Académique Documents
Professionnel Documents
Culture Documents
STRUCTURE
THEORIES
CAPITAL STRUCTURE
Capital structure is the proportion of debt
and preference and equity shares on a
firms balance sheet
Optimum Capital structure is that at
which the weighted average cost of capital
is minimum and thereby maximum value
of the firm
TRADITIONAL APPROACH
The traditional approach argues that moderate
degree of debt can lower the firms overall cost
of capital and thereby, increase the firm value.
The initial increase in the cost of equity is more
than offset by the lower cost of debt. But as debt
increases, shareholders perceive higher risk
and the cost of equity rises until a point is
reached at which the advantage of lower cost of
debt is more than offset by more expensive
equity.
NET INCOME APPROACH
Its relevant to the value of the firm
Change in financial leverage will lead to
change in overall cost of capital and value of
the firm
If degree of financial leverage(debt to equity)
increases then overall cost of capital and
market price of share decreases but value of
firm increases
And vice-versa
Assumptions in NI Approach
No taxes
Cost of debt < cost of equity (equity
capitalisation rate)
Use of debt does not change risk
perception of investors
Illustration (10%Debentures of Rs.200000)
EBIT = Rs. 50000
Less: Interest on debentures 20000
Earning available to shareholders(NI) 30000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 240000
Market Value of debt(B) 200000
Total Value of firm(V=S+B) 440000
Overall cost of capital(ko=EBIT/V) 11.36%
When Financial leverage increases(10%
Debentures of Rs.300000)
EBIT = Rs. 50000
Less: Interest on debentures 30000
Earning available to shareholders(NI) 20000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 160000
Market Value of debt(B) 300000
Total Value of firm(V=S+B) 460000
Overall cost of capital(ko=EBIT/V) 10.9%