This document provides an overview of various theories of capital structure, including the net income approach, traditional approach, net operating income approach, and Modigliani & Miller approach. It discusses the basic assumptions and propositions of each theory. The net income approach states that firm value increases with more debt. The traditional approach argues there is an optimal capital structure. The net operating income approach and MM approach find capital structure irrelevant to firm value.

1. Prof. Kripa Shanker Jaiswal
Head
Department of Commerce
Former Dean & Director
Faculty of Commerce & Management Studies
Mahatma Gandhi Kashi Vidyapith, Varanasi
Email: kjaiswal_2001@yahoo.co.in / ksjaiswal@mgkvp.ac.in
Subject: Commerce
Class: B. Com. / M. Com. / M.B.A.
Year: III / I/ II
Name of Paper: Business Finance/ Financial
Management
Topic: THEORIES OF CAPITAL STRUCTURE: RELEVANCE &
IRRELEVANCE APPROACH
Sub Topics: Capital Structure, Net Income Approach,
Traditional Approach, Net-Operating Income Approach
& Modigliani & Miller(M&M) Approach
Keywords: Capital, Capital Structure, Business Finance,
Finance

2. CAPITAL STRUCTURE THEORIES
Capital Structure theories establishes relationship between capital
structure and the value of firm.
Basic assumptions are as follows:
 Only two kinds of funds used by firm i.e., debt & equity.
 Taxes are not considered.
 The payout ratio is 100%.
 The firm’s total financing remains constant.
 Business risk is constant over time.
 The firm has perpetual life.
 EBIT are not expected to grow.
 Total assets of the company are given &do not change.

3. THEORIES OF CAPITAL STRUCTURE
Theories
Relevance
Theories
Net Income
Approach Traditional
Approach
Irrelevance
Theories
Net-Operating
Income
Approach
Modigliani &
Miller(M&M)
Approach

4. NET INCOME APPROACH
 The exponent of this theory is David Durand.
 As per this theory a firm can increase its value or lower the overall cost
of capital by increasing the proportion of debt in the capital structure.
 The NI approach clearly underlines the importance of debt as it is the
determinant of the value of the firm(V).
Basic assumption:
 Corporate tax doesn’t exist.
 The use of debt doesn’t change the perception of the investors.
 The Cost of Debt is less than the cost of equity.
Cost of capital is measured as:
rA= rD[D/ (D+E)]+ rE [E(D+E)]
Here, rD =I/D; rE = D/E; rA= O/Y

5. Y
Rate of Return
rA rD
x
Value of firm
From the above graph it is clear that as D/E increases rA decreases because the proportion of debt , the cheaper
source of finance & increase in the capital structure.

6. The Net Income approach may be explained with the
following example:
Particulars Firm A Firm B
O - Operating Income
I- Interest on Debt
P- equity earning
rE – Cost of equity
rD- Cost of Debt
E- Market value of
Equity
D- Market value of Debt
V- Total Value of the
Firm
Average Cost of Capital
for the Firm
Rs. 10,000
Rs. 0
Rs. 10,000
10%
6%
Rs. 1,00,000
Rs.0
Rs. 1,00,000
= rD* ( D/V) +rE* (E/V)
= 6%
*(0/1,00,000)+10%(1,00,
000/100,000)
= 10%
Rs.10,000
Rs.3,000
Rs.7,000
10%
6%
Rs.70,000
Rs.50,000
Rs.1,20,000
= rD* ( D/V) +rE* (E/V)
= 6%
*(50,000/1,20,000)+10%
(70,000/100,000)
=8.33%

7. Traditional Approach
 There exist an optimal capital structure for every firm.
 Traditional approach offers an intermediate view which is a compromise
between NOI & NI approaches.
 The value of firm increases with increase in financial leverage but up to
certain limit only.
 Beyond that limit the financial leverage will increases its WACC, hence
the value of the firm will decline.
BASIC ASSUMPTIONS
 The cost of debt capital remains more or less constant up to certain degree
of leverage bat rises thereafter at an increasing rate.
 The cost of equity capital remains more or less constant or rises only
gradually up to a certain degree of leverage and rises sharply there after.

