Introduction to Financial Management

The Theory of Capital Structure

This is closely related to the firms cost of capital. Capital structure is the risk of the

long-term sources of funds used by the firm. The primary objective of capital structure

decisions is to maximize the market value of the firm though an appropriate risk of long

term sources of funds. This risk called the optional capital structure will minimize the

firm’s overall cost of capital.

There are four different approaches to the theory of capital structure:

(1) Net operating income (NOI) approach (2) Net income (NI) approach

(3) Traditional approach (4) Modigliani – Miller (MM) approach.

All four use the following simplifying assumptions:

1. No income taxes are included, they will be removed later


2. The Company makes a 100 percent dividend payment


3. No transaction costs are incurred


4. The Company has constant earnings before interest and taxes (EBIT)


5. The Company has a constant operating risk.

o Factors Affecting Capital Structure

Many financial managers believe, in practice, that the following factors influence

financial structure.

(1) Growth rate of future sales
(2) Stability of future sales
(3) Competitive structure in the industry
(4) Asset make up of the individual firm.
(5) Attitude of owners and management towards risk
(6) Control position of owners and management
(7) Lender’s attitude towards the industry and a particular firm.