This lesson examines two early and contrasting approaches to capital structure. The Net Income (NI) approach argues that capital structure affects firm value, while the Net Operating Income (NOI) approach argues it is irrelevant, prefiguring the later Modigliani-Miller theorem.

Detailed Notes:

  • The Net Income (NI) Approach: This approach, proposed by Durand, posits that there is a definite relationship between capital structure and the value of the firm. Capital structure influences the WACC, which affects firm value.

    • Key Assumption: The cost of debt (Kd) is less than the cost of equity (Ke), and both are constant regardless of leverage.

    • Mechanism: As the proportion of cheaper debt increases, WACC decreases, increasing the firm’s value.

    • Optimal Structure: Under this approach, the optimal capital structure is achieved when the firm is almost entirely debt-financed.

  • The Net Operating Income (NOI) Approach: This approach, also given by Durand, is the opposite of the NI approach. According to this view, WACC remains constant, and the value of the firm is independent of its capital structure.

    • Key Assumption: As debt increases, the risk to shareholders increases, raising the cost of equity (Ke). This increase perfectly offsets the advantage of cheaper debt.

    • Mechanism: The increase in Ke is exactly proportional to the increase in the debt-to-equity ratio, leaving WACC unchanged.

    • Implication: There is no optimal capital structure; any mix of debt and equity results in the same firm value.

  • The Traditional Approach: This is an intermediate position between NI and NOI. It argues that an optimal capital structure exists where WACC is minimised and firm value is maximised at a “best possible” mix of debt and equity.

    • Three Stages: Initially, value increases with debt (WACC falls); then, WACC stabilises; finally, WACC increases and value falls as excessive debt raises financial risk.

PreviousNext