THEORIES OF CAPITAL STRUCTURE

The objective of a firm should be directed towards the maximisation of the value of the firm, the Capital Structure, or leverage decision should be examined from the point of view of its impact on the value of the firm. If the values of the firm can be affected by Capital Structure or financing decision, a firm would like to have a Capital Structure, which maximize the market value of the firm.

There are broadly four approaches in this regard. These are:

• Net Income Approach.
• Net Operating Income Approach.
• Traditional Theory.
• Modigliani- Miller Approach.

1. Net Income Approach (NI):

According to this approach, the cost of debt and cost of equity do not change with a change in the leverage ratio. As a result the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weightage in the calculation of the cost of capital. According to this approach, the cost of debt capital, k_d and the cost of equity capital, k_e remain unchanged when B/S, the degree of leverage, varies. The constancy of k_d and k_e the average cost of capital measured as

declines as Balance sheet increases. This happens because when Balance sheet increases, k_d increases which is lower than k_e receives a higher weight in the calculation of k_o.

2. Net Operating Income Approach (NOI):

According to this approach:

• The overall capitalization rate remains constant for all levels of the financial leverage
• The cost of the debt also remains constant for all levels of financial leverage
• The cost of equity increase linearly with financial leverage.

• Ko and kd are constant for all degrees of leverage. Given this, the cost of equity can be expressed as:

• The critical premise of this approach is that the market capitalizes the firm as a whole at a discount rate, which is independent of the firm’s degree of leverage. As a consequence, the division between debt and equity is irrelevant. An increase in the use of debt funds, which are ‘apparently cheaper’ is offset by an increase in the equity capitalization rate. This happens because equity investors seek higher compensation as they are exposed to greater risk arising from increase in the degree of leverage. They raise the capitalization rate ke (lower the price-earnings ratio, P/E), as the degree of leverage increases.

3. Traditional or Intermediate approach:

This approach is midway between the NI and the NOI approach. The main preposition of this approach is:

The cost of debt remains almost constant up to a certain degree of leverage. But rises thereafter at an increasing rate

• The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter.
• The cost of capital due to the behaviour of the cost of debt and cost of equity

• Decrease up to a certain point.
• Remains more or less constant for moderate increases in leverage thereafter
• Rises beyond that level at an increasing rate.

4. MM Approach:

According to this approach, the capital structure decision of a firm is irrelevant. This approach supports the NOI approach and provides a behavioural justification for it. Additional assumption of this approach includes:

• Capital markets are perfect. All information is freely available and there are no transaction costs.
• All investors are rational
• Firms can be grouped into 'Equivalent risk classes' on the basis of their business risk.

This approach indicates that the capital structure is irrelevant because of the arbitrage process which will correct any imbalance ie. Expectation will change a stage will be reached where further arbitrage is not possible.

MM Theorem:

• No transaction costs.
• No taxes and bankruptcy costs.
• Total agreement.
• Perfectly competitive markets.
• Equal borrowing and lending rates.
• Set company asset structure
• Capital structure is irrelevant
• Value of firm is independent of its debt ratio.