Capital Structure Theories

Bhagavathi Krishna

A genda
Going

Back.. Net Income Theory Net Operating incomeTheory Traditional Theory of Capital Structure Modigliani and Miller Hypothesis

Net Income Theory

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 theweighted average cost of capital. High debt content mixture of equity debt mix

Assumptions Under NI Theory

Total

Capital requirement of the

firm are given and remain constant

Kd Kd Ko

< Ke and Ke are constant (Overall cost of capital)

decreases with the increase in

N e t O p e ra ti g I co m e n n T h e o ry
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.

A ssu m p ti n s U n d e r N O I o T h e o ry
Ko

and Kd is constant.

Ke

will change with the degree of

leverge.
There

is no tax.

Tra d i o n a lT h e o ry ti
It

takes mid way between Net Income Theory and Net Operations Income Theory. It has three stages
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. 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

A ssu m p ti n s o
The

value of the firm increases

with the increase in financial leverage, upto a certain limit only.

Kd

is assumed to be less than Ke.

M o d i l a n ia n d g i M i l rT h e o ry le
Modigliani

and Miller (1958) show that financing decisions dont matter in perfect capital markets. MM theory or approach is fully opposite of traditional approach. 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

A ssu m p ti n s o

There is a perfect capital market. Capital markets are perfect when

Investors are free to buy and sell securities, They can borrow funds without restriction at the same terms as the firms do, They behave rationally, They are well informed, and There are no transaction costs.

Firms can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk. All investors have the same expectation of a firms net operating income (EBIT). The dividend payout ratio is 100%, which means there are no retained earnings. There are no corporate taxes. This assumption has

Pro p o si o n s o f M M ti A p p ro a ch
M

- M Hypothesis can be explained in terms of two propositions of Modigliani and Miller. They are :
The overall cost of capital (Ko) and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. Firms cannot change the total value of their securities by splitting cash flows into two different streams

Pro p o si o n s o f M M ti A p p ro a ch
Proposition

The financial risk increases with more debt content in the capital structure. As a result cost of equity (Ke) increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same

A rb i g e tra
According

to M M, two firms identical in all respects except their capital structure, cannot have different market values or different cost of capital. In case, these firms have different market values, the arbitrage will take place and equilibrium in market values is restored in no time.

A rb i g e Pro ce ss tra
Arbitrage

process refers to switching of investment from one firm to another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. The use of debt by the investors is known as personal leverage or home made leverage. Because of this arbitrage process, the market price of securities in higher valued market will come down and the market price of securities in the lower valued market will go up, and this switching process is continued until the equilibrium is established in the market values. So, MM, argue that there is no possibility of

R e ve rse W o rki g o f n A rb i g e tra

Arbitrage

process also works in the reverse direction. Leverage has neither advantage nor disadvantage. If an unlevered firm (with no debt capital) has higher market value than a levered firm (with debt capital) arbitrage process works in reverse direction. Investors will try to switch their investments from unlevered firm

Li i ti n o f M M m ta o H yp o th e si s
The

major limitation of M M hypothesis is the existence of corporate taxes. Since the interest charges are tax deductible, a levered firm will have a lower cost of debt due to tax advantage when taxes exist. The assumption that transaction costs do not exist is not valid because these costs are necessarily involved in buying and selling securities. The working of arbitrage is affected by institutional restrictions, because the institutional investors are not allowed to practice home made leverage i.e moving from over priced shares to those

B e yo n d H yp o th e si s
Modigliani

and Miller later recognized the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximizing debt component in the capital structure.