Theory of Capital Structure

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A number of theories are there for the theory of Capital Structure. Every author has shown their expertise in the field to develop some important theories that include:

  1. Traditional Approach
  2. Modigliani and Miller Approach
  3. Net Operating Income Approach
  4. Net Income Approach
  1. Traditional Approach:

According to traditional approach for Capital Structure, the capital value of an organization can be increased in the beginning. With the proper allocation of investments, thecost of capital gets decreased. This can only happen when more debt are taken as it is much cheaper source than other sources of funds like equity. It is also called as Ezra Solomon’s Approach.

  1. Modigliani and Miller Approach:

According to this approach, the capital value of an organizationis independent of the Capital Structure. This is how Modigliani-Miller Approach checks the average cost of capital. Its value does not change with the change of capital structure of the organization. This statement is truly like simple switching mechanism and can be called as arbitrage.

In this MM Approach, comparing two firms, every feature of these organizations will be identical except that of Capital Structure. Both these firms cannot have different cost of capital as they have arbitrage process.

For instance, these two organizations have different cost of capital. This means they do not possess arbitrage process. In this case, the firms will perform personal leverage to balance the situation and maintain the same value for arbitrage process. The MM Approach is also called as similar to Net Operating Income Approach.

Modigliani-Miller Approach is based on assumptions:

  • No transaction records of the organization
  • Every investor is free to sell and buy securities
  • No retained earnings but dividend payout ratio is considered as 100%
  • There is no risk of borrowing capital
  • No corporate taxes (However, it has been removed from the assumptions later)
  1. Net Operating Income Approach:

According to the Durand, Net Operating Income Approach is consideredas, any change in the Capital Structure of an organization or Cost of Capital does not affect company’s market value. Irrespective of the financing methods, overall Capital Structure remains the same.

For instance, if the debt-equity mix has different figures like 30:70, 10:90 or 50:50, the cost of capital remains constant. This approach is based on a few assumptions where all the structures are considered as optimum capital structure:

Other assumptions as follows:

  • The risk in the business process remains constant at each level of debt-equity
  • The market value of the organization capitalizes.
  1. Net Income Approach:

Net Income Approach is entirely opposite to Net Operating Income Approach. According to this approach, any organization can improve or better their market stand with more debt. This helps in minimizing the average cost of capital.

NI Approach is based on assumptions that include:

  • Cost of debt is always less than cost of equity
  • Debt of the firm never change the risk parameters of investors
  • No corporate taxes

What is Balanced Capital Structure?

Balanced or Optimum Capital Structure can be termed as ideal combinations of owned and borrowed capital. This helps to achieve maximization of market share along with decreasing the cost of capital. In every capital investment, the source of funds will always remain the same.

Characteristics of Balanced Capital Structure:

  1. Economy
  2. Conservatism
  • Attraction to the Investors
  1. Profitability
  2. Ease and Simplicity
  3. Effective Control
  • Solvency
  • Minimum Remuneration


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