Page 117 - DMGT409Basic Financial Management

Basic Financial Management

Notes 6.9 Keywords

EBIT-EPS Approach: This approach determines the impact of debt on earnings per share.

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.
WACC Approach: It is midway between NI and NOI approaches.

6.10 Self Assessment

Fill in the blanks:
1. According to ......................., capital structure decision is relevant to the valuation of the
fi rm.

2. NI approach assumes that cost of debt is ....................... than the cost of equity.
3. According to NOI approach, the capital structure decision is irrelevant and there is nothing
like ....................... .

4. According to ......................., the value of the firm is independent of its capital structure.
5. Arbitrage process helps to bring ....................... in the market.
6. The ....................... keeps balance between share capital and debt capital.
7. ....................... is helpful to analyse the impact of debt on earnings per share.
8. ....................... analyses the firm’s debt service capacity.

State whether the following statements are true or false:

9. Net income approach of capital structure was propounded by David Durand.
10. According to NI approach the cost of debt and the cost of equity change with a change in
the leverage ratio.

11. According to NI theory, cost of equity is assumed to be less than the cost of debt.
12. Net operating income (NOI) theory is propounded by David Durand.

13. According to NOI theory, the market value of the firm is not affected by the capital structure
changes.
14. The WACC approach is midway between the NI and NOI approach.
15. According to WACC approach, the cost of debt remains almost constant up to certain
degree of leverage but decreases thereafter at an increasing rate.

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