- Capital structure refers to the proportion of different types of capital (equity, debt, preference shares) that make up a company's total financing. It influences the value of a firm. - Three main approaches to capital structure are the net income approach, net operating income approach, and traditional approach. The Modigliani-Miller approach argues that the value and cost of capital of a firm are unaffected by its capital structure under certain assumptions. - The net income approach suggests that increasing debt lowers the weighted average cost of capital and increases firm value. The net operating income approach argues that leverage does not affect total firm value. The traditional approach proposes an optimal debt-equity mix that maximizes firm value.

1. BY:-
DEEPAK KUMAR
DEEPAK KUMAR N
JAIKANTH

2. • Capital structure is the proportion of all types of
capital viz. equity, debt, preference etc. It is
synonymously used as financial leverage or financing
mix.
• Capital structure is also referred as the degree of
debts in the financing or capital of a business firm.
• It is believed that with the change in capital
structure, the value of a firm can be influenced.

3. • net income
• net operating income
• traditional
• M&M(Modigliani and Miller Approach)

4. Net Income Approach
This approach was suggested by Durand and he
was in the favour of financial leverage
decision. According to him, change in financial
leverage would lead to change in cost of
capital. In short, if the ratio of debt in the
capital structure increases, the weighted
average cost of capital decreases and hence
the value of the firm.

5. ASSUMPTION
• The cost of debt is less than cost of equity
• There is on tax
• Risk perception of investor remains constant
• Net income approach effect of leverage or
cost of capital

6. Diagram
Ke :- cost of equity
Ko :- order cost of capital
Kd :- cost of debt

7. • Value of firm(v)= S(Market value of
debt)+D(Market value of equity)
• Ko :- EBIT/V
Formula

8. Net Operating Income Approach (NOI
Approach)
• Net Operating Income Approach suggests that
change in debt of the firm/company or the
change in leverage fails to affect the total
value of the firm/company.

9. ASSUMPTION
• The overall capitalization rate remains constant irrespective
of the degree of leverage. At a given level of EBIT, value of
the firm would be “EBIT/Over all capitalization rate”
• Value of equity is the difference between total firm value
less value of debt i.e. Value of Equity = Total Value of the
Firm – Value of Debt
• WACC (Weightage Average Cost of Capital) remains
constant; and with the increase in debt, the cost of equity
increases. Increase in debt in the capital structure results in
increased risk for shareholders. As a compensation of
investing in highly leveraged company, the shareholders
expect higher return resulting in higher cost of equity
capital.

10. Diagram
Ke :- cost of equity
Ko :- order cost of capital
Kd :- cost of debt

11. EFFECTS OF LEVERAGE ON COST OF
CAPITAL
• Value of firm:-EBIT/ Ko
• S=V-D
Order cost of capital
Eraning before interest & tax
Market value of equity
Market value of debt
Value of firm

12. Traditional approach
• Traditional approach to capital structure
advocates that there is a right combination of
equity and debt in the capital structure, at
which the market value of a firm is maximum.
As per this approach, debt should exist in the
capital structure only up to a specific point,
beyond which, any increase in leverage would
result in reduction in value of the firm.

13. ASSUMPTION
• There are only two sources of funds used by a
firm; debt and shares.
•The firm pays 100% of its earning as dividend.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to
grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The total assets are given and do not change.
• The investors behave rationally.

14. Diagram

15. Modigliani & Miller Approach
• Modigliani and Miller (M.M) argue that, in the
absence of taxes, a firm’s market value and
the cost of capital remain invariant to the
capital structure changes.
• This theory proof that the cost of capital is not
effected by changes in the capital structure or
says that the debt equity mix is irrelevant in
the determination value of the firm.

16. ASSUMPTION
• The securities are traded in the perfect
market situation.
• 2. Firms can be grouped into homogeneous
risk classes.
• 3. The expected NOI is a random variable
• 4. Firm distribute all net earnings to the
shareholders.
• 5. No corporate income taxes exist.

17. Diagram

18. Proposition I
• Given the above stated assumptions, M-M
argue that, for firms in the same risk class, the
total market value is independent of the debt
equity combination and is given by capitalizing
the expected net operating income by the rate
appropriate to that risk class.

19. THANK YOU