = 14%

 EBIT = 100,000

Less: Interest cost (10% of 300,000) = 30,000

Earnings (since tax is assumed to be

absent) = 70,000

Shareholders’ Earnings = 70,000

Market value of
Equity (70,000/14%) = 500,000

Market value of Debt = 300,000

Total Market value = 800,000

EBIT/(Total value of
= firm)

= 100,000/800,000

Overall cost of capital = 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything
else remains same.

(EBIT)
= 100,000

Less: Interest cost (10% of 400,000)

= 40,000

Earnings (since tax is assumed to be

absent)
= 60,000

Shareholders’ Earnings
= 60,000

Market value of Equity (60,000/14%)

= 428,570 (approx)

Market value of Debt

= 400,000

Total Market value

= 828,570

Overall cost of capital = EBIT/(Total value of

 firm)

= 100,000/828,570

= 12% (approx)

As observed, in case of Net Income Approach, with increase in debt proportion, the total
market value of the company increases and cost of capital decreases. Reason for this
conclusion is that assumption of NI approach that irrespective of debt financing in capital
structure, cost of equity will remain same. Further, cost of debt is always lower than cost of
equity, so with increase in debt finance WACC reduces and value of firm increase.

NET OPERATING INCOME APPROACH

This approach was put forth by Durand and totally differs from the Net Income Approach.
Also famous as traditional approach, Net Operating Income Approach suggests that change in
debt of the firm/company or the change in leverage fails to affect the total value of the
firm/company. As per this approach, the WACC and the total value of a company are
independent of the capital structure decision or financial leverage of a company.

As per this approach, the market value is dependent on the operating income and the
associated business risk of the firm. Both these factors cannot be impacted by the financial
leverage. Financial leverage can only impact the share of income earned by debt holders and
equity holders but cannot impact the operating incomes of the firm. Therefore, change in debt
to equity ratio cannot make any change in the value of the firm.
It further says that with the increase in the debt component of a company, the company is
faced with higher risk. To compensate that, the equity shareholders expect more returns.
Thus, with an increase in financial leverage, the cost of equity increases.

ASSUMPTIONS / FEATURES OF NET OPERATING INCOME APPROACH:

1. The overall capitalization rate remains constant irrespective of the degree of leverage.
At a given level of EBIT, the value of the firm would be “EBIT/Overall capitalization rate” 
2. Value of equity is the difference between total firm value less value of debt i.e. Value
of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weightage Average Cost of Capital) remains constant; and with the increase
in debt, the cost of equity increases. An increase in debt in the capital structure results in
increased risk for shareholders. As a compensation of investing in the highly leveraged
company, the shareholders expect higher return resulting in higher cost of equity capital.

EXAMPLE

Consider a fictitious company with below figures. All figures in USD. 

Earnings before Interest Tax (EBIT) = 100,000

 Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

WACC = 12.5%

Calculating the value of the company:

(EBIT) = 100,000

WACC = 12.5%

= EBIT/WACC

= 100,000/12.5%

Market value of the company = 800,000

Total Debt = 300,000

= Total market value – total debt

= 800,000-300,000

Total Equity = 500,000

= EBIT-interest on debt

= 100,000-10% of 300,000

Shareholders’ earnings = 70,000

= 70,000/500,000

Cost of equity = 14%

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything
else remains same.
 (EBIT) = 100,000

WACC = 12.5%

= EBIT/WACC

= 100,000/12.5%

Market value of the company = 800,000

Total Debt = 400,000

= Total market value – total debt

= 800,000-400,000

Total Equity = 400,000

= EBIT-interest on debt

= 100,000-10% of 400,000

Shareholders’ earnings = 60,000

= 60,000/400,000

Cost of equity = 15%

As observed, in the case of Net Operating Income approach, with the increase in debt
proportion, the total market value of the company remains unchanged, but the cost of equity
increases.

TRADITIONAL APPROACH

The traditional approach to capital structure advocates that there is a right combination of
equity and debt in the capital structure, at which the market value of a firm is maximum. As
per this approach, debt should exist in the capital structure only up to a specific point, beyond
which, any increase in leverage would result in the reduction in value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the WACC is the
lowest and the market value of the firm is the highest. Once the firm crosses that optimum
value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC.
 Above the threshold, the WACC increases and market value of the firm starts a downward
movement.

ASSUMPTIONS UNDER TRADITIONAL APPROACH: 

1. The rate of interest on debt remains constant for a certain period and thereafter with
an increase in leverage, it increases. 
2. The expected rate by equity shareholders remains constant or increase gradually.
After that, the equity shareholders starts perceiving a financial risk and then from the optimal
point and the expected rate increases speedily.
3. As a result of the activity of rate of interest and expected rate of return, the WACC
first decreases and then increases. The lowest point on the curve is optimal capital structure. 

EXAMPLE

Consider a fictitious company with the following data.

