Capital Structure Theory –

Different theories of capital structure:

The following theories of capital structure have been developed in the literature of finance :-
1) Net Income approach.
2) Net Operating Income Approach.
3) Modigliani and Miller Theory.
4) The Tradeoff Theory.
5) Signaling Theory.

The following sub-sections explain each of the theories of capital structure

Net Income Approach:
Net Income theory was introduced by David Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. This means that a change in the
financial leverage will automatically lead to a corresponding change in the overall cost of capital
as well as the total value of the firm. A firm can choose a degree of capital structure in which
debt is more than equity share capital. According to NI approach, if the financial leverage
increases, the weighted average cost of capital decreases and the value of the firm and the
market price of the equity shares increases. Similarly, if the financial leverage decreases, the
weighted average cost of capital increases and the value of the firm and the market price of the
equity shares decrease
Net Income Approach suggests that value of the firm can be increased by decreasing the overall
cost of capital (WACC) through higher debt proportion. There are various theories which
propagate the ‘ideal’ capital mix / capital structure for a firm. Capital structure is the proportion
of debt and equity in which a corporate finances its business. The capital structure of a
company/firm plays a very important role in determining the value of a firm.

A corporate can finance its business mainly by 2 means i.e. debts and equity. However, the
proportion of each of these could vary from business to business. A company can choose to
have a structure which has 50% each of debt and equity or more of one and less of another.
Capital structure is also referred to as financial leverage, which strictly means the proportion of
debt or borrowed funds in the financing mix of a company.

Debt structuring can be a handy option because the interest payable on debts is tax deductible
(deductible from net profit before tax). Hence, debt is a cheaper source of finance. But
increasing debt has its own share of drawbacks like increased risk of bankruptcy, increased
fixed interest obligations etc.
For finding the optimum capital structure in order to maximize shareholder’s wealth or value of
the firm, different theories (approaches) have evolved. Let us now look at the first approach
NET INCOME APPROACHEXPLAINED
 Net Income Approach was presented by Durand. The theory suggests increasing value of
the firm by decreasing the overall cost of capital which is measured in terms of Weighted
Average Cost of Capital. This can be done by having a higher proportion of debt, which is a
cheaper source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where the weights are the amount of capital raised from each source.

Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt

WACC = Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of
the company. The Net Income Approach suggests that with the increase in leverage (proportion
of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a
decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it
would have a positive impact on the value of the business and thereby increase the value per
share.

ASSUMPTIONS OF NET INCOME APPROACH

Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 The cost of debt is less than the cost of equity.
 There are no taxes levied.

Criticisms of NI Approach
However, NI approach takes in to consideration the earning available for equity shareholders
for calculating the market value of equity shares, it is more realistic and reflects the impact of
financial leverage on market value of the firm, it suffers from some drawbacks. The NI approach
is criticized on following grounds:
(i) The assumption of constant cost of debt at any level of debt is not correct. The funds
providers insist for more rate of interest above certain level of debt.
(ii) The assumption of risk perception of equity shareholders is also not correct. As the debt
increases the financial risk also increases and equity shareholders will expect more return on
their investment and hence the rate equity capitalization also increases with the increase in
financial leverage.
(iii) 100% dividend payout and absence of corporate tax are not practically possible.
Example:
A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and
the cost of equity is 12.5(ke)%.

Net Operating Income Approach

Net Operating Income Approach was also suggested by Durand. This approach is of the
opposite view of Net Income approach. This approach suggests that the capital structure
decision of a firm is irrelevant and that any change in the leverage or debt will not result in a
change in the total value of the firm as well as the market price of its shares. This approach also
says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:

At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a
given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to
EBIT/overall capitalization rate.

The value of equity of a firm can be determined by subtracting the value of debt from the total
value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm -
value of debt. Cost of equity increases with every increase in debt and the weighted average
cost of capital (WACC) remain constant. When the debt content in the capital structure
increases, it increases the risk of the firm as well as its shareholders. To compensate for the
higher risk involved in investing in highly levered company, equity holders naturally expect
higher returns which in turn increases the cost of equity capital.

