CAPITAL STRUCTURE THEORIES

SUBMITTED TO: Prof. Karamjeet singh

SUBMITTED BY: Pooja Miglani
ROLL NO: 22
CONTENT
● Net income approach (NI Approach)
● Net operating income approach (NOI Approach)
● Traditional approach
NET INCOME APPROACH(Relevance approach)
According to this approach, There exists a relationship between capital
structure and value of the firm. This approach was given by David
Durand.

ASSUMPTIONS
● There are no corporate taxes.
● The cost of debt is less than the cost of equity
● Cost of debt and equity will remain constant.
V=E+D V: Value of the firm Ke: Cost of equity
E=NI/Ke or EBIT-I/Ke E: Value of equity Kd: Cost of debt
D=I/Kd D: Value of Debt I: Interest
Ko=EBIT/V NI: Net income EBIT: Earning

before income& tax

CONCLUSION OF NI APPROACH
❖ Value of the firm(V) will increase.
❖ Cost of equity(Ke) will remain constant.
❖ Overall cost of capital(Ko) will decrease.
❖ 100% debt is optimum capital structure.
NET OPERATING INCOME APPROACH
According to this approach, capital structure of the firm is independent
and does not exert any influence on the value of the firm or the overall
cost of capital.(Business risk affects the earning capacity).This approach
was given by David Durand. It is called as irrelevance approach.
ASSUMPTIONS
● Overall cost of capital remains constant.
● Split between debt and equity is not important.
● Cost of debt is constant.
● Use of more and more debt result in the increase of cost of equity.
● There are no taxes.
E=V-D V: Value of the firm Ke: Cost of equity
Ke=NI/E, Ko+(Ko-Kd)D/E E: Value of equity Kd: Cost of debt
V=EBIT/Ko D: Value of Debt
EBIT: Earning before income& tax
CONCLUSION OF NOI APPROACH
❖ Value of firm will remain constant at all pattern of debt equity mix.
❖ Overall cost of capital will remain constant.
❖ Cost of equity will increase.
❖ No optimum capital structure.
TRADITIONAL APPROACH
This approach has suggested a middle path between NI and NOI
approach. The crux of this approach is that through a judicious use of
debt and equity, the firm can increase its total value and therby reduce
the overall cost of capital. It was advocated by Ezta solomon & Fred
weston.
CONCLUSION OF TRADITIONAL APPROACH:
❖ Value of the firm will increase upto a certain proportion of debt.
❖ Ke will increase rapidly and offset the benefit of use of further debts.
❖ Ko will decrease initially, it starts increasing beyond a certain level
of debts.
❖ V is maximum when Ko is the lowest and that is optimum capital
structure.
REFERENCES
Singh, S.& Kaur, R.(2018).Basic Financial Management.New Delhi:
Mayur Paperbacks.

Khan, MY.& Jain, PK.(2019).Financial Management.Haryana: Raj

kamal electronic process.

IMAGE SOURCE: http://www.google.com