Page 96 - DMGT409Basic Financial Management

Nancy Sahni, Lovely Professional University Unit 6: Capital Structure Theory

Unit 6: Capital Structure Theory Notes

CONTENTS

Objectives
Introduction
6.1 Theory of Capital Structure
6.2 Net Income Approach (NI)
6.3 NOI Approach

6.4 Traditional or Intermediate Approach or WACC Approach
6.5 Modigliani Miller Approach (MM)
6.5.1 Proof of MM Argument
6.5.2 Working of the Arbitrage Process

6.6 Optimum Capital Structure
6.6.1 Computation of Optimum Capital Structure
6.6.2 Approaches to Determine Appropriate Capital Structure
6.7 The Trade off Theory: Cost of Financial Distress and Agency Cost
6.8 Summary

6.9 Keywords
6.10 Self Assessment
6.11 Review Questions
6.12 Further Readings

Objectives

After studying this unit, you will be able to:
Discuss theories of capital structure
Describe Optimum capital structure

Introduction

The Capital structure decision is yet another important area under financial management. Capital
structure refers to the mix of proportions of a firm’s permanent long-term fi nancing represented

by debt, preference capital and equity share Capital.

While taking any financial decisions, the firm must ensure the maximization of wealth of
shareholders. So even the Capital structure decision must be taken in the light of wealth
maximization objective. That particular mix of debt and equity which maximizes the value of the

firm, is known as optimum capital structure.

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