Capital structure and theories
- 1. Submitted by – shivam chaturvediSubmitted to – Nirbhay mahor sir
- 2. Meaning Capital structure Capital structure refer to the proportion between the various long term source of finance in the total capital of firm. A financial manager choose that source of finance which include minimum risk as well as minimum cost of capital.
- 3. Sources of long term finance Proprietor’s funds Borrowed funds Equity capital Preference capital Reserve and surplus Long term debts
- 4. Theories of Capital structure Net Income (NI) Theory. Net Operating Income (NOI) Theory. Traditional Theory. Modigliani-Miller (M-M) Theory.
- 5. Basic assumptions of all these theories Firms employees only debt and equity capital. Total assets of the firm are given. The film had 100% payout ratio. The operating earnings of the firm are not expected to grow it means EBIT remain same of all years. Business risk remain constant.
- 6. Capital structure Capital structure relevance theory Capital structure Irrelevance theory Net income approach Traditional approach Traditional Theory Modigliani- Miller (M-M) Theory
- 7. Net Income (NI) Theory It is discovered by DAVID DURAND. Relevance theory of capital structure. This theory says that there is relevance impact on the value of the firm and the overall cost of capital if we mix a debt in our capital structure " Greater the debt capital employed lower shall be the overall cost of the capital and more shall the be the value of the firm“.
- 8. Assumptions Cost of equity is always greater than cost of debt. There is no corporate tax. The risk perception of investors is not affected by the use of debt.
- 9. The proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces.
- 10. Net Operating Income Approach (NOI) It was discovered by David Durand . This capital structure theory is opposite of what he said in IN approach. This approach represent another view that Capital structure and the value of the firm are IRRELEVANT “. Capital structure of the firm does not influence by the debt proportion in it and lead to decrease the cost of capital and the value of the firm. Value effect because of market trends.
- 11. • According to David, " the use of the less costly debt increases the risk to equity shareholders, this cause, to increase as a result the low cost advantage of debt is exactly offset by increase in the capitalization rate. • Thus the overall capitalization rate () remain same and value of the firm does not change.
- 12. • Cost of capital (Ko) is constant. • As the proportion of debt increases, (Ke) increases. • No effect on total cost of capital (WACC) ke ko kd Debt Cost
- 13. Assumptions of NOI The market capitalizes the value of the firm as whole. The split between debt and equity is not important. Business risk remain same. No corporate taxes. Debt capitalization rate (kd) is constant.
- 14. Traditional Theory This theory is also known as intermediate approach. Theory was propounded by EZRA SOLOMON. It is combination of two theories Ni and NOI approach. Talks about both relevance and irrelevance impact on capital structure. Cost of capital can be reduced or the value of the can be increased with the justifiable mix of debt or equity. ko can be decreased with increase in debt capital upto a reasonable level and if debt is tried to Increase beyond the level then it results in rise of ko.
- 15. • Cost of capital (Ko) is reduces initially. • At a point, it settles. • But after this point, (Ko) increases, due to increase in the cost of equity. (Ke)
- 16. Modigliani-Miller (M-M) Theory This theory is invented by Modigliani and Miller. This theory is invented by Modigliani and Miller. MM argued that in the absence of tax, cost of capital and the value of the are not effected by the change in capital structure. other words, capital structure decision is irrelevant and the value of the firm is independent of debt- equity mix.
- 17. Imbalance will create ke rise and consequently lead ko rise.
- 18. Thank you