Particulars Case 1 Case 2  Case 3 Case 4 Case 5

Weight  of debt 10% 30% 50% 70% 90%

Weight  of equity 90% 70% 50% 30% 10%

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

WACC 16.3% 15.9% 15.5% 16.1% 16.7%

From case 1 to case 3, the company increases its financial leverage and as a result, the debt
increases from 10% to 50% and equity decreases from 90% to 50%. The cost of debt and
equity also rise as stated in the table above because of the company’s higher exposure to risk.
The new WACC is decreased from 16.3% to 15.5%.

MODIGILANI AND MILLER APPROACH

This approach was devised by Modigliani and Miller during the 1950s. The fundamentals of
the Modigliani and Miller Approach resemble that of the Net Operating Income Approach.
Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the
valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is
highly leveraged or has a lower debt component in the financing mix has no bearing on the
value of a firm.
The Modigliani and Miller Approach further states that the market value of a firm is affected
by its operating income, apart from the risk involved in the investment. The theory stated that
the value of the firm is not dependent on the choice of capital structure or financing decisions
of the firm

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

 There are no taxes.
 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is
nil.
 There is a symmetry of information. This means that an investor will have access to
the same information that a corporation would and investors will thus behave
rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
 There is no corporate dividend tax.

PROPOSITION WITHOUT TAXES

PROPOSITION 1

The capital structure does not influence the valuation of a firm. In other words, leveraging the
company does not increase the market value of the company. It also suggests that debt
holders in the company and equity shareholders have the same priority, i.e., earnings are split
equally amongst them.

PROPOSITION 2

It says that financial leverage is in direct proportion to the cost of equity. With an increase in
the debt component, the equity shareholders perceive a higher risk to the company. Hence, in
return, the shareholders expect a higher return, thereby increasing the cost of equity. 

PROPOSITION WITH TAXES

This theory recognizes the tax benefits accrued by interest payments. The interest paid on
borrowed funds is tax deductible. However, the same is not the case with dividends paid on
equity. In other words, the actual cost of debt is less than the nominal cost of debt due to tax
benefits. Therefore change in debt component can affect value of a firm.

PECKING ORDER THEORY

Pecking order theory is a theory related to capital structure. It was initially suggested by
Donaldson. In 1984, Myers and Majluf modified the theory and made it popular.According to
this theory, managers follow a hierarchy to choose sources of finance. The hierarchy gives
first preference to internal financing. If internal financing is not enough, then managers
would have to shift to external sources. They will issue debt to generate funds. After a point
when it is no longer practical to issue more debt, equity is issued as a last option.

The pecking order theory arises from the concept of asymmetric information. Asymmetric
information, also known as information failure, occurs when one party possesses more
(better) information than another party, which causes an imbalance in transaction power.

Company managers typically possess more information regarding the company’s

performance, prospects, risks, and future outlook than external users such as creditors (debt
holders) and investors (shareholders). Therefore, to compensate for information asymmetry,
external users demand a higher return to counter the risk that they are taking. In essence, due
to information asymmetry, external sources of finances demand a higher rate of return to
compensate for higher risk.

In the context of the pecking order theory, retained earnings financing (internal financing)

comes directly from the company and minimizes information asymmetry. As opposed to
external financing, such as debt or equity financing where the company must incur fees to
obtain external financing, internal financing is the cheapest and most convenient source of
financing.

When a company finances an investment opportunity through external financing (debt or

equity), a higher return is demanded because creditors and investors possess less information
regarding the company, as opposed to managers. In terms of external financing, managers
prefer to use debt over equity – the cost of debt is lower compared to the cost of equity.

The issuance of debt often signals an undervalued stock and confidence that the board
believes the investment is profitable. On the other hand, the issuance of equity sends a
negative signal that the stock is overvalued and that the management is looking to generate
financing by diluting shares in the company.

When thinking of the pecking order theory, it is useful to consider the seniority of claims to
assets. Debtholders require a lower return as opposed to stockholders because they are
entitled to a higher claim to assets (in the event of a bankruptcy). Therefore, when
considering sources of financing, the cheapest is through retained earnings, second through
debt, and third through equity.

SUMMARY

To summarize, Capital structure theory refers to a systematic approach to financing business

activities through a combination of equities and liabilities.

There are several capital structure theories, the theories covered here are

Net income approach by which change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value
of the company.

Net operating income approach As per this approach, the market value is dependent on the
operating income and the associated business risk of the firm. Both these factors cannot be
impacted by the financial leverage. Therefore, change in debt to equity ratio cannot make any
change in value of firm.

Traditional approach . As per this approach, debt should exist in the capital structure only up
to a specific point, beyond which, any increase in leverage would result in the reduction in
value of the firm.
Modigliani and miller approach . Whether a firm is highly leveraged or has a lower debt
component in the financing mix has no bearing on the value of a firm. Approach further
states that the market value of a firm is affected by its operating income.

Pecking order theory , managers follow a hierarchy to choose sources of finance. The

hierarchy gives first preference to internal financing. If internal financing is not enough, then
managers would have to shift to external sources. They will issue debt to generate funds.
After a point when it is no longer practical to issue more debt, equity is issued as a last
option.