Net income theory and net operating income theory are two traditional theories that attempt to explain the relationship between capital structure and the value of the firm. Let’s explore each theory:
- Net Income Theory: Net income theory suggests that the capital structure of a firm does not affect its value. According to this theory, the value of the firm is determined solely by its profitability, represented by its net income. It assumes that the cost of equity remains constant regardless of the capital structure. Under this theory, an increase in leverage (debt financing) may result in higher financial risk, but it is offset by the higher returns expected by equity investors due to the increased risk. Therefore, changes in the capital structure do not impact the overall value of the firm.
- Net Operating Income Theory: Net operating income theory proposes that the value of a firm is influenced by its operating income rather than its net income. It suggests that the capital structure affects the operating income of the firm, and therefore, it indirectly affects the firm’s value. The theory argues that a higher level of debt can lead to financial distress costs, such as bankruptcy costs or increased interest expense, which can impact the operating income of the firm. As a result, the value of the firm is influenced by the operating income generated, which is affected by the capital structure