Theories of Capital Structure

In practice it is difficult to specify an optional capital structure-indeed, managers even feels uncomfortable about specifying an optional capital structure range. Thus, financial managers worry primarily about whether their firms are using too little or too much debt, not about the precise optimal amount of debt. Even if a firm’s actual capital structure varies widely from the theoretical optimum, this capital structure decisions are secondary in importance to operating decisions, especially those relating to capital budgeting and the strategic direction of the firm.

Different kinds of theories have been propounded by different authors to explain the relationship between capital structures. The four important theories of capital structure are:

1. Net Income Approach: According to this approach, a firm can minimize the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. A higher debt content in the capital structure means high financial leverage and this results in decline in the overall or weighted average cost of capital. This result in increases in the value of the firm and also increases in the value of the equity shares. In an opposite situation, the reverse conditions prevail.

2. Net Operating Income Approach: This theory as suggested by Durand is another extreme of the effects of leverage on the value of the firm. It is diametrically opposite to the net income approach. Accordingly to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the debt-equity mix is 50:30 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and every capital structure is the optimum capital structure.

3. The Traditional Approach: The traditional approach, also known as intermediate approach, is a compromise between the two extremes f net income approach and net operating income approach. According to this theory, the value of the firm can be increase initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source funds than equity. Thus, optimum capital structure can be reached by a proper debt equity mix. Beyond a particular point, the cost of equity increase because increased debt increase the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantages of low cost debt.

4. Modigliani and Miller Approach: M & M hypothesis is identical with the net opening income approach if taxes are ignored. However, when corporate taxes are assured assumed to exist, their hypotheses are similar to the Net Income Approach.

  1. In the absence of taxes. (Theory of Irrelevance): The theory proves that the cost of capital is not affected by changes in the capital structure or say that the debt equity mix is irrelevant in the determination of the total value of a firm. The reason argued is that though debt is cheaper to equity, with increased use of debt as source of finance, the cost of equity increase. This increase in cost of equity offsets the advantage of the low cost of debt. Thus, although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The theory emphasizes the fact that a firm’s opening income is a determinant of its total value.
  2. When the corporate taxes are assumed to exist. (Theory of Relevance): Modigliani and Miller have recognized that the value of the firm will increase or cost of capital will decrease with the use of debt on account of deductibility of increase charges for tax purpose. This, the optimum capital structure can be achieved by maximizing the debt mix in the equity of a firm.

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