Explain the theories of capital structure.
Capital structure is a term which is referred to be the mix of sources from which the long term funds are required for business purposes which are raised to improve the capital of the company. The theories which are involved in these are as follows:-
1) Net operating income (NOI):- this is an approach in which both value of the firm and weighted average cost are independent of capital structure. Individual holding the debt and equity receives the same cash flows without worrying about the taxes as they are not involved in it.
2) Traditional approach and Net income (NI) approach :- this is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and don’t depend on how much debt the firm is using.
3) MM hypothesis with and without corporate tax : This approach tells that firm's value is independent of capital structure. The same return can be received by shareholders with the same risk.
4) Miller’s hypothesis with corporate and personal taxes : This approach gives important advantage over equity. This ignores bankruptcy and agency costs.
5) Trade-off theory: costs and benefits of leverage.