Top 4 Theories of Capital Structure

This article throws light upon the top four theories of capital structure. The theories are: 1. Net Income Approach 2. Net Operating Income Approach 3. Traditional Approach 4. Modigliani-Miller Approach.

Theory # 1. Net Income (NI) Approach:

David Durand’ suggested the two famous capital structure theories, viz, Net Income

Approach and the Operating Income Approach:

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 firms 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 (K_d) is less then Cost of Equity (K_e);

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.

Illustration:

X Ltd. presents the following particulars:

EBIT (i.e., Net Operating income) is Rs. 30,000

The equity capitalisation ratio (i.e., cost of equity) is 15% (K.)

Cost of debt is 10% (K_d)

Total Capital amounted to Rs. 2,00,000

Calculate the cost of capital and the value of the firm for each of the following alternative leverage after applying the NI approach

Leverage (Debt to total Capital) 0%, 20%, 50%. 70% and 100%

Solution:

Workings:

Average Cost of Capital is computed as under (under various financing plans):

From the above table it is quite clear that the value of the firm (V) will be increased if there is a proportionate increase in debt capital but there will be a reduction in overall cost of capital. So, Cost of Capital is increased and the value of the firm is maximum if a firm uses 100% debt capital.

It is interesting to note that the NI approach can also be graphically presented as under (with the help of the above illustration):

The degree of leverage is plotted along with the X-axis whereas K_e K_w and K_d on the Y- axis. It reveals that when the cheaper debt capital in the capital structure is proportionally increased, the weighted average cost of capital K_w, decreases and consequently the cost of debt K_d. Thus, it is needless to say that the optimal capital structure is the minimum cost of capital, if financial leverage is one, in other words, the maximum application of debt capital.

The value of the firm (V) will also be the maximum at this point.

Theory # 2. Net Operating Income Approach:

Now we want to highlight the Net Operating Income (NOI) Approach which was advocated by David Durand based on certain assumptions.

They are:

(i) The overall capitalization rate of the firm K_w is constant for all degree of leverage;

(ii) Net operating income is capitalized at an overall capitalisation rate in order to have the total market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital (K_w):

V = EBIT/ K_w (Since both are constant and independent of leverage)

(iii) The market value of the debt is then subtracted from the total market value in order to get the market value of equity.

S = V-T

(iv) As the Cost of Debt is constant, the cost of equity will be:

K_e = EBIT – I / S

The NOI Approach can be illustrated with the help of the following diagram:

Under this approach, the most significant assumption is that the K_u is constant irrespective of the degree of leverage. The segregation of debt and equity is not important here and the market capitalizes the value of the firm as a whole. Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the corresponding increase in the equity-capitalisation rate.

So, the weighted average Cost of Capital K_w and K_d remain unchanged for all degrees of leverage. Needless to mention here that as the firm increases its degree of leverage it becomes more risky proposition and investors are to make some sacrifice by having a low P/E ratio.

Illustration:

Solution:

Although the value of the firm Rs. 2,50,000 is constant at all levels, the cost of equity is increased with the corresponding increase in leverage. Thus, if the cheaper debt capital is used, that will be offset by the increase in the total cost of equity, K_s and as such, both K_e and K_d remain unchanged for all degrees of leverage i.e., if cheaper debt capital is proportionately increased and used, the same will offset the increase of cost of equity.

Theory # 3. Traditional Approach:

It is accepted by all that the judicious use of debt will increase the value of the firm and reduce the cost of capital. So, the optimum capital structure is the point at which the value of the firm is highest and the cost of capital is at its lowest point. Practically, this approach encompasses all the ground between the net income approach and the net operating income approach i.e., it may be said as intermediate approach.

The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline. But after attaining the optimum level, any additional debt will cause to decrease the market value and to increase the cost of capital.

In other words, after attaining the optimum level, any additional debt taken, will offset the use of cheaper debt capital since the average cost of capital will increase along with a corresponding increase in the average cost of debt capital.

Thus, the basic, proposition of this approach are enumerated below:

(a) The cost of debt capital, K_d, remains constant more or less up to a certain level and thereafter rises.

(b) The cost of equity Capital, K_e, remains constant more or less or rise gradually up to a certain level and thereafter increases rapidly.

(c) The average cost of capital, K_w, decreases up to a certain level, remains unchanged more or less and thereafter rises after attaining a certain level.

The traditional approach can graphically be represented as under taking the data from the previous illustration.

It is found from the above, the average cost curve is U-shaped. That is, at this stage the cost of capital would be minimum which is expressed by the letter ‘A’ in the graph. If we draw a perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm.

Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. At that optimal structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal Real cost of equity in equilibrium.

For degree of leverage before that point, the marginal real cost of debt is less than of equity, beyond that point the marginal real cost of debt excess that of equity.

Illustration:

Solution:

Thus, from the above table, it becomes quite clear that cost of capital is lowest (at 25%) and the value of the firm is the highest (at Rs 2,33,333) when debt-equity mix is (1,00,000 : 1,00,000 or 1 : 1). Hence, optimum capital structure in this case is considered as Equity Capital Rs. 1,00,000 and Debt Capital Rs. 1,00,000 which bring the lowest overall cost of capital followed by the highest value of the firm.

Variations on the Traditional Theory:

We know that this theory underlies between the Net Income Approach and the Net Operating Income Approach. Thus, there are some distinct variations in this theory. Some followers of the traditional school of thought suggest that K_e does not practically rise till some critical conditions arise.

After attaining that level only, the investors apprehend the increasing financial risk and penalize the market price of the shares. This variation expresses that a firm can have lower cost of capital with the initial use of leverage significantly.

This variation in Traditional Approach is depicted as under:

Other followers e.g., Solomon, are of opinion that K is as being saucer shaped along with a horizontal middle range. It explains that optimum capital structure has a range where the cost of capital is rather minimised and where the total value of the firm is maximised.

Under the circumstances, a change in leverage has, practically, no effect on the total firm’s value. So, this approach grants some sorts of variation in the optimal capital structure for various firms under debt-equity mix.

Theory # 4. Modigliani-Miller Approach:

Modigliani-Miller (MM) advocated that the relationship between the cost of capital, capital structure and the valuation of the firm, should be explained by NOI (Net Income Operating Approach) by making an attack on the Traditional Approach.

The Net Income Operating Approach, we know, supply proper justification for the irrelevance of the capital structure. In this context, MM support the NOI approach on the principle that the cost of capital is not dependent on the degree of leverage irrespective of the debt-equity mix.

In other words, according to their thesis, the total market value of the firm and the cost of capital are independent of the capital structure. They advocated that the weighted average cost of capital does not make any change with a proportionate change in debt-equity mix in the total capital structure of the firm.

The same can be shown with the help of the following diagram: