This document discusses various theories of capital structure. It begins by defining capital structure as the mix of long-term funds used by a company, including long-term debt and shareholder equity. It then outlines four main approaches to capital structure: 1) The Net Income Approach suggests capital structure impacts a firm's market value through its effect on net income. 2) The Net Operating Income Approach argues capital structure does not impact firm value. 3) The Traditional Approach finds an optimal capital structure that balances increasing and decreasing returns. 4) The Miller-Modigliani Approach similarly argues capital structure does not matter under certain assumptions but allows for tax benefits of debt.

1. CORPORATE
FINANCE
Name: Urvah Ashraf.
Roll no: F-363
Class: M.com 4.
Lecturer: Sir Awais
Akram.

2. Capital Structure Theories
 Capital Structure.
 Net Income Approach. ( NI )
 Net Operating Income Approach. (NOI)
 Traditional Approach.
 Miller and Modigliani Approach. (M.M)

3. Capital Structure
Mix of Long term funds is called capital
structure.
A capital structure consists of long term debt
and shareholder equity of a company.
Liabilities + Share
Holder Equity
Long Term Debt
Share Holder equity Capital Structure

4. Capital Structure Theories
 Types
• Net Income Approach. ( NI )
• Net Operating Income Approach. (NOI)
• Traditional Approach.
• Miller and Modigliani Approach. (M.M)

5. I. Net Income Approach (NI)
• According to David Durand, NI indicates that
there exists a relationship between the capital
structure of the company and the market value
of the company.
Capital
Structure
Market
Value
Net Income
Approach

6. I. Net Income Approach (NI)
• Assumptions:
a. The amount of the capital, which is required is
given and will remain constant.
b. Cd > Ce
c. Cd and Ce are constant at all levels of
leverages. The market value of a firm will
increase.
d. Co will decrease as there will be an increase in
leverage.

7. X-axis = Cost of Capital
Y- axis = Financial Leverage
Ce
Co
Cd
I. Net Income Approach
• Graph

8. II. Net Operating Income Approach
(NOI)
According to NOI the capital structure and the
value of the firm has no relationship and capital
structure decisions have no impact on the value
of the firm.
• Assumptions
a. Co and Cd remain constant.
b. Ce will change as the degree of financial
leverage will increase or decrease.
c. No taxation exists.

9. X- axis = cost of capital
y- axis = financial leverage
Ce
Co
Cd
 Net Operating Income
Approach

10. III. Traditional Approach
 Mixture of Net Income Approach and Net Operating
Income Approach
 Suggests that there exists an optimal capital structure at
a suitable use and point of financial leverage up to a
limit.
Assumptions.
a. The value of the firm will increase as the size of
financial leverage will increase, but conditionally up to
a certain limit only.
b. Cd < Ce
c. Co (Weighted Average Cost of Capital) will be
minimum where a range of optimal capital structure
will exist.

11. * Figure 1
X- axis = cost of capital
Y- axis = Financial Leverage
* Figure 2
X- axis = value of firm
Y- axis = Financial leverge
Ce
Co
Cd
• Traditional Approach
• Figure 1
• Figure 2

12. IV. Modigliani and Miller Approach
 The approach of Modigliani and
Miller (1958) is same like Net
Operating Income Approach.

13. IV. Modigliani and Miller Approach
Assumption
• Tax rate =0%
• Transaction cost
• = 0
• Same
information
access to
investors
• Floatation cost
• = 0
• CDT rate =0%
Propositions
without
taxes
• P1
• The capital structure
does not influence
the value of firm.
• Debt holders
&equity
shareholders have
same priority.
• P2
• financial leverage is
in direct proposition
to COE.
• With rise in debt,
the equity
shareholders
perceive a higher
risk.
Proposition
with
taxes
• It assumes
existence of
taxes, therefore
tax benefits due
to interest
payments are
recognized.
• So, COST OF
DEBT reduces
by interest Tax
shields.
• Therefore,
change in debt
component can
affect value of a
firm.

14. THANK YOU