Capital Structure Theories Archives - RBL Academy

Capital Structure Theory notes & solved questions - NI & NOI Approach, Financial Management study material on Capital Structure - NI Approach, NOI & Traditional Approach, M&M Hypothesis Arbitrage Theory. Critical theories or approaches to financial leverage or capital structure or financing mix are as follows: Net Income Approach Durand suggested this approach, and he favored the financial leverage decision. According to him, a change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases, and hence the value of the firm increases. Net Operating Income Approach Durand also provides this approach. It is the opposite of the Net Income Approach if there are no taxes. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate that has no relation to the debt-equity ratio. If tax information is given, it recommends that WACC reduces with an increase in debt financing, and the firm’s value will start increasing. Traditional Approach This approach does not define hard and fast facts, and it says that the cost of capital is a function of the capital structure. The unique thing about this approach is that it believes in an optimal capital structure. Optimal capital structure implies that the cost of capital is minimum at a particular ratio of debt and equity, and the firm’s value is maximum. For more details – Traditional Approach. Modigliani and Miller Approach (MM Approach) It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory proposed two propositions. Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not affect the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes. Proposition II: It says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

Capital Structure Theories

Capital Structure Theories

Financial Management study material on Capital Structure – NI Approach, NOI & Traditional Approach, M&M Hypothesis & Arbitrage Theory

By admin, 3 yearsJune 4, 2022 ago