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(^262) Financial Management
Chapter-11
Capital Structure Theories
There are basically three approaches to capital structure decision:
l Net income Approach
l Net Operating Income approach
l Modigliani Miller Approach
Net Income Approach
According to this approach, the cost of debt capital, Kd and the cost of equity capital
Ke remains unchanged when D/S, the degree of leverage, varies. Here S stands for
total capital employed = D+E). The constancy of Kd and Ke with respect to the degree
of leverage means that Ko, the average cost of capital, measured by the following
formula declines as the degree of leverage increases.

( )

*

( )

*

D E

E

k

D E

D

Ko kd e

+

+

+

=

This happens because when the degree of leverage increases, Kd which is lower than

Ke, receives a higher weight in the calculation of Ko.

This can also be illustrated by a graph shown in Figure 11.1.

Figure 11.1 : Net Income Approach Graph

Degree of Leverage D/S

Cost of Capital

Ke

Ko

Kd