Assumptions / Features of Net Operating Income Approach:

1. 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/Overall capitalization rate”
2. 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
3. WACC (Weighted Average Cost of Capital) remains constant; and with the increase in
debt, the cost of equity increases. An increase in debt in the capital structure results in
increased risk for shareholders. As a compensation of investing in the highly leveraged
company, the shareholders expect higher return resulting in higher cost of equity capital
Modigliani and Miller Theory:
MM theory or approach is fully opposite of traditional approach. This approach says that there
is not any relationship between capital structure and cost of capital. There will not effect of
increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor's expectations. Investors'
expectations may be further affected by large numbers of other factors which have been
ignored by traditional theorem of capital structure. Here the market value of the firm depends
on, net operating income and risk involved in it interest on the firm financing. Modigliani and
Miller (1958) cannot be left out when the discussion of capital structure is in force. In corporate
finance literature, these two scholars are credited as the originators of the capital structure
theories. In their contribution to theories on capital structure, they came out with two main
propositions namely M and M proposition I and M and M proposition II.

M and M proposition I

The first preposition put forward by Modigliani and Miller (1958), states that a firms cost of
capital which is represented by weighted average cost of capital remains stable at all levels of
leverage, the import of this is that, there is no optimal capital structure for a particular
company and for that matter an industry. Their notion was that, it is completely irrelevant how
a firm chooses to arrange its finance. In other words, the value of the firm is independent of its
capital structure. In drawing this conclusion, the following assumptions were made;
An individual can borrow at the same rate and conditions as corporations, such that if
individuals can borrow at a higher rate, one can easily show that corporations can increase firm
value by borrowing.
Secondly that the capital markets were perfect, this assumption was central to means that,
bankruptcy risk could be ignored so that distressed companies could always raise additional
finance in a perfect market. The notion of the perfect capital market is also defined by; the
stocks of different companies are homogenous and there can serve as perfect substitute,
Investors are in a consensus about the expected future returns for all shares and all securities
are traded under perfect market conditions
In sum according to the theory the way in which a firm arrange its assets can have no impact on
the value of the firm. The value of a firm is derived from the net present value of investments
the firm has committed its current resources into.

M & M proposition II

Modigliani and Miller (1963) amended their model in their second paper and the result was the
proposition II. The amendment according to Watson and Head (2010) was done in relation to
their acknowledgement of the existence of corporate tax and the tax deductibility of interest
payment. This means that as the firm increases its leverage, by replacing equity with debt, it
shields more and more of its profits from tax. However they indicated that, although varying
capital structure of the firm may not change the firms’ total value; it does cause important
changes in the firms’ debt and equity.
M&M II demonstrated that, as the firm raises its gearing proportion, the increase in leverage
raises the risk of the equity and therefore the required return, or cost of equity (KE). Modigliani
and Miller (1963), Proposition II indicated that the cost of equity depends on three things: the
required rate of return on the firm’s assets; the firm’s cost of debts and the firm’s debt-equity
ratio.
Modigliani and Miller (1963), proposition II therefore states that, a firm’s cost of equity capital
has a positive linear relationship with its capital structure. Modigliani and Miller therefore
concluded from figure 4 that the cost of capital or the required rate of return on the firm’s
assets (KA) does not depend on the debt-equity ratio; it is the same no matter what the debt-
equity ratio is. The import of this is that the firm’s overall cost of capital is unaffected by its
capital structure.
Hence, the fact that the cost of debt is lower than the cost of equity means that, the benefit of
cheaper debt capital is exactly offset by the increase in the cost of equity from borrowing as a
result of the increment in financial risk exposed to the equity holders of the company. In other
words, the change in the weight of debts and equity in the capital structure of a particular firm
is exactly offset by the change in the cost of equity (RE), so the cost of capital of the company
stays the same.
Gatsi and Akoto (2010) recognised that, the fundamental theoretical model of capital structure
centres on some key assumptions which include; the idea that firms have information that
investors do not have, and that the interest of managers, equity – holders and debt holders
may not coincide. The writers also found that though the theories have also recognized the
benefits of financial leverage in firm financing while avoiding friction and bankruptcy costs of
financial distress arises the need to review friction and bankruptcy cost.
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.

Basic Propositions of MM approach:

1. At any degree of leverage, the company's overall cost of capital (ko) and the Value of
the firm (V) remains constant. This means that it is independent of the capital structure.
The total value can be obtained by capitalizing the operating earnings stream that is
expected in future, discounted at an appropriate discount rate suitable for the risk
undertaken.

