Capital Structure Theories: NI, NOI, Traditional and MM Approach (Overview)

Overview

Capital structure refers to the mix of long-term funds—equity, preference and debt—used by a firm. Capital structure theories examine how changes in leverage (debt proportion) affect:

• cost of capital (WACC), and
• value of the firm.

This unit is usually theory-based and highly scoring if you present a neat comparison table and clear conclusions.

Learning objectives

You should be able to:

• Define capital structure and explain why it matters.
• Explain NI, NOI, Traditional and MM approaches at a conceptual level.
• State key assumptions and conclusions of each approach.
• Draw a simple WACC vs leverage relationship for each theory (in words/table).

Meaning of capital structure

Capital structure is the proportion of various long-term sources of finance (equity, preference, debt) used to finance assets of the firm.

It differs from financial structure (which may include short-term liabilities too).

Key terms

• Leverage: use of debt in financing.
• WACC (Ko): overall cost of capital.
• Ke: cost of equity.
• Kd: cost of debt (after-tax where applicable).
• Value of firm (V): market value of debt + equity.
• EBIT: operating profit before interest and tax.

Capital structure decision and firm value

Core idea: If changing debt–equity mix changes WACC, then it changes the PV of cash flows and hence firm value.

General logic: Lower WACC → higher firm value (for given cash flows).

Net Income (NI) approach

Assumptions (basic)

• Cost of debt (Kd) is constant and cheaper than Ke.
• Cost of equity (Ke) is constant (or does not rise with leverage in the basic NI view).

Conclusion

As leverage increases:

• WACC decreases (because more cheap debt),
• Firm value increases.

So, NI suggests: “use more debt to increase value” (extreme view).

Net Operating Income (NOI) approach

Assumptions (basic)

• Overall cost of capital (WACC/Ko) is constant.
• Ke increases with leverage to offset the benefit of cheap debt.

Conclusion

As leverage increases:

• WACC remains constant,
• Firm value remains constant.

So, capital structure is irrelevant under NOI.

Traditional approach

Traditional approach is a compromise between NI and NOI.

Conclusion (shape)

• At low leverage: debt is cheaper → WACC falls → firm value rises
• Beyond an optimum point: increased risk raises Ke and Kd → WACC rises

Thus, there is an optimum capital structure where WACC is minimum and value is maximum.

Modigliani–Miller (MM) approach: basics

MM theory (without taxes) states capital structure is irrelevant under certain assumptions.

Key assumptions (simplified)

• perfect capital markets (no transaction costs)
• investors can borrow/lend at same rate as firms
• no taxes (in the basic MM proposition)
• no bankruptcy costs
• same risk class firms

Conclusion (without taxes)

• firm value is independent of capital structure (irrelevance)
• WACC is constant
• Ke increases linearly with leverage

MM with taxes (concept)

With corporate taxes, interest is tax deductible, creating a tax shield.

Conclusion (basic):

• more debt can increase firm value because of interest tax shield,
• in a simple model, higher leverage may increase value (though in reality bankruptcy costs may limit debt).

Comparison table (NI vs NOI vs Traditional vs MM)

Exam-ready flowchart + key conclusions

Flow (write/draw): Increase debt → Kd effect + Ke risk effect → WACC change → Firm value change

Key exam conclusions:

• NI: more debt → lower WACC
• NOI/MM (no tax): WACC constant
• Traditional: optimum structure
• MM with tax: debt adds value due to tax shield

Quick recap (1-minute revision)

• Capital structure = mix of long-term funds; leverage affects risk and WACC.
• NI: WACC ↓ as debt ↑; value ↑.
• NOI: WACC constant; value constant.
• Traditional: WACC ↓ then ↑; optimum exists.
• MM (no tax): irrelevance; MM (tax): tax shield makes debt beneficial.