8. y
Percentage Cost
rE rA
rd
x
Leverage (B/S)
This graph depicts that a firm can be benefited from a moderate
level of leverage when the advantages of using debt outweigh the
disadvantages of increasing cost of equity.

9. Traditional Approach may be explained as follows
Interest
on Debt
(Rs.)
Equity
Earnings(
Rs.)
rD(%) rE(%) D (Market
value of
Debt) in Rs
E (
Market
Value of
Equity) in
Rs.
V(Total
Value of
Firm) in
Rs.
rA
Averag
e rate
of cost
of
capital
in Rs.
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
1,00,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
6.0
6.0
6.5
6.5
7.0
7.5
9.0
11.0
15.0
18.0
10.0
10.0
10.5
11.0
11.0
11.5
12.0
14.0
16.0
200
0
1,66,667
3,07,692
4,61,538
5,71,429
6,66,667
6,66,667
6,36,364
5,33,333
5,00,0000
10,00,000
9,00,000
7,61,905
6,36,363
5,45,455
4,34,783
3,33,333
2,14,286
1,25,000
1,00,000
10,00,000
10,66,667
10,69,597
10,97,901
11,16,884
11,01,450
10,00,000
8,50,000
6,58,333
6,00,000
10.00
9.37
9.36
9.10
8.95
9.08
10.00
11.75
15.20
16.67

10. NET OPERATING INCOME APPROACH
 This theory has also been propounded by David Durand.
 The market value of a firm depends on its net operating income and
business risk.
 Change in the degree of leverage merely changes the distribution of
income and risk between debt & equity without affecting the total
income and risk that influences the market value of the firm.
In the equation form:

11. BEHAVIOR OF rA , r D & rE as per NOI
APPROACH
Y
Rate of return rE
rA
rD
x
value of Firm
From the above graph, it is clear that, as the degree of leverage
increased, over all cost of capital & cost of debt remains the same but
the cost of equity increases with leverage and exactly neutralizes the
benefits of low cost debt.

12. NET OPERATING INCOME APPROACH
CAN BE EXPLAINED AS:
PARTICULARS FIRM A FIRM B FIRM C
EBIT
Less: Interest
Earning available to ESH
Cost of Equity
Market Value of the equity
shares
Market Value of the Debt
Total Value of the Firm
Overall Cost of Capital (
EBIT/ V)
400,000
1,00,000
3,00,000
0.16
18,75,000
10,00,000
28,75,000
(400,000/28,
75,000)=13.9
400,000
1,65,000
2,35,000
0.17
13,82,352
15,00,000
28,82,352
(4,00,000/28,82,352
)=13.80%
4,00,000
2,50,000
1,50,000
0.20
7,50,000
20,00,000
27,50,000
(4,00,000/27,50,0
00)=14.50%

13. MODIGLIANI & MILLER AAPPROCH
(MM)
 There is a relationship between cost of capital and valuation of firm just as
NOI approach.
 The value of Firm is dependent on its capital structure.
BASIC ASSUMPTIONS
 Capital Markets are perfect.
 Investors are free to buy & sell securities.
 There are no transaction cost
 They behave rationally.
 Dividend payout ratio is 100% & there are no related earning.
 There are no corporate income taxes.
 All the firms are within the same class and have same degree of business risk.

14. BASIC PROPOSITIONS OF MM APPROCH
 The overall cost of capital and the value of the firm are independent to
its capital structure. The rA and V are constant for all degrees of
leverage.
 rE increases in a manner to offset exactly the use of less expensive
source of funds represented by the debt.
 The cut off rate for investment purposes s is completely independent of
the way in which an investment is financed.
Following formulas have been given by Miler
Firm Market Value(V)= EBIT(Operating Profit)/rE (Cost of Equity)

15. BEHAVIOR OF rA , r D & rE as per NOI
APPROACH
Y
rE
Cost of Capital rA
rD
x
Degree of leverage
MM theory of irrelevance : Effect of Leverage on cost of debt, equity & overall cost
of capital

16. MM APPROACH CAN BE EXPLAINED AS:
PARTICULARS COMPANY A COMPANY B
EBIT
Less: Interest
Earning available to
ESH
Cost of Equity
Market value of Equity
Market value of Debt
Total value of
Company(V)
rA= EBIT/V
5,00,000
Nil
5,00,000
20%
25,00,000
Nil
25,00,000
20%
5,00,000
3,00,000
2,00,000
25%
8,00,000
20,00,000
28,00,000
17.80%

17. Continuation of MM Approach with arbitrage
process
It is clear from the previous calculation that the market value of the levered
company is higher than its total cost of capital as compared to the
unlevered company. The MM approach contends that such discrepancy
in the value of the two identical risk equivalent company cannot prevail
for long because of arbitrage process. Due to arbitrage process the
investors in the levered company will start selling their share in the
equity capital in the company B and invest in the company A. As the
degree of risk in the unlevered company is low as compared to levered
company.
If Mr. A holds 1% share in the equity of the
company Y(levered) his share in the equity will be Rs. 8000.Mr A will
sell his portion equity holding in company Y and purchase equity shares
in company X (unlevered) besides this he will also borrowed Rs.20,000
that is 1% (his equivalent shares in equity) of 20,00,000. from the
market at same rate of 15%. In the phraseology of MM leverage, Mr. a
will substitute home made leverage for corporate leverage.

18. Continuation of MM Approach with
arbitrage process
Net Return on Proportionate Investment of Mr. A
PARTICULARS AMOUNT(Rs.)
* Prior to the purchase of Equity shares
(in the company X)
Return on Equity= rE *V
=25% of Rs. 8,000
•After the purchase of equity shares I
( in the company Y)
Return on the equity=r E * V
= 20% *25,000
Less: Interest on Loan=15%*20,000
2000
5000
(3000)
2000

19. RELATIONSHIP BETWEEN LEVERAGE &
VALUATION
 As per MM Approach there is no relationship between total vale of firm
& degree of leverage.
 The cost of Capital as well as the market value of shares must be the same
regardless of the financing mix.
 Arbitrage Process :
y
D S
Equilibrium
x
D= Demand/buying in one market at lower price & S= supply in other market at higher price.

20. SUMMARIZED FORM OF THEORIES OF
CAPITAL STRUCTURE
Net Income
Approach
Net Operating
income
M.M Approach Traditional
Approach
•Leverage always
affects the overall
cost of capital and
the value of the
firm.
•There is an
optimum capital
structure at which
the value of the
firm is the highest
and the cost of
capital is lowest.
• Capital
structure is totally
irrelevant.
• No, affects of
leverage on
overall cost of
capital and the
market value of
the firm.
• MM concur with
NOI and provide
behavioral support
to its basic
propositions.
• The arbitrage
process is
impeded. It implies
with the judicious
use of the mix of
debt & equity
which can be
•This approach
strikes a balance
between the two
extremes i.e.; (
relevance &
irrelevance
approaches)
•Up to a certain
level increase of
debt reduces the
overall cost of
the firm beyond

21. CONCLUSION:
The Traditional Approach provides a fairly close
approximation of the position. The optimum
capital structure would of course vary from case
to case. In other words, an appropriate capital
structure will depend upon the circumstances of
each case and the factors which have the bearing
on the determinants of an appropriate capital
structure.

22. Assignment
Short Type Questions
1. Name various theories of Capital Structure ?
2. Distinguish between the relevance and irrelevance theories
of Capital Structure ?
Long Type Questions
1. Describe Modigliani & Miller(M&M) Approach in detail.
2. What do you mean by Capital Structure? Discuss the
importance of various theories.

23. References
1. Khan and Jain , “Financial Management” (Tata McGraw Hill, 7th Ed.)
2. Pandey, I. M., “Financial Management” (Vikas, 11th Ed.)
3. William Hakka Bettner Carcello- “Financial and Management Accounting” (TMH-16th)
4. Sheeba kapil, “Fundamental of financial management” (Wiley,2015 )
5. Chandra, Prasanna, “Fundamentals of Financial Management” (TMH, 9th Ed.)
6. Bark Demazo Thampy-“ Financial Management” (Pearson,2nd Ed.)
7. Rustagi, R P., “Financial Management”(Galgotia, 2000, 2nd revised ed.)
8. Damodaran, A., “Applied Corporate Finance”, 3rd Edition, Wiley, 2012
9. Ravi. M Kishore, “Financial Management” (Taxman, 7th Ed)
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-- Prof. K. S. Jaiswal