Page 97 - DMGT409Basic Financial Management

Basic Financial Management

Notes

Notes Assumptions of Capital Structure Theories

1. There are only two sources of funds i.e. debt and equity.
2. The total assets of the company are given and do not change.

3. The total financing remains constant. The firm can change the degree of leverage,
either by selling the shares and retiring debt or by issuing debt and redeeming
equity.
4. Operating profits (EBIT) are not expected to grow.

5. All the investors are assumed to have the same expectation about the future profi ts.

6. Business risk is constant over time and assumed to be independent of its capital
structure and fi nancial risk.
7. Corporate tax does not exit.

8. The company has infi nite life.
9. Dividend payout ratio = 100%.

6.1 Theory of Capital Structure

The long-term source of finance, which a company may use for investments, may be broadly
classified into 2 types. They are debt capital and equity capital. The financial manager must

determine the proportion of debt and equity and fi nancial leverage.
There are 4 major theories explaining the relationship between capital structure, cost of capital

and valuation of the firm. They are:
1. Net income approach (NI)
2. Net operating income approach ( NOI)
3. Traditional approach

4. Modigliani-Miller approach

6.2 Net Income Approach (NI)

According to this approach, the cost of debt and the cost of equity do not change with a change in
the leverage ratio. As a result, the average cost of capital declines as the leverage ratio increases.
This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of
equity, gets a higher weightage in the calculation of the cost of capital.

This approach has been suggested by David Durand. According to this approach, capital
structure decision is relevant to the valuation of the firm. According to the theory it is possible to

change the cost of capital by changing the debt equity mix. In other words, a change in the capital
structure causes a change in the overall of capital as well as the value of the fi rm.
The formula to calculate the average cost of capital is as follows:
K = K (B/ (B + S)) + K (S/(B + S))
o d e

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