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 MM theorem.

• 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. According to the NI approach, a firm may increase its total value by lowering its cost of capital through the use of cheaper debt capital. When the cost of capital is lowest and the value of the firm is greatest, the optimum capital structure is achieved—which, under this approach, is when the firm is almost entirely debt-financed.

• Key Assumptions of NI Approach: The NI approach is based on the assumptions that the cost of debt is less than the cost of equity, continuous increase in debt will not affect investor risk perception, and there are no corporate taxes.

• The Net Operating Income (NOI) Approach: This approach is the opposite of the NI approach and is also given by Durand. According to this view, the WACC remains constant, and the value of the firm is independent of its capital structure. As debt increases, the risk to shareholders increases, which raises the cost of equity. This increase perfectly offsets the advantage of cheaper debt, leaving the WACC unchanged.

• The Traditional Approach (Intermediate): This approach is seen as 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. The approach suggests three stages: first, value increases with debt (WACC falls); second, WACC stabilises; and third, WACC increases and value falls as excessive debt raises financial risk.