Page 186 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

5. All the investors are assumed to have the same expectation about the future profits. Notes
6. Business risk is constant over time and assumed to be independent of its capital structure
and financial risk.

7. Corporate tax does not exit.
8. The company has infinite life.
9. Dividend payout ratio = 100%.

Notes Definitions and Symbols Used
S = Total market value of equity shares.

B = Total market value of debt
I = Total interest payments.
V = Total market value of the firm
NI = Net income available to equity shareholders.

V = B+S
Cost of debt ( Kd) = 1/ B
Value of debt (B) = 1/ K
e
Cost of equity capital (K ) = D1/P + g
e
Because of assumption no-4 growth rate = O. So, K = D/P and since payout ratio = 100%
e
D = earnings or dividends.
Therefore, K = E/P
d
Multiplying both, numerator and denominator by the number of shares, we get:

E×N EBIT 1
K = orNI
e
P×N S
Netincomeavailabletotheshareholder
K =
e
Totalmarketvalueofequityshares
Overall costs of Capital (K )
o
K = W K + W K (W & W are weights)
o 1 d 2 e 1 2
 
B S K
 or
K
B/V(K )+ S/V K   + e
d e d
B+ S B+ S
or
1+ NI EBIT
K = =
o
V V
so
EBIT
V =
K
o

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