Management Notes

Reference Notes for Management

Capital Structure Theories – Capital Structure | Corporate Finance

Capital Structure Theories | Net Income (NI) approach | Traditional Approach | Net Operating Income (NOI) Approach | Modigliani and Miller (MM) Approach | Capital Structure | Corporate Finance

Capital Structure

Any business organization needs funds to run their business organization. Sources of funds can be broadly classified as the short term sources and long term sources. Combination of these long term and short term sources is called financial structure of the firm but capital structure is the mixture of only long term debt and equity capital.

There are different debt instruments and ownership capital instruments are available in capital market. i.e. bond, promissory notes, preferred stocks, retain earnings, common stocks. Different instruments have different cost, different risk and different benefits.

Theories of Capital Structure

Capital Structure Theories


One of the crucial financing decisions is the decision of proportion of debt and equity that is concerned with the effect of mix of capital sources on its overall cost and valuation of the firm. There are four theories on capital structure which can be classified as irrelevant theory and relevant theory.

Relevant theories explains how the capital structure affects the value of firm and irrelevant theory criticize the relevant theories and explains how capital structure is irrelevant in determination of value of firm based on certain assumptions.

Above mentioned theories are based on some assumptions. They are as follows:

i. There are only two sources of financing i.e. common stock and long term debt.
ii. The issue of additional common stock is used to redeem debt and the issue of additional debt is used to repurchase common stock.
iii. All earnings are distributed as dividend that means dividend payout ratio is 1 and retention ratio is zero.
iv. The debt is assumed to be perpetual and no existence of flotation cost at the time of issuance of securities.
v. The firm operating income (EBIT) is assumed to be constant.
vi. No existence of tax.
vii. The firm is not exposed to the risk of financial distress and hence there is no bankruptcy cost.

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