What should be the ratio of Debt and Equity in our Capital Structure

For answering this question the most important thing is, to know what the object of financial management is. The super most object of financial management is to maximizing the shareholder’s wealth or increase the value of the firm.

The other question which hits in our mind is whether a change in the financing mix would have any impact on the value of the firm or not.

How can Financial Leverage or Capital Structure affect the value of Firm ?

It is certain that for all type of sources of finance the operating income levels (EBIT) is same. Financial leverage or capital structure can have an impact on the net income or the EPS (Earning per Share). Changing the financing mix means change in composition of capital. If debt level is increase in capital structure the interest payable amount will increase and vice versa. The interest amount ultimately affects our Net Profit. The increase or decrease in interest would decrease or increase the net income and thereby the EPS and it is a general belief that the increase in EPS leads to an increase in the value of the firm and vice versa.

Net Income Approach: –

This approach has been suggested by Durand. According to this approach, capital structure decision is relevant to the value of the firm. It means a change in capital structure (proportion of Equity and Debt) causes a corresponding change in the overall cost of capital as well as total value of firm. It means as per Net Income approach Value of Firm is depends on Capital structure of organization and hence Net Income approach is relevant Capital Structure Theory.

Net Operating Income (NOI) Approach:-

It is refined  and apposite approach of Net Income. According to David Durand, under NOI approach, the total value of the firm will not be affected by the composition of capital structure. It means value of firm is not depends on Capital Structure and hence it is called irrelevant Capital Structure Theory. Under this approach Value of firm is depends on operating profit and associated business risk

The Traditional Approach:-

This theory was advocated by Ezta Solomon and Fred Weston is a midway approach also known as “intermediate approach”. It takes a mid-way between the NI approach and the NOI approach. This approach is,  a compromise between the two extremes of net income approach and net operating income approach. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity but at latter stage the value of the firm will decrease or the cost of capital will increased

Thus, optimum capital structure can be reached by a proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt.