19-11-2012, 06:30 PM
CAPITAL STRUCTURE
CAPITAL STRUCTURE.ppt (Size: 110 KB / Downloads: 34)
Optimum capital structure
Is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value the firm.
The optimum capital structure minimizes the firms overall cost of capital and maximizes the value of the firm.
Optimum capital structure is also referred as “ appropriate capital structure” and “sound capital structure”
Theories of capital structure
Net Income NI approach
Net Operating Income NOI approach
Modigliani Miller MM approach
Theories of capital structure
Basic assumptions
There are no corporate taxes. This assumption is removed later.
The dividend-payout ratio is 100%. that is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings.
The total assets are given and do not change. The investment decisions are in other words assumed to be constant.
The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the cost of equity capital.
Net Income approach
This approach is given by ‘Durand David’
Assumptions: this approach is based on three assumptions
There are no taxes
Cost of debt is less than the cost of equity
Use of debt does not change the risk perception of the investor.
According to this approach, the capital structure decision is relevant to the valuation of the firm.
Net operating income approach
This is another theory suggested by Durand
NOI approach is opposite to NI approach
According to NOI approach value of the firm is independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm
Any change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage
Assumptions
The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole
The overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchanged
The cost of debt (kd) is also constant
There is no tax
The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke)
Modigliani Miller Approach
The M.M thesis relating to the relationship between the capital structure, cost of capital and valuation is similar to the NOI approach.
The NOI approach does not provide operational or behavioral justification for the irrelevance of the capital structure.
The significance of M.M approach lies in the fact that it provides behavioral justification for constant overall cost of capital and therefore total value of firm.