In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. There are several competing capital structure theories, each of which explores the relationship between debt financing, equity financing, and the market value of the firm slightly differently.

Net Income Approach to Capital Structure Theory

David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs. In other words, if there's an increase in the debt ratio, capital structure increases, and the weighted average cost of capital (WACC) decreases, which results in higher firm value.

Also proposed by Durand, this approach is the opposite of the Net Income Approach, in the absence of taxes. In this approach, WACC remains constant. It postulates that the market analyzes a whole firm, and any discount has no relation to the debt/equity ratio. If tax information is provided, it states that WACC reduces with an increase in debt financing, and the value of a firm will increase.

In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It's important to remember, however, that this approach assumes an optimal capital structure. Optimal capital structure implies that at a certain ratio of debt and equity, the cost of capital is at a minimum, and the value of the firm is at a maximum.

The M&M theorem is a capital structure approach named after Franco Modigliani and Merton Miller in the 1950s. Modigliani and Miller were two professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. This proposition states that in perfect markets, the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. The M&M theorem made two propositions:

  • Proposition I: This proposition 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 be affected by 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: This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

Pecking Order Theory

The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.

Conclusion

To summarize, it is essential for finance professionals to know about the capital structure. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability.