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Accounting and Finance

for Managers

LESSON

22
CAPITAL STRUCTURE THEORIES
CONTENTS
21.0

Aims and Objectives

22.1

Introduction

22.2

Assumption of the Capital Structure Theories

22.3

Net Income Approach

22.4

Net Operating Income Approach

22.5

ModiglianiMiller Approach

22.6

Traditional Approach

22.7

Types of Dividend Policies

22.7.1 Cash Dividend Policy
22.7.2 Bond Dividend Policy
22.7.3 Property Dividend Policy
22.7.4 Stock Dividend Policy

22.8

Let us Sum up

22.9

Lesson-end Activity

22.10 Keywords
22.11 Questions for Discussion
22.12 Suggested Readings

22.0 AIMS AND OBJECTIVES

The purpose of this lesson is to identify the optimum capital structure for business fleeces.
After studying this lesson you will be able to:
(i)

describe different theories of capital structure

(ii)

explain aspects of capital structure decision-making

(iii) describe different types of dividend policies

22.1 INTRODUCTION

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The capital structure theories are facilitating the business fleeces to identify the optimum
capital structure. The optimum capital structure of the organization differs from one
approach to another due the assumption which are underlying with reference to many
factors of influence. The success of the firm is normally depending upon the rate at
which the financial resources are raised, differs from one organisation to another depends
upon the needs. The cost of capital is having greater influence on the EBIT level of the

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firm; which directs affects the amount of earnings available to the investors, that finally
reflects on the value of the firm. The more earnings available at the end will lead to
greater return on investment holdings of the investors, would enhance the value of shares
due to greater demand. There are two set of approaches with reference to capital
structure; which normally influences the Value of the firm through the cost of overall
capital(Ko) is one approach called relevance approach capital structure theories and
other do not have any influence on the value of the firm is known as irrelevance approach.
The debt finance in the capital structure facilitates the firm to enhance the value of EPS
on one side on the another side it is subject to the financial leverage with reference to
trading on equity. The application of leverage in the capital structure enhances the value
of the firm through the cost of capital.

Capital Structure Theories

The following are the various capital structure theories:

(i)

Net income approach

(ii)

Net operating income approach

(iii) Modigliani and Miller approach

(iv) Traditional approach

22.2 ASSUMPTION OF THE CAPITAL STRUCTURE

THEORIES
(i)

There are only two resources in the capital structure viz Debt and Equity share
capital

(ii)

The dividend pay out ration 100% which means that there is no scope for the
retained earnings

(iii) The life of the firm is perpetual

(iv) The total assets of the firm do not change
(v)

The total financing remains constant through balancing taking place in between the
debt and share capital

(vi) No corporate taxes; this was removed later

22.3 NET INCOME APPROACH

Algebraically, the relationship between the cost of equity, cost of overall capital and
debt-equity ration are explained as follows:
Ke=Ko+ (KoKi)B/S
Net income approach was developed by Durand, in this he has portrayed the influence
of the leverage on the value of the firm, which means that the value of the firm is subject
to the application of debt i.e., leverage.
In this approach, the cost of debt is identified as cheaper source of financing than equity
share capital. The more application of debt in the capital structure brings down the
overall capital, more particularly 100% application of debt finance leads to resemble the
over all cost of capital as cost of debt. The weighted average cost of capital will come
down due to more application of leverage in the capital structure, only with reference to
cheaper cost of raising than the equity share capital cost.
Ko= Ke(S/V)+Ki(B/V)
The value of the firm is more in the case of lesser overall cost of capital due to more
application of leverage in the capital structure. The optimum capital structure is that at

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Accounting and Finance

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when the value of the firm is highest and the overall cost of capital is lowest.
V=B+S
V= EBIT/Ko
This approach highlights that the application of leverage influences the overall cost of
capital and that affects the value of the firm.

22.4 NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that the
application of leverage do not have any influence on the value of the firm through the
overall cost of capital. The more application of leverage leads to bring down the explicit
cost of capital on one side and on the other side implicit cost of debt is expected to go up.
How the implicit cost of debt will go up? The more application of debt leads to increase
the financial risk among the investors, that warranted the equity share holders to bear
additional financial risk of the firm. Due to additional financial risk, the share holders are
requiring the firm to pay additional dividends over the existing. The increase in the
expectations of the shareholders with reference to dividends hiked the cost of equity.
Under this approach, no capital structure is found to be a optimum capital structure. The
major reason is that the debt-equity ratio does not influence the cost of overall capital,
which always nothing but remains constant.
It is finally concluded that this approach highlights that application of leverage never
makes an attempt to enhance the value of the firm, in other words which is known as
unaffected by the application of leverage.

22.5 MODIGLIANIMILLER APPROACH

It is the approach, attempts to explain the application of leverage does not have any
influence on the value of the firm through behavioural pattern of the investors. The
behavioural pattern of the investors is taken into consideration for explaining the value of
the firm which is unaffected by the application of debt/leverage in the capital structure
through arbitrage process. The MM approach has three different propositions:
(i)

The overall capital structure of the firm is unaffected by the cost of capital an
degree of leverage

(ii)

The cost of equity goes up and offset the increase of leverage in the capital structure

(iii) The cut off rate for the investment purposes is totally independent.
For discussion, the proposition is only considered for the study of usage of leverage in
the capital structure, which do not have any impact in the value of the firm.

