In Financial Management book, you would read the topic theories of capital structure.

Here, I have made these theories simplified. I hope, you can study these theories here and use these theories as reference. We all know that capital structure is combination of sources of funds in which we can include two main sources' proportion. One is share capital and other is Debt. All four theories are just explaining the effect of changing the proportion of these sources on the overall cost of capital and total value of firm. If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. First 50 represent the share capital and second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure in simple and clean words.

1st Theory of Capital Structure Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.

2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: Ist Stage

In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 3rd Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. 4th Theory of Capital Structure Name of theory = Modigliani and Miller MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital. Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.

Generally, the capital structure theories have the following assumptions: 1. 2. 3. 4. 5. 6. 7. 8. 9. There are no corporate taxes (this assumption has been removed later). The firms use only 2 sources of financing namely perpetual debts ad equity shares The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms. The total assets are given which do not change and the investment decisions are assumed to be constant. Business risk is constant over time and it is assumed that it is independent of the capital structure. The firm has a perpetual life. The firms earnings before interest and taxes are not expected to grow. The firms total financing remains constant. The firms degree of leverage can be altered either by selling shares and to retire the debt using the proceeds or by raising more debt and reduce the equity financing. All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm. Modigliani Millar Approach Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debtequity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for independence of the company's cost of capital.

Basic Propositions of MM approach:

1.

At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.

2.

The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.

3.

The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.

Assumptions of MM approach:

1.

Capital markets are perfect.

2.

All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.

3.

Within similar operating environments, the business risk is equal among all firms.

4.

100% dividend payout ratio.

5.

An assumption of "no taxes" was there earlier, which has been removed.

Arbitrage process Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is higher. This results in restoration of equilibrium in the market price of a security asset. This process is a balancing operation which implies that a security cannot sell at different prices. The MM hypothesis states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation. Generally, investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's price is higher. This process or this behavior of the investors will have the effect of increasing the price of the shares that is being purchased and decreasing the price of the shares that is being sold. This process will continue till the market prices of these two firms become equal or identical. Thus the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

Limitations of MM hypothesis:

1.

Investors would find the personal leverage inconvenient.

2.

The risk perception of corporate and personal leverage may be different.

3.

Arbitrage process cannot be smooth due the institutional restrictions.

4.

Arbitrage process would also be affected by the transaction costs.

5.

The corporate leverage and personal leverage are not perfect substitutes.

6.

Corporate taxes do exist. However, the assumption of "no taxes" has been removed later. Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

Assumptions of NI approach:

1. 2. 3.

There are no taxes The cost of debt is less than the cost of equity. The use of debt does not change the risk perception of the investors

Example A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%. Calculation of the Value of the firm:

Effect of change in the capital structure: (Increase in debt capital) Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of new debt issue worth the same amount. The cost of debt and equity would remain the same as per the assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.

Calculation

of

new

value

of

the

Firm

Please note: Overall cost of capital can also be calculated by using the weights of debt and equity contents with the respective cost of capitals. This proves that the use of additional financial leverage (debt) causes the value of the firm to increase and the overall cost of capital to decrease.

Net Operating Income Approach Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:

1.

At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

2.

The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm - Value of debt

3.

Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

Example: Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate). Solution: EBIT = $50,000

WACC Therefore, Total Therefore,

(overall total market

capitalization value value of

rate) the firm of

= = EBIT/Ko debt Total $400,000 to equity = market value $200,000 market on value Interest $200,000) of Value equity on of $50,000/12.5%

12.5% $400,000 =$200,000 debt $200,000 shares debt $30,000 15% WACC: x ($200,000/$400,000) 12.5%

total

value

of

equity

Cost Earnings

of

equity

capital

= to

Earnings equity

available

holders/Total EBIT (10% =

available

holders $50,000 capital of

Therefore, Verification 10% x

cost

of

equity

$30,000/$200,000

($200,000/$400,000)

15%

Effect of change in Capital structure (to prove irrelevance) Let us now assume that the leverage increases from $200,000 to $300,000 in the firm's capital structure. The firm also uses the proceeds to re-purchase its equity stock so that the market value of the firm remains the same at $400,000. EBIT WACC Total Less: Therefore, market Total market rate value = cost = value market of of 12.5% the value equity ($50,000 of = firm of $400,000 [10% on = (overall = capitalization $50,000/12.5% debt $300,000 $300,000)/$100,000 capital $50,000 rate) $400,000 $300,000 $100,000 20% =

Equity-capitalization Overall

10% x $300,000/$400,000 + 20% x $100,000/$400,000 12.5% The above example proves that a change in the leverage does not affect the total value of the firm, the market price of the shares as well as the overall cost of capital.

Traditional Approach The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases. Example: Let us consider an example where a company has 20% debt and 80% equity in its capital structure. The cost of debt for the company is 9% and the cost of equity is 14%. According to the traditional approach the overall cost of capital would be: The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases. WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity) (20% x 9%) + (80% x 14%)

 1.8 + 11.2 13% If the company wants to raise the debt portion in the capital structure to be 50%, the cost of debt as well as equity would increase due to the increased risk of the company. Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost of capital would be: WACC 5 + 7.5 12.5% In the above case, although the debt-equity ratio has increased, as well as their respective costs, the overall cost of capital has not increased, but has decreased. The reason is that debt involves lower cost and is a cheaper source of finance when compared to equity. The increase in specific costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a cheaper source, namely debt. Now, let us assume that the company raises its debt percentage to 70%, thereby pushing down the equity portion to 30%. Due to the increased and over debt content in the capital structure, the firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be: WACC = (70% x 15%) + (30% x 20%) 10.5 + 6 16.5% This decision has increased the company's overall cost of capital to 16.5%. The above example illustrates that using the cheaper source of funds, namely debt, does not always lower the overall cost of capital. It provides advantages to some extent and beyond that reasonable level, it increases the company's risk as well the overall cost of capital. These factors must be considered by the company before raising finance via debt. = (50% x 10%) + (50% x 15%)