Corporate Accounting and Financial Management · Capital Structure

Capital Structure Theories: NI, NOI, Traditional and MM Approaches

Updated 11 October 2026 · Fact-checked

Capital structure theories explain how the debt-equity mix affects the overall cost of capital (Ko) and firm value (V). NI says debt lowers Ko and raises V. NOI says leverage changes nothing. The Traditional view says Ko falls, then rises. MM agrees with NOI without taxes; with taxes, V rises with debt.

Understand Capital Structure Theories

A firm raises long-term funds from debt and equity. The mix is its capital structure. The big question: does the mix change the firm's total value? Each theory gives a different answer.

All theories share some assumptions: no personal taxes (in the basic versions), only two sources of funds (debt and equity), the firm pays out all earnings as dividends, EBIT does not grow, and the firm can change its mix by issuing debt to buy back shares, or the reverse. Under these assumptions, value is V = S + D, where S is the market value of equity and D is the market value of debt.

Net Income (NI) approach. Cost of debt (Kd) and cost of equity (Ke) stay constant as leverage rises. Debt is cheaper than equity. So more debt pulls the weighted cost Ko down and value up. The firm is best at nearly 100% debt. The weak point is the assumption that Ke never rises, even though shareholders face more risk.

Net Operating Income (NOI) approach. Ko is constant at every leverage level. Value depends on business risk, not on how you finance. Debt looks cheap, but Ke rises just enough to cancel the benefit. So V = EBIT ÷ Ko, and there is no optimal structure. The firm's value is found first, and equity is the balance.

Traditional approach. This is a middle view. Up to a point, cheap debt lowers Ko, because Ke rises only slowly. After that point, Ke and Kd both rise fast and Ko climbs. So the curve of Ko is U-shaped, and there is an optimal structure where Ko is lowest and V is highest.

Modigliani-Miller (MM). Without taxes, MM Proposition I matches NOI: value is independent of capital structure. The proof is arbitrage. Investors can create their own leverage, so two firms with the same EBIT cannot trade at different values. With corporate taxes, interest is tax-deductible, so the levered firm is worth more by the value of the tax shield. In theory, that pushes towards maximum debt, though real-world costs of distress limit it.

Key rules to remember

Value of the firm: V = S + D; S = market value of equity, D = market value of debt.
NI approach: value of equity: S = (EBIT − Interest) ÷ Ke; Ke and Kd are constant. Interest = Kd × D.
Overall cost of capital (any approach): Ko = EBIT ÷ V; Equivalent to the weighted average of Ke and Kd at market-value weights, with no taxes.
NOI approach: value of the firm: V = EBIT ÷ Ko; Ko is given and constant. Then S = V − D.
NOI approach: cost of equity: Ke = (EBIT − Kd × D) ÷ (V − D); Ke rises with leverage.
MM Proposition I (no taxes): Vu = Vl = EBIT ÷ Ko; Value does not depend on leverage.
MM Proposition II (no taxes): Ke = Ko + (Ko − Kd) × (D ÷ S); Cost of equity rises linearly with the debt-equity ratio.
MM with corporate tax: Vl = Vu + (t × D); t = tax rate. t × D is the present value of the interest tax shield, assuming permanent debt.

How to solve Capital Structure Theories questions

Use this method for any numerical or theory question on capital structure theories.

1Identify which theory the question names or implies: NI, NOI, Traditional or MM, and whether taxes are given.
2List the data: EBIT, debt D, Kd, Ke or Ko, tax rate, and any other debt levels to compare.
3Compute interest as Kd × D. For NI, find earnings for equity as EBIT − Interest.
4Find the value under the stated theory. NI: S = earnings ÷ Ke, then V = S + D. NOI: V = EBIT ÷ Ko, then S = V − D. MM with tax: Vl = Vu + tD.
5Compute the other measures asked: Ko = EBIT ÷ V, or Ke for NOI from (EBIT − interest) ÷ S.
6Compare the structures in a small table of S, D, V, Ko (and Ke).
7Write the conclusion: say whether leverage raised or lowered V and Ko, and name the assumption behind it.
8For theory answers, state each approach's assumption, its effect on Ko and V, and one criticism.

Quickest way: Anchor on the constant, then solve for the rest

When to use it: Use this for numerical questions comparing two or more debt levels under NI or NOI.

Find what the theory holds constant: NI holds Ke and Kd; NOI holds Ko and Kd.
Under NI, compute S and V directly for each level, then Ko = EBIT ÷ V.
Under NOI, compute V once (it is the same at every level), then S = V − D and Ke = (EBIT − interest) ÷ S.
Under MM with tax, compute Vu first, then add t × D.
Cross-check: Ko × V must equal EBIT (no taxes).

Common mistakes in Capital Structure Theories

Treating NI and NOI as giving the same result.
Both mention debt being cheap, so the difference blurs.
Fix: Remember: NI keeps Ke constant and Ko falls. NOI keeps Ko constant and Ke rises.
Using EBIT instead of EBIT − interest to value equity under NI.
Students rush into the NOI formula.
Fix: Under NI, equity value is (EBIT − interest) ÷ Ke. Only the NOI approach starts from total EBIT.
Using book value of debt or equity for Ko.
The balance sheet is the easiest data source.
Fix: Use market values, as the theories do. Compute S from earnings, not from the share capital figure.
Saying the Traditional approach has a constant Ko.
It is confused with NOI as a 'middle' theory.
Fix: The Traditional Ko falls, reaches a minimum, then rises. There is an optimal capital structure.
Applying Vl = Vu + tD to the no-tax MM case.
Students memorise one formula for MM.
Fix: Without taxes Vl = Vu. Use the tax shield only when a corporate tax rate is given.
Giving a numerical answer with no conclusion.
Time pressure.
Fix: Add a closing line: which structure gives the lowest Ko or highest V, and why.

Worked examples

Example 1

Company A has EBIT of ₹5,00,000. It has ₹10,00,000 of 10% debentures. Ke is 15%. Using the Net Income approach, find the value of the firm and its overall cost of capital.

Show the solution

Interest = 10% × ₹10,00,000 = ₹1,00,000.
Earnings for equity = ₹5,00,000 − ₹1,00,000 = ₹4,00,000.
Market value of equity S = ₹4,00,000 ÷ 15% = ₹26,66,667 (approx.).
Value of firm V = S + D = ₹26,66,667 + ₹10,00,000 = ₹36,66,667.
Ko = EBIT ÷ V = ₹5,00,000 ÷ ₹36,66,667 = 13.64% (approx.).

Answer: V = ₹36,66,667 (approx.) and Ko = 13.64% (approx.). Ko is below Ke of 15% because cheaper debt is in the mix.

Example 2

Company B has EBIT of ₹6,00,000 and Ko of 12%, held constant. It has ₹15,00,000 of 8% debt. Using the Net Operating Income approach, find the value of the firm, the value of equity and the cost of equity.

Show the solution

V = EBIT ÷ Ko = ₹6,00,000 ÷ 12% = ₹50,00,000.
S = V − D = ₹50,00,000 − ₹15,00,000 = ₹35,00,000.
Interest = 8% × ₹15,00,000 = ₹1,20,000.
Earnings for equity = ₹6,00,000 − ₹1,20,000 = ₹4,80,000.
Ke = ₹4,80,000 ÷ ₹35,00,000 = 13.71% (approx.).
Check: Ke from the formula Ko + (Ko − Kd) × D/S = 12% + 4% × (15 ÷ 35) = 12% + 1.71% = 13.71%.

Answer: V = ₹50,00,000, S = ₹35,00,000 and Ke = 13.71% (approx.). Value does not change if debt changes; only Ke moves.

Exam tips

Learn one line for each theory: NI (Ke constant, V rises), NOI (Ko constant, V constant), Traditional (U-shaped Ko), MM (arbitrage, tax shield).
Write the formula and the assumption before you calculate. Examiners give marks for method.
For a 'differentiate NI and NOI' question, use points: cost of equity, cost of capital, effect of debt on value, optimal structure, and criticism.
In a theory answer on MM, cover both the no-tax and tax cases, and mention arbitrage and the tax shield.
Round only at the end and show Ko × V = EBIT as a quick check.

Practice questions from Capital Structure

Capital Structure Theories in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Capital Structure Theories: frequently asked questions

What is the difference between NI and NOI approach?

Under NI, Ke and Kd are constant, so more debt lowers Ko and raises value. Under NOI, Ko is constant, so Ke rises with debt and value does not change. NI says an optimal structure is almost all debt; NOI says none exists.

What does Modigliani-Miller say with and without taxes?

Without taxes, firm value is independent of capital structure. With corporate taxes, a levered firm is worth more than an unlevered one by the tax shield, t × D, because interest is deductible. In practice, costs of financial distress limit how much debt a firm should use.

Why is the Traditional approach called a middle path?

It sits between NI and NOI. Ko falls at first as cheap debt is added, then rises when risk of debt and equity increases. So there is an optimal capital structure at the lowest Ko.

Which approach is used for sums in CS Executive?

Numerical questions usually test NI and NOI, and sometimes MM with tax. Read the question for what is held constant and which values are given. Theory questions may ask for any of the four approaches.