Scribd
Upload
21 views

Chapter - Capital Structure

Notes of the chapter capital structure in financial management this is very helpful for u

Uploaded by

disha gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
21 views

Chapter - Capital Structure

Notes of the chapter capital structure in financial management this is very helpful for u

Uploaded by

disha gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
You are on page 1/ 19
_ a 4.4 CAPITAL STRUCTURE THEORIES Capital structure theories give an understanding of the different approaches to debt equity mix and the effect on the value of the share. There is a view point that supports the fact that debt- equity mix has an impact on shareholders wealth. Another view point opposes this and finds debt equity mix irrelevant to maximize the value of the wealth of the shareholders. The four basic theories and a new theory for understanding the capital structure of a company are the following: 1. Net Income (NI) Approach : This approach states that there is a positive relationship betveen capital structure and value of the firm. 2. Net Operating Income (NOI) Approach : The Net Operating Income Approach Capital Structure e states that the capital structure does not matter for valuation of a firm. 3, Traditional Approach : The traditional approach is between the NI and NOI approach. Itbelieves in moderate debt for maximizing the value of the share. A high debt is detrimental for the company 4. Modigilani-Miller (MM) Approach : It introduces the arbitrage approach and justifies the NOI approach by stating that the capital structure does not have matter for valuation ofa firm. 5, Pecking Order : The Pecking order introduces the concept of internally generated resources because they are the cheapest form of funds available for a company for its capital structure. 4.4.1 Assumptions of Capital Structure Theories ‘There are some general Assumptions of the different capital structure theories. In addition to these there are some assumptions specifically of the particular theory: 1. There are only two types of sources of funds. Equity Shares and Risk-less Debt which has a fixed interest... 2. There are no corporate or personal taxes but these assumptions are refined and removed in one of the theories explained within the theory. 3. The company pays its entire earnings to shareholders. Dividend Payout Ratio 100% so the company does not retain any funds. |. Firm’s assets are constant and do not change. 5, Firms financing is constant but the degree of leverage can change by reducing debentures or equity shares or by adding equity. 6. The firm’s profits are given and do not change. 7. All Investors have same expectation of EBIT of the firm. 8, Business risk is constant and is independent of capital structure and financial risk. 9. Firm has perpetual life. 10. Cost of debt(k, ) is less than cost of equity( ke) 11. There are no costs of transfer of securities and no floatation costs. 12. Debt does not change the investor’s perception of the risk of the company While discussing the different theories the following symbols are used E = Total market value of Equity. Total market value of Debt. Total market value of Fund. (E+ D) - <0 q = Interest 1 = Net Income Available to Equity shareholder Zz Financial Management : Principles ang p "aeH 48 idend = Expected Current market price of shares Growth rate Cost of debt Cost of equity k, = Overall cost of capital D, Po g ky K 4.4.2 Net Income Approach — Durand The Net Income Approach is a contribution by Durand, to capital structure theory, Py relationship between cost of capital, leverage and value of the firm. According to Durand ye? is a positive relationship of debt on the capital structure and value of the firm. When, a increased in the overall financing mix, cost of capital decreases and the value of the firm market price of equity increases. When debt is reduced, cost of capital increases and the ya Of'the firm and market price of equity decreases. Therefore, debt is considered to be B00d the company for increasing its market value. i ‘The theory focuses its explanation on the following assumptions: * There are no corporate or personal taxes. °K,

You might also like