Page 145 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

 ln planning the capital structure, one should keep in mind that there is no one definite Notes
model that can be suggested/used as an ideal for all business undertakings.
 To obtain a balanced capital structure it is necessary to consider the ability of the company
to market corporate securities.
 Small companies rely heavily on owners’ funds while large companies are generally
considered to be less risky by the investors and therefore, they can issue different types of
securities.
 The Net Income (NI) approach is the relationship between leverage and cost of capital and
value of the firm.
 According to the NOI approach, the market value of the firm depends upon the net operating
profit or EBIT and the overall cost of capital, WACC.

 According to Modigilani-Miller approach, the value of a firm is independent of its capital
structure.

 Earnings per share would be the highest in case of financing, which has the least cost to the
company.
 EPS volatility shows whether a company enjoys a stable income or not.

7.7 Keywords

Arbitrage: It refers to an act of buying a security in one market having lower price and selling it
in another market at higher price.

Capital Structure: It is that part of financial structure, which represents long-term sources.
MM Theory: According to this theory the value of the firm is independent of its capital structure.
Net Income Approach: According to this approach, the cost of debt and the cost of equity do not
change with a change in the leverage ratio.
NOI Approach: According to this approach, the market value of the firm is not affected by the
capital structure changes.

Optimum Capital Structure: It is that capital structure where market value per share is maximum
and the cost of capital is minimum.

7.8 Review Questions

1. Explain briefly the major considerations in capital structure planning.

2. Explain briefly, the Modigliani-Miller approach on cost of capital.
3. Explain the conditional theory of capital structure.
4. What important factors in addition to quantitative factor should a firm consider when it is
making a capital structure decisions?
5. The total value of a firm remains unchanged, regardless of the variations in the financing
mix. Discuss the statement and point out the role of arbitrating and who made leverage?

6. How will the firm go for optimizing capital structure?
7. List down the approach which advocates that the cost of Equity Capital and Debt Capital
remains unaltered when the degree of leverage varies?

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