2. The cost of capital (ke) equals the capitalization rate of a pure equity stream and a
premium for financial risk. This is equal to the difference between the pure equity
capitalization rate and ki times the debt-equity ratio.
 3. The minimum cut-off rate for the purpose of capital investments is fully independent of
the way in which a project is financed.

Assumptions of MM approach:

a) Inventors can borrow or lend at the same market rate of interest .

b) There is absence of bankruptcy costs.
c) The capital markets are efficient , so the information flows freely to the investors and there
exists no transaction cost.
d) The capital market is highly competitive.
e) There is absence of tax.
f) Investors are indifferent between dividend and retained earnings.
g) There is co-incidence of expectation among investors.

Arbitrage process
Arbitrage process is the operational justification for the Modigliani-Miller hypothesis.
Arbitrage is the process of purchasing a security in a market where the price is low and selling it
in a market where the price is higher. This results in restoration of equilibrium in the market
price of a security asset. This process is a balancing operation which implies that a security
cannot sell at different prices. The MM hypothesis states that the total value of homogeneous
firms that differ only in leverage will not be different due to the arbitrage operation. Generally,
investors will buy the shares of the firm that's price is lower and sell the shares of the firm
that's price is higher. This process or this behavior of the investors will have the effect of
increasing the price of the shares that is being purchased and decreasing the price of the shares
that is being sold. This process will continue till the market prices of these two firms become
equal or identical. Thus the arbitrage process drives the value of two homogeneous companies
to equality that differs only in leverage.

Limitations of MM hypothesis:
a) Investors would find the personal leverage inconvenient.
b) The risk perception of corporate and personal leverage may be different.
c) Arbitrage process cannot be smooth due the institutional restrictions.
d) Arbitrage process would also be affected by the transaction costs.
e) The corporate leverage and personal leverage are not perfect substitutes.
f) Corporate taxes do exist. However, the assumption of "no taxes" has been removed
later.
Criticisms of M-M approach

a) In practice , there is the absence of perfect markets and rational investors . As a result, the
investors may not have the requisite information.
b) By avoiding taxes and transaction cost ,the model becomes too simplified to reflect the actual
condition in the security market.
c) The assumes that firms and individual can borrow and lend at the same interest rate does
not hold in will in real situation.
d) The proof of proposition -1 assumes that investors are willing to pledge their stock as
collateral to borrow money . But in really , investors may be willing to accept such a personal
risk .
e) The existence of transaction costs also interferes with working of arbitrage.
f) Institutional restrictions also impede the working of arbitrage .
g) It is incorrect to assume that personal home made leverage is a perfect substitute for
corporate leverage.

Trade-off Theory of Capital Structure

The Trade-off theory of capital structure refers to the idea that a company chooses how much
debt finance and how much equity finance to use by balancing the costs and benefits . Trade-off
theory of capital structure basically entails offsetting the costs of debt against the benefits of
debt.
The Trade-off theory of capital structure discusses the various corporate finance choices that a
corporation experiences. The theory is an important one while studying the Financial
Economics concepts. The theory describes that the companies or firms are generally financed by
both equities and debts.
Trade-off theory of capital structure primarily deals with the two concepts – cost of financial
distress and agency costs. An important purpose of the trade-off theory of capital structure is to
explain the fact that corporations usually are financed partly with debt and partly with equity.
It states that there is an advantage to financing with debt, the tax benefits of debt and there is a
cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and
non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms,
bondholder/stockholder infighting, etc).
The marginal benefit of further increases in debt declines as debt increases, while the marginal
cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when
choosing how much debt and equity to use for financing.
Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an optimal
capital structure which is given by the trade off theory. According to Modigliani and Miller, the
attractiveness of debt decreases with the personal tax on the interest income. A firm experiences
financial distress when the firm is unable to cope with the debt holders’ obligations. If the firm
continues to fail in making payments to the debt holders, the firm can even be insolvent. The first
element of Trade-off theory of capital structure, considered as the cost of debt is usually the
financial distress costs or bankruptcy costs of debt. It is important to note that this includes the
direct and indirect bankruptcy costs.
Trade-off theory of capital structure can also include the agency costs from agency theory as a
cost of debt to explain why companies don’t have 100% debt as expected from Modigliani and
Miller. 95% of empirical papers in this area of study look at the conflict between managers and
shareholders. The others look at conflicts between debt holders and shareholders. Both are
equally important to explain how the agency theory is related to the Trade-off theory of capital
structure.
The direct cost of financial distress refers to the cost of insolvency of a company. Once the
proceedings of insolvency starts, the assets of the firm may be needed to be sold at distress price,
which is generally much lower than the current values of the assets. A huge amount of
administrative and legal costs are also associated with the insolvency. Even if the company is not
insolvent, the financial distress of the company may include a number of indirect costs like –
cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and
cost of shareholders.
debt holders and shareholders. These disputes generally give birth to agency problems that
in turn give rise to the agency costs. The agency costs may affect the capital structure of a
firm. There may be two types of conflicts – shareholders-managers conflict and
shareholders-debt-holders conflict. The introduction of a dynamic Trade-off theory of
capital structure makes the predictions of this theory a lot more accurate and reflective of
that in practice.
The tradeoff theory of capital structure suggests that target debt ratio may vary from to firm.
While firms with safe tangible assets and enough taxable income to shield ought to have high
target ratios, the unprofitable firms with risky intangible assets ought to rely on equity
financing. In the absence of the cost of adjustment, each firm should be at its debt target ratio.
The trade off avoids extreme-predictions and rationales moderate The firms may often
experience a dispute of interests among the management of the firm, debt ratio.

