Theories of Capital Structure

In Financial Management book, you would read the topic theories of capital structure. Here, I have made these theories simplified. I hope, you can study these theories here and use these theories as reference.

We all know that capital structure is combination of sources of funds in which we can include two main sources' proportion. One is share capital and other is Debt. All four theories are just explaining the effect of changing the proportion of these sources on the overall cost of capital and total value of firm.

If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. First 50 represent the share capital and second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure in simple and clean words.

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure

This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.

High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.


2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.


3rd Theory of Capital Structure

Name of Theory = Traditional Theory of Capital Structure

This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:

Ist Stage

In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm.

2nd Stage

In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure.

3rd Stage

Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital.

4th Theory of Capital Structure

Name of theory = Modigliani and Miller

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.