Page 187 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Self Assessment

Fill in the blanks:
6. Keeping the objective of …………………… in mind, capital structure has to be determined.
7. …………………… is the firm’s ability to adopt its capital structure to the needs of changing
conditions.
8. The …………………… shareholder have voting right to elect the directors of the company.
9. …………………… is preferred only when the firm’s debt service capacity is good.

10. Firm can use industry leverage ratio as standard for construction of…………………… .
8.7 Theory of Capital Structure

The long-term source of finance, which a company may use for investments, may be broadly
classified into two types. They are debt capital and equity capital. The financial manager must
determine the proportion of debt and equity and financial leverage. Understanding the
relationship between financial leverage and cost of capital is extremely important for taking
capital structure decisions. Theoretically the value of a firm can be maximized when the cost of
capital in minimized. That capital structure, where the cost of capital is minimum, is known as
optimum capital structure. Existence of optimum capital structure is not accepted by all. There
exist extreme views. The first viewpoint strongly supports the argument that, the financing or
debt equity mix has a major impact on the shareholders wealth. The second, however, is of the
opinion that, capital structure is irrelevant.

There are four 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

8.7.1 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 firm.
The formula to calculate the average cost of capital is as follows:
K = K (B/ (B+S)) + K (S/(B+S))
o d e
Where,
K is the average cost of capital
o
K is the cost of debt
d

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