30  Capital structure

30.1 Concept of Capital Structure

Capital structure is “the mix of long-term sources of funds — equity capital, retained earnings, preference capital and long-term debt — used by a firm”. The decision is how much debt and how much equity to employ. The objective is usually to find the optimal capital structure — the mix that minimises the weighted average cost of capital (WACC) and thereby maximises the market value of the firm. The theoretical literature on capital structure is dominated by four classical theories: the Net Income approach, Net Operating Income approach, Traditional approach, and the Modigliani-Miller (MM) approach.

30.2 Capital Structure vs Financial Structure

TipCapital vs Financial Structure
Dimension Capital Structure Financial Structure
Scope Long-term sources only All sources — long-term + short-term
Components Equity, preference, debentures, term loans Capital structure + current liabilities
Shown in Liabilities side of balance sheet (long-term half) Full liabilities side

30.3 Theories of Capital Structure

30.3.1 Assumptions Common to All Four Theories

TipCommon Assumptions
  • Only debt and equity in the capital structure (no preference shares).
  • No corporate or personal taxes (relaxed later).
  • All earnings paid out as dividends; no retention.
  • 100 % payout, perpetual cash flows.
  • No transaction costs or flotation costs.
  • Investors have homogeneous expectations.
  • The firm’s operating risk is unchanged.

30.3.2 1. Net Income (NI) Approach — David Durand (1952)

TipNI Approach
  • Both K_d and K_e are constant regardless of leverage.
  • Since K_d < K_e, increasing debt lowers WACC and raises firm value.
  • Optimal capital structure is 100 % debt.

30.3.3 2. Net Operating Income (NOI) Approach — Durand (1952)

TipNOI Approach
  • K_o (WACC) is constant — independent of leverage.
  • K_e rises in exact proportion to leverage to compensate equity holders for higher financial risk.
  • Firm value is independent of capital structure.
  • This is the precursor to the MM Proposition I.

30.3.4 3. Traditional Approach (Ezra Solomon)

TipTraditional View
  • Combines elements of NI and NOI.
  • Phase 1: At low leverage, debt is cheap and K_e rises slowly → WACC falls.
  • Phase 2: At moderate leverage, WACC is at minimum — optimal capital structure.
  • Phase 3: At high leverage, both K_d and K_e rise sharply (financial distress) → WACC rises.
  • The result: an U-shaped WACC with a definite optimum.

30.3.5 4. Modigliani-Miller (MM) Approach (1958, 1963)

Franco Modigliani and Merton Miller in 1958 published the foundational paper that won them Nobel Prizes (1985 and 1990).

TipMM Propositions (Without Tax — 1958)
Proposition Statement
MM I The market value of the firm is independent of its capital structure
MM II Cost of equity rises linearly with debt-equity ratio: K_e = K_0 + (K_0 − K_d) × (D/E)

Under the assumption of no taxes, NOI approach is vindicated. The crucial arbitrage proof: if leveraged and unleveraged firms had different values, investors could home-leverage — borrow personally and buy unleveraged equity — to capture risk-free profit, restoring equality.

MM with Corporate Tax (1963)

TipMM with Corporate Tax
  • Interest is tax-deductible → debt creates a tax shield = T × D.
  • Value of levered firm = Value of unlevered firm + Tax shield (T × D).
  • Implication: firm value rises with debt → optimal capital structure is 100 % debt in the absence of financial distress.

Miller Model with Personal Taxes (1977)

When both corporate and personal taxes are considered (Miller alone, 1977), the tax shield is partly offset by differential personal taxes on dividend vs interest income.

30.4 Trade-Off Theory

The trade-off theory holds that the optimal capital structure balances: - Tax shield benefits of debt (positive). - Financial distress and bankruptcy costs (negative; rise with leverage). - Agency costs — between shareholders, managers, debt-holders.

The optimal D/E is where the marginal benefit of additional debt equals the marginal expected cost of distress.

30.5 Pecking Order Theory — Myers and Majluf (1984)

Stewart Myers and Nicholas Majluf (1984) proposed that firms follow a pecking order in financing:

TipPecking Order
  1. Internal funds (retained earnings) — preferred first; no flotation cost or information asymmetry.
  2. Debt — cheaper than external equity; little information signal.
  3. External equity — last resort; signals to the market that the firm may be over-valued.

This explains why profitable firms often have low leverage — they have ample internal funds and avoid external financing.

30.6 Other Theories

TipOther Capital Structure Theories
  • Signalling theory (Ross 1977) — managers signal future prospects via leverage choice.
  • Agency theory (Jensen-Meckling 1976) — debt disciplines managers (Jensen’s free-cash-flow hypothesis).
  • Market-timing theory — firms issue equity when share price is high, debt when low.
  • Stakeholder theory — capital structure considers non-investor stakeholders.

30.7 Determinants of Capital Structure

TipPractical Determinants
  • Business risk — high operating leverage → low financial leverage.
  • Tax position — higher tax rate → more value from interest deductibility.
  • Financial flexibility — keep spare debt capacity.
  • Asset structure — tangible assets support more debt (collateral).
  • Growth opportunities — high-growth firms prefer equity (avoid debt overhang).
  • Profitability — pecking-order: high-profit firms use less external financing.
  • Size — larger firms borrow more easily.
  • Industry norms — sector benchmarks.
  • Control considerations — owners may avoid equity dilution.
  • Cost of capital — minimise WACC.
  • Cash flow stability — stable cash flows support more debt.
  • Capital market conditions — issuance windows matter.

flowchart LR
  CS[Capital Structure] --> NI[NI<br/>100% debt optimal]
  CS --> NOI[NOI<br/>Value independent]
  CS --> TR[Traditional<br/>U-shaped WACC]
  CS --> MM[MM 1958<br/>arbitrage proof]
  MM --> MMTax[MM 1963 with tax<br/>Tax shield = T×D]
  CS --> PO[Pecking Order<br/>Myers-Majluf 1984]
  CS --> TO[Trade-off<br/>Tax shield vs Distress]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

30.8 Operating, Financial and Combined Leverage

TipThree Leverages
Leverage Formula Measures
Degree of Operating Leverage (DOL) Contribution / EBIT = % ΔEBIT / % ΔSales Sensitivity of EBIT to sales
Degree of Financial Leverage (DFL) EBIT / EBT = % ΔEPS / % ΔEBIT Sensitivity of EPS to EBIT
Degree of Combined Leverage (DCL) DOL × DFL = Contribution / EBT = % ΔEPS / % ΔSales Sensitivity of EPS to sales

A high DOL means business risk is high; high DFL means financial risk is high. High combined leverage amplifies sales-fluctuation impact on EPS.

30.9 EBIT-EPS Analysis

The EBIT-EPS framework compares alternative capital structures by plotting EPS against EBIT for each. The indifference EBIT level — where two financing plans yield the same EPS — helps the firm choose. Above the indifference level the more-leveraged plan gives higher EPS; below it, the less-leveraged.

NoteDistractor warning

PYQs sometimes confuse MM Proposition I (firm value independent) with MM with tax (firm value rises with debt). The original 1958 MM is without tax; the corrected 1963 version with corporate tax gives the tax shield.

30.10 Practice Questions

Q 01 NOI Easy

Under the Net Operating Income (NOI) approach to capital structure:

  • AFirm value depends on leverage
  • BFirm value is independent of leverage
  • CFirm value falls with leverage
  • DOptimal capital structure is 100 % debt
View solution
Correct Option: B
NOI — WACC constant → firm value **independent** of capital structure.
Q 02 MM Easy

MM Proposition I (without tax) states:

  • AFirm value rises with debt
  • BFirm value is independent of capital structure
  • CFirm value falls with debt
  • DFirm value depends on dividend policy
View solution
Correct Option: B
MM I (1958, without tax) — value independent.
Q 03 MM Author Medium

The Modigliani-Miller (MM) propositions were originally published in:

  • A1932
  • B1948
  • C1958
  • D1976
View solution
Correct Option: C
**MM 1958** — "The Cost of Capital, Corporation Finance and the Theory of Investment".
Q 04 MM with tax Medium

Under MM with corporate tax (1963), the value of a levered firm equals:

  • AV_u
  • BV_u + T × D
  • CV_u − T × D
  • DV_u × T
View solution
Correct Option: B
**V_L = V_U + T × D** — tax shield from deductible interest.
Q 05 Pecking Medium

The pecking-order theory of capital structure was proposed by:

  • AModigliani-Miller
  • BMyers and Majluf (1984)
  • CSharpe
  • DMarkowitz
View solution
Correct Option: B
**Myers and Majluf (1984)** — pecking order driven by information asymmetry.
Q 06 Order Medium

Arrange the sources of finance in the pecking order suggested by Myers-Majluf:

  • AExternal equity → debt → internal funds
  • BInternal funds → debt → external equity
  • CDebt → internal funds → external equity
  • DExternal equity → internal funds → debt
View solution
Correct Option: B
Internal → debt → external equity (last resort).
Q 07 Traditional Medium

The Traditional approach to capital structure asserts that the WACC curve is:

  • AHorizontal
  • BContinuously falling
  • CU-shaped with an optimal point
  • DContinuously rising
View solution
Correct Option: C
Traditional view — **U-shaped WACC** with an optimal debt-equity mix.
Q 08 Trade-off Medium

The trade-off theory balances tax shield against:

  • ADividend payout
  • BCosts of financial distress and bankruptcy
  • CCost of issuing equity
  • DCost of advertising
View solution
Correct Option: B
Tax shield + agency benefits vs distress and bankruptcy costs.
Q 09 DFL Medium

Degree of Financial Leverage (DFL) is computed as:

