Capital structure

theories
Net operating income approach,
Modigliani miller model

Under The Guidance Of Dr. Shilpi Jauhari

 PRESENTED BY:-
1.AMIT MISHRA
2.ANSHIKA RANA
3.MAHIMA KASAUDHAN
4.PRIYA SINGH
5.VAISHALI SINGH
6.VANSH GUPTA
7.YOGESH CHANDRA SHUKLA
 AGENDA

1.Introduction to Capital Structure and Theories

2.Net Operating Income (NOI) Approach - Concept and
Assumptions
3.Features and Implications of NOI Approach
4.Modigliani and Miller (MM) Approach - Basics and Assumptions
5.MM Approach with and without Taxes
6.Criticisms and Limitations of NOI and MM Approaches
7.Comparative Analysis and Practical Implications
INTRODUCTION TO CAPITAL STRUCTURE :-

Funds are required in order to run a business smoothly and successfully. Finance plays an
important role right from the inception of business to its winding up. Both inadequacy and
excess funds are bad for a business. So it is significant to correctly estimate the capital
requirements of a business. Not only estimation of total requirement of capital is
important but determination of capital structure is also very important.

As per Gerestenberg,
‘’capital structure of a company refers to the composition or
make-up of its capitalization and it includes all long-term capital
resources viz. loans, reserves, shares and bonds.’’
So, it can be concluded that capital structure is the combination of debt and
equity securities and termed as the permanent sources of financing.
Importance of Financing Decisions:-
1. Ensuring Availability of Capital:-

Financing decisions ensure that an organization has sufficient funds to operate, invest in new
projects, and meet its obligations.
2. Optimal Capital Structure
• These decisions help strike a balance between debt and equity financing, aiming for a cost-effective
and risk-minimized capital structure.
• A well-balanced capital structure enhances profitability and financial stability
3. Impact on Financial Risk
• Financing choices directly influence the organization's financial risk. Too much
debt can lead to high financial leverage, while excessive equity can dilute
ownership.
• Careful analysis helps mitigate risks and maintain investor confidence
4.Adapting to Market Conditions
By making the right financing decisions, organizations can adapt quickly to changing market conditions, such as
interest rate fluctuations or economic downturns.
 THEORIES OF CAPITAL STRUCTURE:-
The important point of discussion is that whether the changes in the mix of debt
and equity in the capital structure of the business really affect the overall cost of
capital. The financial managers spend lots of time in deciding the mix of debt and
equity to reduce the overall cost of capital and to maximize the wealth of
shareholders. Thereois a diverse opinion of experts in this regard. A group of
expert says that the financial leverage decisions, capital structure decisions or mix
of debt and equity decisions do not affect the overall cost of capital. However, the
other panel says that these types of decisions are significant and certainly affect
the overall cost of capital or weighted cost of capital. Broadly speaking, the
theories of capital structure decisions have been divided into two categories.
These are:
• Relevant theories
• Irrelevant theories
 Net Income
Approach
Relevant
theories

Net Operating
Income Approach
THEORIES OF Irrelevant
CAPITAL theories
STRUCTURE
Modigliani and
Miller’s
Proposition
Mid-way
theories

Traditional
Approach
Assumption
1. The Ko(ovrall cost of capital) of the firm is constant.
2. The Kd (cost of debt) is constant.
3. There is no corporate Tax.
4. The use of more and more debt increases the risk of the
shareholders & thus result in increasing the ke( cost of equity).
5. Investor see the firm as whole and thus capitalises the total
earning of the firm.
Formula: V= EBIT/Ko
Formula
V=EBIT/Ko
E=V- D
Where, V: Value of the firm
E: Total Market Value of Equity
D: Total Market Value of Debt
# Graph
Features and Implications of Net Operating Income
(NOI) Approach
Key Features of NOI Approach:-
1. Cost of Capital Remains Constant
- Overall cost of capital (Ko) stays unchanged regardless of capital structure.
- Increased cost of equity offsets cheaper debt, keeping Ko constant.
- Investors demand higher equity return as financial risk increases.

2. Irrelevance of Capital Structure

- Proposed by David Durand.
- Capital structure has no effect on firm value under NOI.
- Value remains the same regardless of debt-equity mix.
How Firm Value is Calculated Under NOI

- Firm Value (V) = EBIT / Ko

• EBIT: Earnings Before Interest and Taxes
• Ko: Overall cost of capital (constant)

- Value of Equity (E) = V - D

• D: Market value of debt
Implications
- Firms cannot increase value by altering the debt-equity ratio.
- Investment decisions are more important than financing
decisions.
- Financial leverage has no impact on the firm's value under NOI.
Capital Structure Theory:–
Modigliani and Miller (MM) Approach

• Modigliani and Miller devised this approach during the 1950s. The
fundamentals of the Modigliani and Miller Approach resemble that
of the Net Operating Income Approach.
• Modigliani and Miller advocate capital structure irrelevancy theory,
which suggests that the valuation of a firm is irrelevant to a
company’s capital structure.
• Whether a firm is high on leverage or has a lower debt component
in the financing mix has no bearing on the value of a firm .
Modigliani and Miller Approach: Two Propositions without
Taxes
Proposition 1:-

