Page 104 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

EBIT (`) 4,00,00,00 Notes

Less: Interest (`) 1,65,000
Earnings available to ESH (`) 2,35,000
Cost of equity 0.17
Value of equity shares ( S = NI / Ke) (`) 13,82,352
Value of debt (`) 15,00,000
Value of the fi rm (V)(`) 28,82,352

EBIT 4,00,000
Overall cost of capital K = = = 13.8%
o V 28,82,353
If the debt is further increased to ` 5,00,000 the cost of debt increases to 12.5% and the cost of
equity is increased to 20%. Find out the overall cost of capital and value of the fi rm.
EBIT 4,00,000
Less: Interest (`) 2,50,000
Earning available to ESH (`) 1,50,000

Cost of equity 0.20
Value of equity shares (S = NI/Ke) 7,50,000
Value of debt (B) (`) 20,00,00
Value of the firm (V = S + B) (`) 27,50,000

EBIT 4,00,000
Overall cost of capital K = = = 14.5%
o V 27,50,353
6.5 Modigliani Miller Approach (MM)

MM theory relating to the relationship between cost of capital and valuation is similar to the NOI

approach. According to this approach, the value of the firm is independent of its capital structure.
However, there is a basic difference between the two. The NOI approach is purely a defi nitional
term, defining the concept without behavioural justification. MM approach provides analytically

sound, logically consistent, behavioral justification in favour of the theory and considers any

other theories of Capital structure as incorrect.
Assumption

Capital markets are perfect. This means,
1. Investors are free to buy and sell securities.

2. Inventors can borrow and lend money on the same terms on which a firm can borrow and

lend.
3. There are no transaction costs.
4. They behave rationally.

5. Firms can be classified into homogenous risk categories. All the firms within the same class
will have the same degree of business risks.

6. All the investors have the same expectations from a firm’s NOI with which to evaluate the
value of the fi rm.

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