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Capital Structure Theories

1. Net Income (NI) Approach:


This approach is suggested by David Durand. According to NI approach a firm may increase the total
value of the firm by lowering its cost of capital.
When cost of capital is lowest and the value of the firm is greatest, we call it the optimum capital
structure for the firm and, at this point, the market price per share is maximised. The same is possible
continuously by lowering its cost of capital by the use of debt capital. In other words, using more debt
capital with a corresponding reduction in cost of capital, the value of the firm will increase.
The same is possible only when:
(i) Cost of Debt is less than Cost of Equity ;
(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the investors since the degree of leverage is
increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital decreases
which leads to increase the total value of the firm. So, the increased amount of debt with constant
amount of cost of equity and cost of debt will highlight the earnings of the shareholders.

2. Net Operating Income (NOI) Approach:


This approach is opposite to Net Income Approach and is suggested by Durand. According to this
approach, any change in capital structure of a company does not affect the market value of the firm. The
overall cost of capital remains the same irrespective of the mix of debt and equity. The assumptions
under this approach are the following:
a) the debt capitalisation rate is constant;
b) no corporate taxes
c) the proportion of debt and equity in the capital structure is not important

3. Modigliani Miller (MM) Approach:


Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income
approach. The MM approach favors the Net operating income approach and agrees with the fact that the
cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The
significance of this MM approach is that it provides operational or behavioral justification for constant
cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide
operational justification for independence of the company's cost of capital.
Assumptions of MM approach:
1. Capital markets are perfect.
2. All investors have the same expectation of the company's net operating income for the purpose of
evaluating the value of the firm.
3. Within similar operating environments, the business risk is equal among all firms.
4. 100% dividend payout ratio] that is all the earnings are distributed to shareholders

Leverage
Leverage can be defined as the employment of an asset or source of funds for which the firm has to pay a
fixed cost or fixed return. Because of the incurrence of fixed costs, the net income and the earnings
available to the equity shareholders as well as the risk gets affected. Leverage is favorable when the
earnings less the variable costs exceed the fixed costs or when the earnings before interest and taxes
exceed the fixed return requirement. Leverage is unfavorable in the reverse situation.
Leverage can be of two types; Operating & Financial leverages.
1. Operating leverage - The leverage associated with investment, i.e., asset acquisition activities is
called as operating leverage. Breakeven analysis shows that there are essentially two types of costs in
a company's cost structure -- fixed costs and variable costs. Operating leverage refers to the
percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio
of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs,
then the firm is said to have high operating leverage. These firms use a lot of fixed costs in their
business and are capital intensive firms. It is calculated as follows:

Operating Leverage = Contribution Operating Profit


Contribution = Sales Variable Cost
Operating Profit = Contribution Fixed Cost or EBIT

2. Financial Leverage - the leverage associated with financing activities is called as financial leverage.
Financial leverage can be aptly described as the extent to which a business or investor is using the
borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in
case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is
not that financial leverage is always bad. However, it can lead to an increased shareholders return on
investment. Also, very often, there are tax advantages related with borrowing, also known as leverage.

Financial Leverage = Operating Profit Profit before tax but after interest

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