Capital Structure 30.5

8/6/2019 Capital Structure 30.5

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Capital structure Theory According to Gestenberg, Capital structure refers to themake up if a firms capitalisation.

It represents the mix of different sources of long-termfunds.

PATTERNS OF CAPITAL STRUCTURE

1. With Equity shares only

2. With both equity and preference shares

3. With equity shares and debentures

4. With equity shares, preference shares and debentures



Ca ital Str ct r D finiti n and

Patt rnsPATTERNS OF CAPITAL STRUCTURE

1. Net Incomes (NI) Approach

2. Net Operating Income (NOI) Approach

3. Modigliani-Miller (MM) Approach

4. Traditional Approach





Net Inc mes (NI) A r ac ..

y Assumptions of Net Income (NI) Approach:

1. There are no corporate taxes

2. Cost of debt is less than cost of equity 3. Debt content does not change the risk perception of

the investors

V=S+B, where V=Value of Firm, S=Market value of

equity, B=Value of debt andS=NI/Ke, where NI=earnings available for equity sh.holders and Ke=Equity capitalisation rate.

Ke=Earnings available to eq.shareholders /V-B



Net O erating Inc me (NOI)

A r ac

y Net Operating Income (NOI) Approach

Suggested by Durand. Opposite of NI approach.

Acc. to this approach, market value of the firm is not atall affected by capital structure changes.

Market value of the firm is ascertained by capitalisingthe net operating income at the overall cost of capitalk, which is considered to be constant.





Modigliani-

Mille

r A ro

acy Similar to Net Operating Income (NOI) Approach

Acc. to this approach, market value of the firm isindependent of capital structure.

MM has given behavioural justification for this approach

whereas NOI approach is purely definitional orconceptual approach.

Arbitrage process



Mo iglia i-Miller pproach ..

y Assumptions of MM Approach:

1. Overall cost of capital and value of the firm are

independent of capital structure.2. Capital markets are perfect.

3. Dividend pay out ratio is 100%

4. No corporate taxes exist

5. All investors have the same expectation of a firmsEBIT with which to evaluate the value of the firm.

Total value of the firm = EBIT / Overall cost of capital



Traditional A roacy NI approach and Net Operating Income (NOI)

Approach are exact opposite.

yMM approach supports NOI approach.

y MM approach with its assumptions is of doubtful validity.

y TRADITIONAL APPROACH is mid-way between thetwo approaches.



Traditional A roac .y ITS FEATURES :

1. Similar to NI approach to the extent that it accepts

that the capital structure or leverage affects the costof capital.

2. Subscribes to NOI approach that beyond a certaindegree of leverage, k increases resulting of the total

value of the firm.y ESSENCE OF TRADITIONAL APPROACH:

A firm through judicious use of debt-equity mix canincrease its total value and thereby reduce its overall k.



Traditional A roac .y Market value of shares

= Earnings available to Eq. Sh holders

Equity capitalisation rate

y Average cost of capital

= EBIT .

Market value of the firm



Factors Determining t e Ca ital

Str ct re1. Financial Leverage

2. Growth and stability of sales

3. Cost of capital4. Ability of cash flow

5. Nature and size of the firm

6. Control over the firm

7. Flexibility in capital structure8. Requirement of Investors

9. Capital market conditions

10. Corporate tax rate and legal requirements

Capital Structure 30.5

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