Theories of Capital Structure Bcom Notes

Theories of Capital Structure Bcom Notes:- In this post, you will get the notes of B.com 3rd year Financial Management, by reading this post you can score well in the exam, hope that this post has helped you with this post to all your friends and all groups right now I must share it so that every student can read this post and it can also be helped in this post.

Theories of Capital Structure

Capital structure theories seek to explain the relationship between capital structure decision and the market value of the firm. There are conflicting opinions regarding whether or not capital structure decizion affects the value of the firm.

BASIC ASSUMPTIONS IN CAPITAL STRUCTURE THEORIES

The study of the following basic assumption is necessary before we study the capital structure theories under traditional and modern views

There are only two sources of funds i.e., the equity and debt. which is having fixed interest.
Corporate Income Tax does not exist.
Firms follow policy of paying 100% of its earnings by way of dividend.
Total assets of a company are given and these are not expected to change over a period of time.
The operating profits of the firm are given and are not expected to gorw/
Business risk is treated constant at different capital structure of a company.
There are no transaction costs and a company can alter its capital structure without any transaction costs.
The company has a perpetual life.

TYPES OF CAPITAL STRUCTURE THEORIES

Net Income Approach: This approach is given by Durand David. According to this approach, the capital structure decision is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. The value of the firm on the basis of NI Approach can be ascertained as follows:

Illustration 1. Anmol Ltd. is expecting an annual EBIT of ₹2 lakh. The Company has ₹8.0 Lakh in 10% debentures. The cost of equity capital or capitalisation rate is 12.5%. You are required to calculate the total value of the firm according to Net Income Theory. Also state the overall cost of capital.

Solution. Calculation of the Value of the Firm

Net Operating Income Approach: This approach has also been suggested by Durand. This is just opposite of Net Income Approach. According to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. According to this approach, the market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital.

Value of Firm: The value of a firm on the basis of NOI Approach can be determined as follows:

Illustration 2. A company expects a net operating income of 2,00,000. It has 10,00,000, 6% Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm and the equity capitalisation rate (cost of equity) according to the Net Operating Income Approach.

Solution.

Traditional Approach: The traditional approach explains that upto a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline. But after attaining the optimum level, any additional debt will cause to decrease the market value and to increase the cost of capital. In other words, after attaining the optimum level, any additional debt taken, will offset the use of cheaper debt capital since the average cost of capital will increase along with a corresponding increase in the average cost of debt capital.
Modigliani and Miller Approach: The detailed study of this theory can be discussed under the following two heads:

(a) Modigliani-Miller (MM) Theory in the Absence of Corporate Taxes: In the absence of corporate taxes, the Modigliani-Miller (MM) approach is similar to the Net Operating Income (NOI) approach. In other words, according to this approach, the value of a firm is independent of its capital structure. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases. This increase in cost of equity offsets the advantage of the low cost of debt.

Assumptions: This approach is based upon the following assumptions: 1. Capital markets are perfect. 2. The firms can be classified into homogeneous risk classes. 3. All investors have the same expectation of a firm’s net operating income (EBIT) with which to evaluate the value of any firm. 4. The dividend pay-out ratio is 100%. 5. There are no corporate taxes.

(b) Modigliani Miller Theory in the Presence of Corporate Taxes: Modigliani and Miller, in their article of 1963 have recognised that the value of the firm will increase or the cost of capital will decline, if corporate taxes are introduced in the exercise. This is because interest is a deductible expense for tax purposes and, therefore, the effective cost of debt is less than the contractual rate of interest. A levered firm should have, therefore, a greater market value as compared to an unlevered firm. The value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firm’s debt multiplied by the tax rate.

Illustration 3. The following information is available about Raja Ltd.:

Conclusion: Net Income approach and Traditional approach strongly support the view point that there exists a relationship between capital structure of a firm and its market value. Whereas, Net Operating Income Approach and Modigliani and Miller rule out any relationship between capital structure and market value.