Capital Structure – Written by Padmaa

The objectives of a firm should be directed towards the maximization of the value of the firm. The capital structure decision should be examined from the point of view of its impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decisions, a firm would like to have a capital structure which maximize the market value of firm.

Approaches:

(i)Net Income(NI) approach

(ii)Net Operating income approach

(iii)Traditional approach

(iv)Modigliani and Miller approach

These approached analyze the relationship between the leverage, cost of capital and value of firm in different ways.

Assumptions for capital structure theories:

• There are two sources of finance debt & equity
• Total asset of the firm and its capital employees are constant. However, debt & equity mix can be changes either by borrowing to repurchase equity or raising equity to repay debt.
• All residual earnings are distributed to equity shareholders
• The firm earns operating profit and it is expected to grow.
• The business risk is assumed to be constant and is not affected by the financing mix decisions ( No changes in fixed cost or operating risks)
• There are no corporate or personal taxes
• The investor have the same subjective probability distribution of expected earnings (No difference in investor expectations)
• Cost of debt (Kd) is less than cost of equity (Ke)