Capital structure theories - NI Approach, NOI approach & MM Approach. Meaning of capital structure , Features of An Appropriate Capital Structure, Determinants of Capital Structure, Planning the Capital Structure Important Considerations,

1. FINANCIAL MANAGEMENT UNIT 04
CAPITAL
STRUCTURE
THEORIES

2. CONTENT
Traditional view vs MM hypothesis, MM position I &II, Capital structure designing
in practice – EBIT- EPS analysis, the pecking order theory. Factors impacting
leverage decision

3. MEANING OF CAPITAL
STRUCTURE
Capital structure is proportions of debt Instruments,
preferred and common stock on a company’s
balance sheet.
The term capital structure is used to represent the
proportionate relationship between debt and equity.
Equity includes paid up share capital, share
premium and reserves and surplus(Retained
earnings).

4. FEATURES OF AN APPROPRIATE CAPITAL
STRUCTURE
Optimal capital structure
Profitability / Return
Solvency / Risk
Flexibility
Conservation / Capacity
Control
Optimal capital structure - is that capital structure at that level of debt – equity proportion where the market
value per share is maximum and the cost of capital is minimum.

5. DETERMINANTS OF CAPITAL STRUCTURE
Seasonal
Variations
Tax benefit of
Debt
Flexibility Control
Industry
Leverage
Ratios
Agency Costs
Industry Life
Cycle
Degree of
Competition
Company
Characteristics
Requirements
of Investors
Timing of
Public Issue
Legal
Requirements

7. PLANNING THE CAPITAL STRUCTURE
IMPORTANT CONSIDERATIONS
Return: ability to
generate maximum
returns to the
shareholders, i.e.
maximize EPS and
market price per share.
Cost: minimizes the cost
of capital (WACC). Debt
is cheaper than equity
due to tax shield on
interest & no benefit on
dividends.
Risk: insolvency risk
associated with high debt
component.
Control: avoid dilution of
management control,
hence debt preferred to
new equity shares.
Flexible: altering capital
structure without much
costs & delays, to raise
funds whenever
required.
Capacity: ability to
generate profits to pay
interest and principal.

10. INTRODUCTION TO THE THEORY
• Can a company affect its total valuation and its required return by
changing its financing mix?
• In this unit, we are going to find out what happens to the total
valuation of the firm and to its cost of capital when the ratio of debt to
equity, or degree of leverage, is varied.
• We use a capital market equilibrium approach because it allows us to
abstract from factors other than leverage that affect valuation.

11. ASSUMPTIONS AND DEFINITIONS
To present the analysis as simply as possible, we make the following
assumptions:
1. There are no corporate or personal income taxes and no bankruptcy costs.
(Later, we remove these assumptions.)
2. There are no transaction costs-The ratio of debt to equity for a firm is
changed by issuing debt to repurchase stock or issuing stock to pay off debt.
3. The firm has a policy of paying 100 percent of its earnings in dividends.
Thus, we abstract from the dividend decision.

12. CONTD….
4. Investors are rational-The expected values of
the subjective probability distributions of expected
future operating earnings for each company are
the same for all investors in the market.
5. The operating earnings of the firm are not
expected to grow. The expected values of the
probability distributions of expected operating
earnings for all future periods are the same as
present operating earnings.

13. CAPITAL STRUCTURE THEORIES
The Net Income
Approach (NI)
The Traditional
Approach
The Net Operating
Approach (NOI)
The Modigliani-
Miller Approach
(MM)

14. NET INCOME APPROACH (NI)
Net Income approach proposes that there
is a definite relationship between capital
structure and value of the firm.
The capital structure of a firm influences its
cost of capital (WACC), and thus directly
affects the value of the firm.
NI approach assumptions –
• Continuous increase in debt does not affect the risk
perception of investors.
• Cost of debt (Kd) is less than cost of equity (Ke) [i.e.
Kd < Ke ]
• Corporate income taxes do not exist.

18. NET OPERATING INCOME
Assumptions –
WACC is always constant, and it depends on the business risk which remains constant.
Value of the firm is calculated using the overall cost of capital i.e. the WACC only. Thus the
split between debt and equity is not important.
The cost of debt (Kd) is constant.
Corporate income taxes do not exist.

19. NET OPERATING INCOME
Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI)
approach.
As per NOI approach, value of a firm is not dependent upon its capital structure. Thus there
is no Optimal Capital Structure.
NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in
the capital structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher
cost of equity (Ke) A higher cost of equity (Ke) nullifies the advantages gained due to
cheaper cost of debt (Kd ).
In other words, the finance mix is irrelevant and does not affect the value of the firm.

31. PECKING ORDER THEORY
• The “PECKING ORDER THEORY” is based on the assertion that
managers have more information about their firms than investors.
• This disparity of information referred to as asymmetric information.
• Managers will issue debts when they are positive about their firms future
prospects and will issue equity when they are unsure.
• A commitment to pay to fixed amount of interest and principal to debt-
holders implies that the company expects steady cash flows. On the other
hand, an equity issue would indicate that the current share price is
overvalued.
• This implies that firms always use internal finance and choose debt over
new issue of equity when external financing is required.

32. CONTD…
• Hence Myers has called it the ‘ Pecking order’ theory . Since there is not well
defined debt-equity target.
• There are two kinds of equity, internal and external.
• Debt is cheaper than internal and external equity because of interest deductibility.
• Internal equity is cheaper and easier to use than external equity because
1. No taxes paid on retained earnings.
2. No transaction costs