UNIT 1

Capital structure
decisions
Optimal capital structure
 It is that mix of debt and equity where in the cost of

overall cost capital (Ko) is minimum and the value of the

firm is maximum.
Assumptions under capital structure decisions
 The firm employs only two type of capital that is debt and equity.
 The proportion of debt can be changed by selling shares to redeem
the debt, selling debentures to redeem shares.
 The firm has a policy of paying 100% earning as dividend.
 The operating earnings is not expected to change.
 Assume no corporate tax. This assumption is removed later.
 Firm has permanent life.
 Business risk assumed to be constant.
 The total assets are given and do not change.
Net Income approach
 It is suggested by Durand.
 According to him the capital structure decision is relevant

to the valuation of the firm.

 The change in the financial leverage will lead to a

corresponding change in overall cost of capital.

 The ratio of debt to equity is increased , the weighted

average cost of capital will decline.

 As well as the market price of ordinary shares will

increase.
 Decrease in the leverage will cause an increase in the

overall cost of capital.

 Assumptions under NI approach

 There are no taxes.

 The cost of debt is less than the cost of equity.
 Use of debt does not change with the introduction of

debt.
 If the firm is not using debt then the overall cost of capital

is equal to cost of equity.

 Net operating income approach

 It is suggested by Durand.
 It is opposite to the NI approach.
 The capital structure decision is irrelevant.
 Any change in the leverage will not lead to any change in

the total value of the firm and the market price per share.
NOI is based on the following propositions.

 Overall cost of capital is constant.

 Residual value of equity. (V-S)
 Changes in cost of equity capital- Ke increases with

the degree of leverage.

 Increase in debts results in increase in financial risk to

equity holders.
Modigliani Miller(MM) approach
 There is no sufficient justification for the assumption that,
investor perception about risk of leverage is different at
different level of leverage.
Basic propositions
1. The overall cost of capital (Ko) and the value of the firm
(V) are independent of its capital structure. The Ko and V
are constant for all degrees of leverages.
2. Financial risk is to the difference between the Ke and Kd.
3. The cut off rate for investment purposes is completely
independent of the way in which an investment is
financed.
Assumptions.

 Perfect capital markets.

 All investors have same EBIT to evaluate value of the

firm.
 Business risk is equal among all the business firms.
 The dividend payout ratio is 100%.
 There are no taxes . This assumption is removed later.