Class: M.B.A.

Year: I/ Semester-II
Name of Paper: Financial Management
and
Corporate Finance

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
 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.
 Total assets of the company are
given &do not change.
 THEORIES OF CAPITAL STRUCTURE

Theories

Relevance Irrelevance
Theories Theories

Net-Operating Modigliani &

Net Income Miller(M&M)
Traditiona Income
Approach Approach
l Approach
Approach
 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.
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.
 Traditional Approach

 There exist an optimal capital structure for every firm(2:1).

 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 average cost of capital, 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 but 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.
 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.
 MODIGLIANI & MILLER AAPPROCH
(MM)
 There is a relationship between cost of capital
and valuation of firm 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.
 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)/KE (Cost of Equity)

 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.
 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 :

D= Demand/buying in one market at lower price & S= supply in other market at higher price.
 SUMMARIZED FORM OF THEORIES OF
CAPITAL STRUCTURE

Net Income Net Operating M.M Approach Traditiona

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