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

Question 1

Define capital structure.

Accepted Answer

Capital structure is the mix of long-term sources of finance like **equity, preference and debt** used by a firm.

Question 2

What is meant by leverage in capital structure?

Accepted Answer

Leverage means the use of **debt** in the capital structure to finance assets.

Question 3

State the objective of an optimum capital structure.

Accepted Answer

Optimum capital structure aims to **minimise WACC** and **maximise firm value**.

Question 4

What does NI approach conclude about firm value when debt increases?

Accepted Answer

NI approach concludes that firm value **increases** as debt increases because WACC decreases (basic view).

Question 5

MM theory (without taxes) is an irrelevance theory.

Accepted Answer

True. Under MM (no tax) assumptions, firm value is **independent** of capital structure.

Question 6

What is Ko in capital structure theories?

Accepted Answer

Ko refers to the overall cost of capital, i.e., **WACC**.

Question 7

Differentiate between NI and NOI approaches (any three points) using a table.

Accepted Answer

NI vs NOI:

| Basis | **NI approach** | **NOI approach** |
|---|---|---|
| WACC (Ko) | decreases with leverage | **constant** |
| Firm value | increases with leverage | **constant** |
| Ke behavior | assumed constant (basic) | increases with leverage |

Thus, NI supports more debt; NOI says capital structure is irrelevant.

Question 8

State the main conclusion of the traditional approach (brief) with a small table/shape.

Accepted Answer

Traditional approach concludes that an **optimum capital structure** exists.

- Initially, debt increases → WACC **falls** → value **rises**.
- After an optimum point, risk increases → WACC **rises** → value falls.

| Leverage level | WACC trend |
|---|---|
| Low to moderate | **falls** |
| Beyond optimum | **rises** |

(Shape: U-shaped WACC curve).

Question 9

Explain the MM approach (no taxes) assumptions (any three) and conclusion.

Accepted Answer

MM (no tax) assumptions (any three):

- **perfect capital markets** (no transaction costs)
- no taxes
- no bankruptcy costs
- investors and firms can borrow/lend at similar rates

Conclusion: firm value is **independent** of capital structure and WACC remains **constant** (irrelevance proposition).

Question 10

Why does MM with taxes support use of debt? (brief) Include a small flow.

Accepted Answer

With corporate taxes, **interest** is tax deductible, creating an **interest tax shield**.

Flow: More debt → more interest → **tax saving** → higher cash flows to investors → higher **firm value**.

Thus, MM (with tax) suggests debt can increase value due to tax shield benefit.

Question 11

Explain the concept of optimum capital structure and how it is identified (brief) with a table.

Accepted Answer

Optimum capital structure is the debt–equity mix at which **WACC is minimum** and **firm value is maximum**.

It is identified by comparing WACC/value at different leverage levels.

| Leverage | WACC | Firm value |
|---|---|---|
| Low | higher | lower |
| Moderate (optimum) | **minimum** | **maximum** |
| High | higher | lower |

Thus, optimum occurs at the turning point of the WACC curve (U-shape).

Question 12

Differentiate between MM approach (no tax) and MM approach (with tax) (any three points) using a table.

Accepted Answer

MM no tax vs MM with tax:

| Basis | **MM (no tax)** | **MM (with tax)** |
|---|---|---|
| Taxes | ignored | corporate tax considered |
| Value vs debt | value **constant** | value generally **increases** due to tax shield |
| Key reason | perfect markets → irrelevance | **interest tax shield** adds value |

Hence, taxes make capital structure relevant in the basic MM-with-tax view.

Question 13

Explain NI approach and NOI approach (exam-style) with assumptions and conclusions (use a table).

Accepted Answer

### NI approach
Assumes **Kd** is cheaper and constant; **Ke** is constant (basic). As debt increases, WACC **decreases** and firm value **increases**.

### NOI approach
Assumes WACC (**Ko**) is constant. As leverage increases, **Ke rises** to offset benefit of cheap debt, so firm value remains **constant**.

| Point | **NI** | **NOI** |
|---|---|---|
| Ko (WACC) | decreases | **constant** |
| Value | increases | **constant** |
| Ke | constant (basic) | increases |

### Conclusion
NI supports more debt; NOI suggests capital structure is irrelevant under its assumptions.

Question 14

Explain traditional approach and the concept of optimum capital structure (exam-style) with a diagram/table and conclusion.

Accepted Answer

### Traditional approach
Traditional approach says that up to a point, additional debt lowers WACC because debt is cheaper. Beyond that point, risk increases and both **Ke** and **Kd** can rise, increasing WACC.

### Optimum capital structure
Optimum structure is where **WACC is minimum** and **firm value is maximum**.

| Leverage | Ke | Ko (WACC) | Value |
|---|---|---|---|
| Low | lower | **higher** | lower |
| Moderate | rises slightly | **minimum** | **maximum** |
| High | rises more | **higher** | lower |

(Shape: WACC U-shaped; Value inverted-U).

### Conclusion
Therefore, an optimal debt–equity mix exists under traditional view.

Question 15

Explain MM approach (no tax and with tax) and summarise conclusions using a comparison table (exam-style).

Accepted Answer

### MM without taxes
Under perfect market assumptions, capital structure does not affect firm value. **WACC is constant** and Ke increases with leverage.

### MM with taxes
With corporate taxes, interest creates a **tax shield**, so higher debt tends to increase firm value (in simple model).

| Case | Value vs leverage | WACC | Key reason |
|---|---|---|---|
| **MM (no tax)** | constant | constant | irrelevance in perfect markets |
| **MM (with tax)** | increases | tends to fall | **interest tax shield** |

### Conclusion
MM shows irrelevance in ideal conditions, but with taxes debt can add value due to tax shield.

Basis	NI approach	NOI approach
WACC (Ko)	decreases with leverage	constant
Firm value	increases with leverage	constant
Ke behavior	assumed constant (basic)	increases with leverage

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

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