Page 116 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

Exhibit 1: Performa Income Statement For December 31, 2001 Notes
Sales 30,00,000
Variable Cost 18,56,000
Marginal Contribution 11,44,000
Fixed Costs 5,60,000
Earnings before interest and tax (EBIT) 5,84,000
Interest 80,000
Earning before tax (EBT) 5,04,000
Taxes 2,62,000
Net Income after tax 2,42,000

Exhibit 2: Performa Balance Sheet For December 2001
Liabilities ` Assets `
Current Liabilities 3,00,000 Cash 1,40,000
Long-term debt 10% 8,00,000 Accounts Receivable 3,00,000
Common stock (` 2%) 4,00,000 Inventory 2,40,000
Retained earnings 15,80,000 Fixed Assets 24,00,000
Total 30,80,000 Total 30,80,000
Normal profit margin is 20 per cent and normal asset turnover is 1.2/1

Questions

1. What will be the effect on EPS of the company in each financing alternative and how
the acceptance of each project will affect the leverage.
2. Without the new projects, what would the fi rms operating, fixed shares, and combined

leverage be, the next year? Does it have a favourable fi nancial leverage?
6.8 Summary

z Capital structures refers to the mix of different sources of long terms funds such as debt,
preference capital and equity capital in the total capitalization of a company. There are
difference of opinion on the relationship between capital structure, cost of capital and
valuation.
z According to the NI approach overall cost of capital continuously decreases as and when
the debt content is increased in the capital structure. So optimum capital structure exists

when the firm borrows maximum.
z NOI is just opposite to NI approach and argues that capital structure is irrelevant. According
to the theory, Ko depends on business risk, which is assumed to be constant. So, K does
O
not change when leverage is changed.
z The MM approach to capital structure is akin to that of NOI approach and argues that
capital structure is irrelevant.
z According to the traditional approach, Ko decreases with the leverage in the beginning,
then reaches the minimum point and rises thereafter. So optimum capital structure exists
according to the theory. Thus traditional theory strikes a balances between NI and NOI
approach.

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