Capital structure simply means: how does a company fund itself? Through debt (loans, debentures) or equity (shares), or a mix? The big question is — does this mix affect the company's value? That's exactly what capital structure theories debate, and ICAI loves asking 8–10 mark questions from this area.
There are four main theories you must know. The Net Income (NI) Approach (by Durand) says yes, capital structure does matter. Since debt is cheaper than equity, using more debt lowers the overall cost of capital (Ko) and increases the firm's value. The catch? Both Kd (cost of debt) and Ke (cost of equity) stay constant regardless of leverage — which is unrealistic. The Net Operating Income (NOI) Approach (also Durand) says the opposite — capital structure doesn't matter at all. As you add more debt, Ke rises proportionately to offset the benefit of cheap debt, so Ko stays flat and firm value is unchanged. The Traditional Approach (the middle path) says there's a sweet spot: up to a point, adding debt reduces Ko and increases value; beyond that point, financial risk makes Ke and Kd both rise sharply, destroying value. The optimal capital structure sits at the lowest point of the Ko curve.
Then comes the big one — Modigliani-Miller (MM) Approach. In a world without taxes, MM agrees with NOI: capital structure is irrelevant because investors can do 'homemade leverage' (personal borrowing) to replicate any firm's leverage themselves, keeping firm values equal. But in the real world with corporate taxes, MM says debt is actually beneficial because interest is tax-deductible, creating a tax shield. The value of a levered firm = Value of unlevered firm + PV of Tax Shield (= Tax Rate × Debt). This tax shield logic is the single most exam-tested idea in this chapter. Remember: MM assumes perfect capital markets, no transaction costs, no bankruptcy costs — conditions that don't hold in practice, which is why the Traditional Approach is considered more realistic.