With the above assumptions of “no taxes,” the capital structure

does not influence the valuation of a firm.
In other words, leveraging the company does not increase the
company’s market value.
It also suggests that debt holders in the company and equity
shareholders have the same priority, i.e., earnings are equally
split amongst them.
MM Proposition I (Capital Structure
Irrelevance)
•Formula:
Vl =vu
where:
•Vl = Value of a levered firm (firm with debt)
•Vu = Value of an unlevered firm (firm without
debt)
•It suggests that the firm's value is independent of
its capital structure.
Proposition 2:-

It says that financial leverage is directly proportional to the

cost of equity. With an increase in the debt component, the
equity shareholders perceive a higher risk to the company.
Hence, in return, the shareholders expect a higher return,
thereby increasing the cost of equity.
A key distinction here is that Proposition 2 assumes that
debt shareholders have the upper hand as far as the claim on
earnings is concerned.
Thus, the cost of debt reduces.
MM Proposition II (Cost of Equity and
Leverage)
•Formula:
rE=rU+D\E(rU−rD)

where:
•rE = Cost of equity
•rU = Cost of capital for unlevered firm
•rD = Cost of debt
•D/E = Debt-to-equity ratio
It suggests that as a firm takes on more debt, the cost
of equity increases due to additional financial risk.
Modigliani and Miller Approach: Propositions with Taxes (The
Trade-Off Theory of Leverage)

The Modigliani and Miller Approach assumes that there are no taxes,
but in the real world, this is far from the truth. Most countries, if not
all, tax companies.
This theory recognizes the tax benefits accrued by interest payments.
The interest paid on borrowed funds is tax-deductible. However, the
same is not the case with dividends paid on equity.
In other words, the actual cost of debt is less than the nominal cost of
debt due to tax benefits. The trade-off theory advocates that a
company can capitalize on its requirements with debts as long as the
cost of distress, i.e., the cost of bankruptcy, exceeds the value of the
tax benefits. Thus, until a given threshold value, the increased debts
will add value to a company.
Modigliani and Miller approach is based on the
following important assumptions:

• There is a perfect capital market.

• There are no retained earnings.

• There are no corporate taxes.

• The investors act rationally.

• The dividend payout ratio is 100%.

Criticisms and Limitations of NOI and MM
Approaches
• Overview of NOI and MM Approaches
• Importance in Capital Structure Theories
• Objective: Critically evaluate limitations and real-world relevance

Recap of NOI Approach

• Proposed by David Durand
• Assumes value of the firm is independent of capital structure
• Cost of capital remains constant regardless of debt-equity mix
Recap of MM Approach
• Proposed by Modigliani and Miller (1958, 1963)
• Capital structure is irrelevant in a perfect market
• Later modified to include tax benefits of debt

Limited Practical Application

• Ideal conditions limit real-world use of NOI and MM
• Empirical evidence often contradicts predictions
• Firms manage capital structure using cost-benefit analysis
Practical Challenges in Application
• Complexity of actual markets
• Different industries have different capital structure preferences
• Case Studies:
- Tech firms (low debt) vs. Manufacturing firms (moderate-high debt)

Real-World Adaptations
• Modern theories build on MM (e.g., Trade-off Theory,
Pecking Order Theory)
• These consider taxes, bankruptcy, agency issues
• MM is foundational but incomplete
Comparative Analysis of NOI and MM Approaches
Net Operating Income (NOI) Approach
Definition: NOI is a measure of a company's or property's operating
performance, calculated by subtracting operating expenses from gross income.
Advantages: Provides a clear picture of operating performance, helps in
evaluating management's efficiency.
Limitations: Does not account for financing costs, taxes, or capital structure.

Modigliani-Miller (MM) Approach

Definition: MM theorem states that a firm's value is unaffected by its capital
structure, assuming perfect markets and no taxes.
Advantages: Provides insights into the relationship between capital structure
and firm value.
Limitations: Assumes perfect markets, ignores taxes and bankruptcy costs.
Comparison of NOI and MM Approaches
Key differences: NOI focuses on operating performance, while MM
explores the impact of capital structure on firm value.
Practical implications: NOI is useful for evaluating operational
efficiency, while MM provides insights into optimal capital structure.

Other Approaches
• Weighted Average Cost of Capital (WACC): Considers the cost of
debt and equity, providing a comprehensive view of capital costs
• Adjusted Present Value (APV): Accounts for the value of tax shields
and other benefits of debt financing.
Practical Implications for Financial Decision-Making

Capital structure decisions: Understanding the impact of debt and equity on firm value and
cost of capital.
Investment analysis: Evaluating projects based on their operating performance and potential
returns.
Risk management: Considering the effects of leverage and market imperfections on firm
value.

Real-Life Relevance in Financial Decision-Making

• Optimal capital structure: Balancing debt and equity to minimize costs and maximize firm
value.
• Investment evaluation: Using NOI and other metrics to assess project viability and potential
returns.
• Risk assessment: Considering the impact of market imperfections and leverage on firm value
and financial stability.
 Conclusion

Understanding NOI, MM, and other approaches provides

valuable insights into financial decision-making. By
considering the advantages and limitations of each approach,
businesses can make informed decisions about capital
structure, investment, and risk management.
THANK YOU