Question

QUESTION THREE

Discuss the following capital structure theories and their implication to the value of the firm.

1. The traditional Theory                                                                                   
2. The Net Income Approach                                                                           
3. The Net Operating Income Approach                                                          
4. Modigliani and Miller (MM) Approach                                                       

Answer 1

The traditional Theory:

We know that the capital structure of a company consists of a mix of security and the major part consist of equity and debt.

So, the traditional theory of capital structure focuses on the weighted average cost of capital (WACC) and it tells us that when WACC is minimized and the market value of assets are maximized then the optimal capital structure exists.

The Net Income Approach:

This theory was proposed by Durand and it suggest that we can increase the total value of the firm by decreasing the WACC(weighted average cost of capital) of the firm.

And this can be done by increasing the proportion of debt in the capital structure of the company as it is the cheaper source of finance than the equity.

The Net Operating Income Approach:

Contradicting the theory of Net Income Approach this theory tells that the capital structure of a firm is irrelevant when it comes to the valuation of a firm. We can't increase or decrease a firm's value by increasing or decreasing the proportion of debt in a company's capital structure.

But the market value of the firm depends on Earnings before Interest and Taxes(EBIT) and the weighted average cost of capital(WACC).

Modigliani and Miller (MM) Approach:

This theory also focuses on the net operating income of a firm in order to increase the value of the firm.

It states that valuation of a firm is irrelevant to its capital structure whether a comapny is highly leveraged or having less amount of debt to it, rather it depends on the operating income of the company.