Capital structure is the proportion of debt and
preference and equity shares on a firm’s balance
Optimum capital structure is the capital structure at
which the weighted average cost of capital is
minimum and thereby maximum value of the firm.
Capital structure theories explain the theoretical
relationship between capital structure, overall cost of
capital (k0) and valuation (V ). The four important
1. Net income (NI) approach,
2. Net operating income (NOI) approach,
3. Modigliani and Miller (MM) approach and
4. Traditional Approach
Capital structure theories
There are only two sources of funds used by a firm:
perpetual riskless debt and ordinary shares.
There are no corporate taxes. This assumption is
The dividend-payout ratio is 100. That is, the total
earnings are paid out as dividend to the shareholders
and there are no retained earnings.
The total assets are given and do not change. The
investment decisions are, in other words, assumed to
The total financing remains constant. The firm can change
its degree of leverage (capital structure) either by selling
shares and use the proceeds to retire debentures or by
raising more debt and reduce the equity capital.
The operating profits (EBIT) are not expected to grow.
Business risk is constant over time and is assumed to be
independent of its capital structure and financial risk.
Perpetual life of the firm.
The essence of this approach is that capital structure
decision of a corporate does not affect its cost of
capital and valuation, and, hence, irrelevant.
Net Operating Income (NOI)
The NOI Approach is based on the following
Overall cost of capital/ capitalization Ratio(K◦) is
Residual Value of Equity
Changes in cost of equity capital
Optimum Capital Structure
Market Price of Share
Cost of Debt
0 0.5 1.0
Degree of Leverage (B/V)
Leverage and Cost of Capital (NOI Approach)
k0 and ki remain unchanged as the degree of leverage changes, but as the
degree of leverage increases, the ke increases continuously.
P resented by Modigliani and Miller in 1958
Modigliani and Miller (MM) concur with NOI and
provide a operational justification for the irrelevance
of capital structure.
They maintain that the cost of capital and the value
of the firm do not change with a change in leverage.
Degree of Leverage (B/V)
Leverage and Cost of Capital (MM Approach)
The overall cost of capital (k0) and the value of the
firm (V) are independent of its capital structure
The cost of equity of a levered firm is equal to the
cost of equity of an unlevered firm plus a financial
risk premium, which depends on the degree of
The discount rate for investment purposes is
completely independent of the way in which an
investment is financed.
Perfect capital markets: The implication of a perfect
capital market is that
investors are free to buy/sell securities
investors can borrow without restrictions on the
same terms and conditions as firms can
there are no transaction costs
information is perfect, that is, each investor has the
same information which is readily available to him
without cost and
investors are rational and behave accordingly.
Given the assumption of perfect information and
rationality, all investors have the same expectation of
firm’s net operating income (EBIT) with which to
evaluate the value of a firm.
Business risk is equal among all firms within similar
The dividend payout ratio is 100 per cent.
There are no taxes. (This assumption is removed later)
MM’s Proposition 1
The market value of any firm is independent of its
If a company has a given set of assets, changing debt
to equity will change the way net operating income
is divided between lenders and shareholders but will
not change the value of the company.
Value of a company is given by:
annual net operating income
According to the MM hypothesis, this situation cannot
continue for long time, as the arbitrage process, based
on the substitutability of personal leverage for
corporate leverage, will operate and the values of the
two firms will be brought to an identical level.
Proof of Proposition 1
Suppose two firms one Levered “L” and the other
unlevered “U” identical by nature i.e. capital, and profits
falling in the same risk class but having different capital
structure and Market value.
Equity 100,000 150,000
8% Debentures 50,000 -
Market price per share Rs. 13 Rs. 10
EBIT Rs. 20,000 Rs. 20,000
Suppose there is an investor “Mr. X”, holding 10%
shares of Levered firm “L”
Since the market value of L is greater than U, where
as profit is the same
So, Mr. X will sell his 10% shares in firm L
And will raise a personal loan in the same
proportion i.e. 10%
Total cash in hand is: Rs. 13,000+5000= Rs.18,000
He will invest that amount in shares of firm U. which
amounts to 12% of total shares in firm U
EBIT Rs. 20,000 Rs. 20,000
Less: Interest (4000) -
EBT/NI 16,000 20,000
Dividend 10% i.e. 1600 12% i.e. 2400
Profit earned by Mr. X from Unlevered firm = Rs. 2400
Less: Interest to be paid on loan(50,000×8%) = (400)
Total profit earned = Rs. 2000
Arbitrage process will continue till the share prices of Firm L fall and Firm U’s rises.
So as to make the market prices of both firms identical