Every business needs money to run — the question is how you raise it. Do you borrow (debt) or bring in owners (equity)? The mix you choose is your capital structure, and the mix that gives you the lowest cost and highest firm value is called the optimum capital structure.
Here's the intuition: debt is cheaper than equity because (a) lenders take less risk than owners, and (b) interest is tax-deductible — the government effectively subsidises your borrowing. So as you add debt, your Weighted Average Cost of Capital (WACC) falls, and firm value rises. But — and this is the critical 'but' — too much debt increases financial risk (risk of default, bankruptcy costs). Beyond a point, shareholders demand a higher return to compensate, equity cost shoots up, and WACC starts rising again. The sweet spot where WACC is lowest and firm value is highest is the optimum capital structure.
The ICAI curriculum tests you on four theories. The Net Income (NI) Approach (Durand) says capital structure does matter — more debt always lowers WACC and raises value (assumes Ke and Kd stay constant). The Net Operating Income (NOI) Approach says it doesn't matter — any gain from cheap debt is exactly offset by rising equity cost, so WACC stays flat. The Traditional Approach is the middle ground: moderate debt is beneficial, but beyond an optimal point WACC rises — this is the most practical view and the one closest to real life. Finally, the Modigliani-Miller (MM) Hypothesis argues (without taxes) that capital structure is irrelevant, but with corporate taxes, debt creates a tax shield (= Tax Rate × Debt), adding value. For exams, know MM with and without taxes separately.
The key formula you must be comfortable with: WACC = (Ke × E/V) + (Kd(1-t) × D/V), where V = D + E. Optimum structure = the D/E ratio where this WACC is minimised. This is asked frequently as a 5–8 mark question in the FM paper, often combined with an EBIT-EPS analysis to find the indifference point between two financing plans.