THEORIES OF

CAPITAL
STRUCTURE
NET INCOME AND NET OPERATING
INCOME APPROACH
Submitted by:
Pooja Sharma
160/14
B.Com.LL.B. - Section

MEANING OF CAPITAL STRUCTURE

Capital structure of a company refers to the composition or makeup for its capitalisation and it includes all long-term capital
resources viz: loans, reserves, shares and bonds.

The capital structure is made up of debt and equity securities and

refers to permanent financing of a firm. It is composed of long-term
debt, preference share capital and shareholders funds.

Capital structure is that level of debt equity proportion where the

market value per share is maximum and the cost of capital is
minimum.

THEORIES OF CAPITAL STRUCTURE

Different kinds of theories have been propounded by different authors
to explain the relationship between capital structure, cost of capital
and value of the firm. The main contributed to the theories are
Durand, Ezra, Solomon, Modigliani and Miller.

Net income approach (NIA)

Net operating income approach (NOIA)

Traditional approach (TA)

Modigliani-Miller approach (MMA)

NET INCOME APPROACH

This theory was propounded by David Durand and is also known

as Fixed Ke Theory.

According to this theory a firm can increase the value of the firm
and reduce the overall cost of capital by increasing the proportion
of debt in its capital structure to the maximum possible extent.

It is due to the fact that debt is, generally a cheaper source of funds
because:
(i) Interest rates are lower than dividend rates due to element of
risk,
(ii) The benefit of tax as the interest is deductible expense for
income tax purpose.

COMPUTATION OF THE TOTAL VALUE OF THE FIRM

Total Value of the Firm (V)=S+D

Where,

V
=
Total
Market
S = Market value of Shares

value

of

firm

= Earning available to Equity Shareholders/ Equity Capitalisation

Rate
D = Market value of Debt
WACCcanbecalculatedas:
KO=EBIT/V

ASSUMPTIONS OF NET INCOME APPROACH

The Cost of Debt is less than the cost of Equity

There are no taxes.

The risk perception of investors is not changed by the use of debt.

NET OPERATING INCOME APPROACH

This theory was propounded by David Durand and is also known

as Irrelevant Theory.

According to this theory, the total market value of the firm (V) is not
affected by the change in the capital structure and the overall cost
of capital (Ko) remains fixed irrespective of the debt-equity mix.

There is nothing such as an optimal capital structure and every

capital structure is the optimum capital structure.

Increased use of debt increases the financial risk of the equity

shareholders and hence the cost of equity increases.

Cost of debt remains constant with the increasing proportion of debt

as the financial risk of the lenders in not affected.

Advantage of using the cheaper source of fund i.e. debt is exactly

offset by the increased cost of equity.

ASSUMPTIONS

The split of total capitalisation between debt and equity is not

essential or relevant.

The equity shareholders and other investors i.e. the market

capitalises the value of the firm as a whole.

The business risk at each level of debt-equity mix remains constant.

Therefore, overall cost of capital also remains constant.

The corporate income tax does not exist.

Cost

of

capital

(Ko)

is

constant.

As the proportion of debt increases, (Ke)

increases.

No effect on total cost of capital (WACC)

COMPUTATION OF VALUE OF FIRM

V = EBIT/KO

Where, V = Value of firm

EBIT = Net operating income or Earnings before interst and tax
KO = Overall cost of capital