Designing Capital structure
structure is the major part of the firm‘s financial decision which affects the
value of the firm and it leads to change EBIT and market value of the shares.
There is a relations hip among the capital structure, cost of capital and value
of the firm. The aim of effective capital structure is to maximize the value of
the firm and to reduce the cost of capital.
two major theories explaining the relations hip between capital struc ture,
cost of capital and value of the fir m.
It is the
mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as inter mediate approach. According to the traditional approach, mix of
debt and equity capital can increase the value of the firm by reducing overall
cost of capital up to certain level of debt. Traditional approach states that
the Ko decreases only within the responsible limit of financial leverage and
when reaching the minimum level, it starts increasing with financial leverage.
structure theories are based on certain assumption to analysis in a single and
There are only two sources of
funds used by a firm; debt and shares.
The firm pays 100% of its earning
The total assets are given and do
The total finance re ma ins constant.
The operating profits (EBIT) are
not expected to grow.
The business risk re mains constant.
The firm has a perpetual life.
The investors behave rationally.
Net Income (NI) Approach
income approach suggested by the Dura nd. According to this approach, the
capital structure decision is relevant to the valuation of the firm. In other
words, a change in the capital structure leads to a corresponding change in the
overall cost of capital as well as the total value of the firm.
to this approach, use more debt finance to reduce the overall cost of capital and increase the value of fir m.
income approach is based on the following three important assumptions :
There are no corporate taxes.
The cost debt is less than the
cost of equity.
The use of debt does not change
the risk perception of the investor.
V = S+B
V = Value
of fir m
Market value of equity
Market value of debt
value of the equity can be ascertained by the following formula:
S =NI/ Ke
Earnings available to equity shareholder
Ke = Cost
of equity/equity capitalization rate
for calculating value of the firm on the basis of NI approach.
Net Operating Income (NOI) Approach
modern theory of capital structure, suggested by Dura nd. This is just the opposite
to the Net Income approach. According to this approach, Capital Structure
decision is irrelevant to the valuation of the firm. The market value of the
firm is not at all affected by the capital structure changes.
to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the
overall cost of capital.
approach is based on the following important assumptions;
The overall cost of capital remains
There are no corporate taxes;
The market capitalizes the value
of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
V = E BIT /K0
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing
decision of a firm does not affect the market value of a firm in a perfect
capital market. In other words MM approach maintains that the average cost of
capital does not change with change in the debt weighted equity mix or capital
structures of the fir m.
Modigliani and Miller
approach is based on the
following important assumptions:
v There is a perfect
v There are no
v There are no corporate taxes.
v The investors act
v The dividend payout ratio
v The business consists of the same level of business risk.