Capital Structure Theories: NI, NOI, Traditional & Modigliani-Miller Explained

 Capital Structure Theories 

Capital structure theories explain how a firm’s mix of debt and equity financing influences its overall value. These theories analyse whether changing the capital structure can increase or decrease the market value of the firm. Different theories offer different perspectives on the relationship between debt, equity, and firm value.

Four Important Theories of Capital Structure

1. Relevant Theory (According to this view, capital structure affects the value of the firm)
• Net Income (NI) Theory - This theory suggests that increasing debt in the capital structure reduces the overall cost of capital and increases the value of the firm. It assumes that debt is a cheaper source of finance than equity.
• Traditional Theory - The traditional approach proposes that there is an optimal capital structure where the cost of capital is minimized and the firm’s value is maximized. Beyond a certain level of debt, the cost of equity increases due to rising financial risk.
2. Irrelevant Theory (According to this approach, capital structure has no impact on the value of the firm)
• Net Operating Income (NOI) Theory - This theory argues that the overall cost of capital and the value of the firm remain constant regardless of the capital structure. Increasing debt only raises the cost of equity proportionately, leaving the total cost of capital unchanged.
• Modigliani–Miller (MM) Theory - MM Theory states that, under perfect market conditions (no taxes, no bankruptcy cost, and efficient markets), the capital structure does not influence the firm’s value. The value depends solely on the firm’s operating income and business risk.

Net Income (NI) Approach

The Net Income Approach was suggested by David Durand. Durand proposed that a change in financial leverage (debt usage) directly affects the cost of capital. In simple terms: if a company increases its debt to finance investments, its capital structure expands, the Weighted Average Cost of Capital (WACC) decreases, and the value of the firm rises.

Key Idea:

In the NI approach, the cost of capital is a function of the capital structure. Leverage is considered a significant factor, and financing decisions have a direct impact on firm value.

Relationship Summary:

1. Firm Value (MV) ↑
2. Cost of Capital (COC) ↓
3. Debt ↑

Assumptions of the Net Income Approach

1. Firms use only two sources of capital: debt and equity.
2. The firm has a policy of paying 100% of earnings as dividends.
3. Operating earnings are not expected to grow.
4. Business risk is assumed to be constant and independent of capital structure.
5. No corporate or personal income taxes exist.

Net Operating Income (NOI) Approach

The Net Operating Income Approach was also suggested by David Durand. This approach is the opposite of the Net Income (NI) Approach. According to the NOI approach, changes in capital structure do not affect the market value of the firm.

According to the NOI approach, changes in capital structure do not affect the market value of the firm. The market value of the firm (V) is determined by capitalising the net operating income (NOI) at the overall cost of capital (K₀), which is assumed to be constant:

                                                      V=D+S=NOI/K₀ 

Key Points:

1. K₀ is the overall capitalisation rate, reflecting the business risk of the firm.
2. If NOI and K₀ are independent of the financial mix (debt-equity ratio), then the firm value (V) remains constant, regardless of changes in capital structure.

Assumptions of the NOI Approach

1. The split between debt and equity is not important.
2. The cost of equity (Kₑ) is constant.
3. No corporate income taxes exist.

Traditional Approach (Intermediate Approach)

It is also called the Intermediate Approach, the Traditional Approach lies between the Net Income (NI) and Net Operating Income (NOI) approaches. According to this theory, the value of the firm can be increased and the cost of capital can be reduced by maintaining a judicious mix of debt and equity.

Key idea:

1. The firm’s value increases as debt are introduced into the capital structure up to a certain point.
2. Beyond this optimal level of debt, the firm’s value remains constant, and if borrowing continues excessively, the value may start to decline due to increased financial risk.

Summary:

1. Optimal capital structure exists where cost of capital is minimized and firm value is maximized.
2. Too much debt can increase financial risk and eventually reduce firm value.

Modigliani–Miller (MM) Approach

The Modigliani–Miller (MM) Approach is similar to the Net Operating Income (NOI) Approach. According to MM, in the absence of taxes, a firm’s market value and cost of capital are unaffected by changes in capital structure.

Key idea: the market value of a firm is determined by the present value of its future earnings, not by the mix of debt and equity.

Assumptions of the MM Approach

1. Perfect capital markets (no transaction costs, no information asymmetry).
2. Business risk remains constant and is independent of financial decisions.
3. No taxes (corporate or personal).
4. Full pay out policy (all earnings are distributed as dividends).

Comparison Table: Capital Structure Theories

Basis of Comparison	Net Income (NI) Approach	Net Operating Income (NOI) Approach	Traditional Approach	Modigliani–Miller (MM) Approach
Suggested By	David Durand	David Durand	– (General Traditional View)	Modigliani & Miller
Basic View	Capital structure affects value of firm	Capital structure does NOT affect value of firm	Intermediate between NI & NOI	Similar to NOI (no taxes): capital structure does NOT affect value
Effect of Leverage on Value of Firm	Firm value increases with more debt	No impact of leverage on firm value	Increases initially, then constant, then decreases	No impact, if no taxes
Cost of Capital (Ko)	Decreases with more debt (because cheaper debt is added)	Constant, irrespective of debt	Decreases up to an optimal point, then increases	Constant, if no taxes
Cost of Equity (Ke)	Slight increase due to high debt	Increases with more debt because equity becomes riskier	Increases gradually as debt increases	Increases as debt increases (risk changes)
Optimal Capital Structure	Yes, achieved when debt is high	No, capital structure irrelevant	Yes, there exists an optimal mix of debt & equity	No optimal structure (in no-tax world)
Assumptions	No taxes, fixed operating income, 100% dividend payout	No taxes, business risk constant, debt rate constant	Conservative, practical approach	Perfect capital market, no taxes, full payout, identical risk class
WACC Behavior	Falls with leverage	Remains constant	Falls at first, reaches minimum, then rises	Constant
Market Value of Firm (V)	Increases with leverage	Independent of leverage	Increases then decreases	Independent of leverage
Main Message	More debt = lower WACC = higher firm value	Capital structure is irrelevant	A balanced mix of debt & equity minimizes WACC	Capital structure is irrelevant under ideal conditions

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