Page 98 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

Where, Notes

K is the average cost of capital
o
K is the cost of debt
d
B is the market value of debt
S is the market value of equity
K is the cost of equity
e
The NI approach is based on the following assumptions:

1. The use of debt does not change the risk of investors and therefore, cost of debt ( Kd) and
cost of equity (K ) remains the same irrespective of the degree of leverage.
e
2. Cost of debt is less than the cost of equity.

3. The corporate income tax does not exist.

!
Caution According to the theory, cost of debt is assumed to be less than the cost of equity.
Therefore, when the financial leverage is increased (proportion of debt in the total capital),

the overall cost of capital will decline and the value of the firm will increase.
The implications of the 3 assumptions of NI approach is that, as the degree of leverage increases,
the proportion of a cheaper source of funds ( debt) in the capital structure increases. As a
result, the weighted average cost of capital tends to decline leading to an increase in the total

level of the firm. Thus, even if the cost of debt and cost of equity remains same regardless of
leverage, increased use of low cost debt will result in the decline of overall cost of capital and
thereby, maximize the value of the firm. So the overall cost of capital will be minimum when the

proportion of debt in the capital structure is maximum. Hence, optimum structure exists when

the firm employs 100% debt or maximum debt in the capital structure.
Illustration 1: A Company’s expected net operating income ( EBIT ) is ` 1,00,000. The company
has issued ` 5,00,000, 10% debentures at ` 100 each. The cost of equity is 12.5%. Assuming no

taxes, find out the overall cost of capital and the value of the firm according to NI approach.
Solution:
S = Value of equity shares (NI/K ) (`) 4,00,000
e
Net operating income (`) 1,00,000
Less: Interest, on debentures ( `) 50,000
Earning available to ESH ( NI) (`) 50,000
Cost of equity (K ) 12.5%
e
Value of debt (B) (`) 5, 00,000

Total Value of the firm ( S + B = V) (`) 9,00,000

Overall cost of capital ( EBIT/V) 11.1%
Alternatively, K = K (W1) + K (W2)
o d e
5,00,000 (0.10 ) + 4,00,000(0.125) = 11.1%

9,00,000 9,00,000

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