The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value of the firm.
Capital Structure of a Firm: Top 4 Approaches With Calculations Article shared by: This article throws light upon the top four approaches of capital structure of a firm.
Net Income Approach NI 2. Capital Structure Approach 1. Net Income Approach NI: Net income approach and net operating income approach were proposed by David Durand.
According to NI approach, there exists positive relationship between capital structure and valuation of firm and change in the pattern of capitalisation brings about corresponding change in the overall cost of capital and total value of the firm.
Thus, with an increase in the ratio of debt to equity overall cost of capital will decline and market price of equity stock as well as value of the firm will rise.
The converse will hold true if ratio of debt to equity tends to decline. This approach is based on three following assumptions: This implies that there will be no change in cost of debt and cost of equity even if degree of financial leverages changes.
Thus, a firm can achieve optimal capital structure by making judicious use of debt and equity and attempt to maximise the market price of its stock. The following illustration will explain the NI approach: Excellent Manufacturing Company expects to earn net operating income of Rs.
The Company has Rs. What would be the value of Company? Also calculate overall cost of capital. Now assume that the management raises the amount of debt from Rs.
Presuming that the cost of debt remains constant, value of the company will be as shown below: A perusal of the above calculation will show that as the amount of debt increases from Rs.
Let us now assume that the amount of debt decreases from Rs. Impact of change in financial leverage on cost of capital and value of the firm as will be under: It is to be noted from the above that with decrease in debt from Rs. In sum, as per NI approach increase in ratio of debt to total capitalisation brings about corresponding increase in total value of firm and decline in cost of capital.
On the contrary, decrease in the ratio of debt to total capitalisation causes decline in total value of firm and increase in cost of capital. Relationship between degree of financial leverage and cost of equity capital, cost of debt and overall cost of capital as per AII approach has been exhibited in figure The graph is based on the information given in Illustration 1.
As the Ki, and Ke are assumed to remain constant, both the curves are parallel to the X-axis. As the degree of leverage increases the weighted cost of capital, Ko decreases and tends to approach the cost of debt Ki.Effect of change in the capital structure: (Increase in debt capital) Let us assume that the firm decides to retire $, worth of equity by using the proceeds of new debt issue worth the same amount.
Capital structure theories notes Published in: Education. 0 Comments 5 Likes Net Income Approach As suggested by David Durand, this theory states that there is a relationship between the Capital Structure and the value of the firm. M Hypothesis can be explained in terms of two propositions of Modigliani and Miller.
They are: i. The.
The capital structure of a company is a mix/ratio of debt and equity in the company’s mode of financing. This ratio of debt in the capital structure is also known as financial feelthefish.com companies prefer more of debt while others prefer more of equity while financing their assets.
Thus, cost of capital curve may be V shaped which yudecdes that applications of additional debt in capital structure beyond a point will result in an increase in total cost of capital .
value. As a consequence cost of capital remains relatively constant. Finally, beyond the acceptable limit of leverage, the value of the firm decreases or the cost of capital increases with the leverage. This happens because investors perceive a high degree of financial risk and this increases equity and debt capitalization rates.
Chapter III CONCEPTS AND THEORIES OF CAPITAL STRUCTURE AND PROFITABILITY: A REVIEW A STUDY ON THE DETERMINANTS OF CAPITAL STRUCTURE AND PROFITABILITY 67 CHAPTER III CONCEPTS AND THEORIES OF CAPITAL STRUCTURE AND PROFITABILITY: A REVIEW David Durand, who argued that the market value of a firm depends on its net.