Signaling theory:
The signalling theory is based on the conception that managers have more superior information
than outside investors when it comes to the financial performance and non financial
performance of the firm, and would thus send some form of message through this potential
information to investors by increasing leverage. Barclay and Smith (2005) in a contrast view to
the market timing theory mentioned that, securities often are seen as an attempt to raise
capital with the minimum cost, the signalling model assumes that financing decisions are
designed basically to convey future prospects to outside investors. This is usually done to raise
the value of shares when managers think they are undervalued.
Gatsi (2012), argued that debt obligates firms to make a fixed cash payment to debt-holders
over the term of the debt security. They also mentioned that firms could be forced into
bankruptcy and liquidity, if they default in honouring their debt obligations, and would
ultimately affect the managers as they could lose their jobs. Managers may be aware of this
and do everything possible to maintain their positions, all things being equal.
Barclay and Smith (2005) contend that, dividend payments are not obligatory and managers
have more judgment over their payments and can omit them in times of financial difficulty.
Ross et al (2011) indicated that adding more debt to the company’s capital structure can show
as a credible signal of higher expected future cash flows as it shows that the firm has a credible
reputation been able to redeem their credit responsibilities on time. In view of this, increasing
gearing has been suggested one of the potentially effective signalling tools.
Two other signalling models are described by Heinkel in 1982 and Blazenko in 1987. The Heinkel
model is focused on debt signalling information to the investors about the average and
variability of the returns. In that model he assumed that positive relationship between the
average and the degree of variability facilitates signalling equilibrium in which higher value
firms signals their quality with higher debt levels while the Blazenko model observes that
managers that are prone to the mean variance criterion would shift risky positive net present
value investments opportunities thus reducing the value of the firm.
From the fore-going discussion, it evident that higher – value firms would use more debt in
their capital structure to signal this value relative to their low – value counterpart and this is
based on the premise that inefficient firms cannot manage debt and any attempt to use more
debt would jeopardize the financial health of the firm due to bankruptcy and its associated
costs.

According to this theory, the use of stock is a negative signal, while using debt is a positive or at
least neutral signal. Therefore, companies try to maintain a reserves borrowing capacity; and
this means using less debt in normal times than the MM trade off theory would suggest.

CONCLUSION

We can see above how many theories exist for defining the optimal capital structure.
Proposition I of MM has become the first step in capital structure theory and it is sometimes
called the 'irrelevance' theorem. It states that, as an implication of equilibrium in perfect capital
markets, the value of a firm is independent of its capital structure. The second step was also
made by MM in 1963, when corporate taxes are introduced in the model, 100% debt financing is
optimal. The third step in capital structure theory was first suggested by Baxter in 1976 and later
formalized by others. Now, bankruptcy costs are introduced. The tradeoff between the tax
advantage of debt and bankruptcy costs associated with debt results in an optimal capital
structure, the so called balancing theorem. Despite these theoretical appeals, researchers in
financial management have not found the optimal capital structure.