  • AContribution / EBIT
  • BEBIT / EBT
  • CContribution / EBT
  • DPAT / EBIT
View solution
Correct Option: B
**DFL = EBIT / EBT**; equivalent to % ΔEPS / % ΔEBIT.
Q 10 DOL Medium

Degree of Operating Leverage is:

  • AContribution / EBIT
  • BEBIT / EBT
  • CSales / Total cost
  • DPAT / Sales
View solution
Correct Option: A
**DOL = Contribution / EBIT** = % ΔEBIT / % ΔSales.
Q 11 DCL Hard

DOL = 1.5; DFL = 2. Degree of Combined Leverage:

  • A0.75
  • B3.5
  • C3.0
  • D2.5
View solution
Correct Option: C
**DCL = DOL × DFL = 1.5 × 2 = 3.0**.
Q 12 NI Medium

Under the Net Income approach:

  • ABoth K_d and K_e remain constant
  • BWACC remains constant
  • CK_e rises with leverage
  • DFirm value is independent of capital structure
View solution
Correct Option: A
NI assumes both K_d and K_e are constant → WACC falls with leverage → optimal is 100 % debt.
Q 13 Arbitrage Hard

The "home-leverage / arbitrage" argument is central to:

  • ANI
  • BTraditional approach
  • CMM 1958
  • DPecking order
View solution
Correct Option: C
**MM 1958** — arbitrage proof underlies value-irrelevance.
Q 14 Capital v Financial Easy

Capital structure differs from financial structure in that:

  • ACapital structure includes current liabilities
  • BCapital structure includes only long-term sources; financial structure includes all liabilities
  • CThey are identical
  • DFinancial structure excludes equity
View solution
Correct Option: B
Capital structure = long-term sources only.
Q 15 Determinants Medium

Which is **not** a determinant of capital structure?

  • ABusiness risk
  • BTax position
  • CAsset structure
  • DDirector's nationality
View solution
Correct Option: D
Nationality of directors is irrelevant.
Q 16 Theories Match Medium

Match each theory with its principal author:

Theory Author
(i) NI / NOI (a) Myers-Majluf
(ii) Traditional (b) David Durand (1952)
(iii) MM (c) Ezra Solomon
(iv) Pecking order (d) Modigliani-Miller (1958)
  • A(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(a), (iv)-(b)
  • D(i)-(d), (ii)-(b), (iii)-(a), (iv)-(c)
View solution
Correct Option: A
NI/NOI — Durand; Traditional — Solomon; MM — Modigliani-Miller; Pecking order — Myers-Majluf.
Q 17 Operating Lev Medium

High operating leverage indicates:

  • AHigh variable cost share
  • BHigh fixed cost share
  • CHigh debt share
  • DHigh equity share
View solution
Correct Option: B
High fixed costs ⇒ EBIT very sensitive to sales fluctuations.
Q 18 MM Prop II Hard

MM Proposition II says K_e equals:

  • AK_0 only
  • BK_0 + (K_0 − K_d) × (D/E)
  • CK_d + Tax shield
  • DK_0 × (1 − T)
View solution
Correct Option: B
**K_e = K_0 + (K_0 − K_d) × (D/E)** — equity cost rises linearly with debt-equity.
Q 19 Signaling Hard

In the Myers-Majluf pecking order, issuing new equity is the *last* resort because it:

  • AHas the highest flotation cost
  • BSignals to the market that managers may believe the stock is overvalued
  • CIs tax-disadvantaged
  • DCannot fund large projects
View solution
Correct Option: B
Information asymmetry → equity issue is a negative signal.
Q 20 EBIT-EPS Hard

The "indifference EBIT" in EBIT-EPS analysis is the EBIT level at which:

  • AEPS is zero
  • BTwo financing alternatives give the same EPS
  • CCost of equity equals cost of debt
  • DSales equal total cost
View solution
Correct Option: B
**Indifference point** — two alternatives yield equal EPS.

30.11 Quick Recall

ImportantQuick recall
  • Capital structure = mix of long-term sources (equity, preference, debt). Financial structure includes short-term.
  • Four classical theories: NI (Durand 1952; 100 % debt optimal), NOI (Durand; value independent), Traditional (Solomon; U-shaped WACC with optimum), MM 1958 (value independent via arbitrage; Prop II — K_e rises linearly with D/E).
  • MM 1963 with corporate tax: V_L = V_U + T × D — tax shield.
  • Trade-off theory — balance tax shield against distress and agency costs.
  • Pecking order (Myers-Majluf 1984) — Internal → Debt → External equity.
  • Other theories: Signalling (Ross 1977), Agency (Jensen-Meckling 1976), Market-timing.
  • Leverages: DOL = Contribution/EBIT; DFL = EBIT/EBT; DCL = DOL × DFL = Contribution/EBT.
  • EBIT-EPS analysis — find indifference EBIT where two financing plans yield equal EPS.
  • Practical determinants — business risk, tax, flexibility, asset structure, growth, profitability, size, industry norms, control, cash-flow stability, market conditions.