## Capital Structure Theories — Foundations
This segment studies the relationship between cost of capital (K₀), capital structure, and the value of the firm (VF).
### The Four Theories
| Category | Theory |
|---|---|
| Relevance (structure matters) | Net Income (NI) Approach |
| Relevance | Traditional Approach |
| Relevance | MM Approach 1963 — With Tax |
| Irrelevance (structure doesn't matter) | Net Operating Income (NOI) Approach |
| Irrelevance | MM Approach 1958 — Without Tax |
### General Assumptions (apply to all theories)
- There is no preference share capital.
- Only two sources of funds: Debt and Equity.
- Taxes are not considered (except MM Approach with Tax).
- Dividend payout ratio is 100% (so DPS = EPS).
- Business risk is constant over time.
- The firm has perpetual life.
- K_d < K_e always (cost of debt is below cost of equity).
- Total financing stays constant — leverage is changed only by swapping debt for shares (or shares for debt).
### Common Formulas
1. Value of the Firm:
$$VF = V_E + V_D$$
2. Value of Equity:
$$V_E \text{ (per share)} = \frac{EPS}{K_e}; \quad V_E \text{ (total)} = \frac{EFE}{K_e}$$
(EFE = Earnings available For Equity)
3. Value of Debt:
$$V_D = \frac{\text{Total Interest}}{K_d}$$
4. Value of Firm (capitalising EBIT):
$$VF = \frac{EBIT}{K_0}$$
5. Overall Cost of Capital (weighted average):
$$K_0 = K_d W_d + K_e W_e$$
### Doubt Busters
1. Generally K_e > K_d (equity is costlier than debt).
2. Lower the K₀ → higher the VF, and vice versa (inverse relationship).