Assumptions of the MM approach:

This approach is discussed under the perfect market conditions
(i)

Securities are divisible infinitely.

(ii)

Investors are allowed to buy and sell securities

(iii) Investors are rational to access the information

(iv) No transaction costs involved in the process of the buying and selling of securities

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Arbitrage process: It is the process facilitates the individual investors to buy the
investments at lower price at one market and sells them off at higher price in another
market. With the help of arbitrage process, the investors are permitted to shift holding of
the Levered firm to the unlevered firm which is known as undervalued. These two firms
are identical in business risk except in the application of debt finance in the levered firm.
In order to maintain the similar amount of the financial risk of the firm, the investor is
required to undergo for personal leverage or home made leverage to maintain the same

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proportion of investment in the unlevered firm. During this process, the investor could
save something and this continuous arbitrage process will level the value of the both
firms. It means that the value of the firm is unaffected by the application of leverage
which is explained through the arbitrage process, nothing but behavioural pattern of the
investors.

Capital Structure Theories

The same thing could be applied in the case of reverse arbitrage process in between the
Unlevered and levered. This also another kind of process in which the investor could
gain through the transfer of the holdings from the unlevered firm to levered firm.
The value of the firm is unaffected by the application of the leverage in the capital structure.

22.6 TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net income
approach and NOI approach. The value of the firm and the cost of capital are affected
by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of
overall capital will come down due to the application cheaper source of financing viz
Debt financing to some extent, after certain usage, the application of debt will enhance
the financial risk of the firm, which will require the share holders to expect additional
return nothing but is risk premium. The risk premium which is expected by the investors
will enhance the overall cost of capital.
The optimum capital structure "the marginal real cost of debt, defined to include both
implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before
that level, the marginal cost of debt would be less than that of equity capital, while
beyond that level of leverage, the marginal real cost of debt would exceed that of equity.

22.7 TYPES OF DIVIDEND POLICIES

The dividend policy is the policy that facilitates the firm to decide how much should be
declared as a dividend. The declaration of dividend is normally to be taken with reference
to the future prospects of the firm. The dividends are normally decided by the board of
directors during the board meeting which may affect other important decisions of the
firm. Most of the companies never think off about the future prospects before the
declaration of the dividends to the shareholders. As a finance manager should emphasize
the importance of declaring or non declaring the dividends which are having greater
influence on the futuristic decisions of the enterprise.
Types of dividend policies:
(i)

Cash dividend

(ii)

Bond dividend

(iii) Property dividend

(iv) Stock dividend

22.7.1 Cash Dividend Policy

The dividends are paid in terms of cash. This type of dividend normally leads to cash
outflow which has greater influence on the cash position of the firm. At the moment of
declaring the cash dividend, future cash needs should be predetermined and dividends
declared to the share holders.

22.7.2 Bond Dividend Policy

Instead of paying dividend in terms of cash, some companies are issuing bond dividends,
which facilitate them to postpone the immediate cash outflows. Immediately after the
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Accounting and Finance

for Managers

issuance of bonds, the bond holders are receiving the interest on their holdings besides
the bond values to be paid on the due date. This method is not popular in India.

22.7.3 Property Dividend Policy

Instead of paying dividends in cash, some assets are given to the shareholders as dividend
payments. This is also not existing in India.

22.7.4 Stock Dividend Policy

Instead of making the payment of cash dividend, the stock are issued to the existing
shareholders. The company shares are issued to existing share holder which is known
other words as stock dividends.
Check Your Progress
1.

Write a note on the ModiglianiMiller approach.

2.

Explain the various types of dividend policies.

22.8 LET US SUM UP

The capital structure theories are facilitating the business fleeces to identify the optimum
capital structure. The optimum capital structure of the organization differs from one
approach to another. The cost of capital is having greater influence on the EBIT level of
the firm; which directs affects the amount of earnings available to the investors, that
finally reflects on the value of the firm. Net income approach, the cost of debt is identified
as cheaper source of financing than equity share capital. Net Operating income approach
developed by Durand, which has underlying principle that the application of leverage do not
have any influence on the value of the firm through the overall cost of capital. The more
application of leverage leads to bring down the explicit cost of capital on one side and on
the other side implicit cost of debt is expected to go up. Under this approach, no capital
structure is found to be a optimum capital structure. Arbitrage process is the process
facilitates the individual investors to buy the investments at lower price at one market
and sells them off at higher price in another market. The traditional approach is known
as intermediate approach in between the Net income approach and NOI approach.

22.9 LESSON-END ACTIVITY

Assuming the condition of the original M & M (Miller-Modigliani) approach, state whether
the following statement is true or false:
In a world of perfect capital market, an increase in financial leverage will increase the
market value of the firm.
Provide an intuitive explanation of your answer.

22.10 KEYWORDS
Arbitrage process
Dividend Policies
Cash dividend policy

22.11 QUESTIONS FOR DISCUSSION

302

1.

Write the various assumption of the capital structure theories.

2.

Explain the Net income approach.

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3.

Elucidate the Net operating approach.

5.

Explain briefly about the traditional approach.

6.

What is meant by the dividend policy?

Capital Structure Theories

22.12 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.
Khan and Jain, Management Accounting.
S.N. Maheswari, Management Accounting.
S. Bhat, Financial Management, Excel Books, New Delhi.
Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

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