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Old 14th February 2016, 02:23 PM
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Join Date: May 2012
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Default Re: Mba ppt on capital structure

Hello buddy Capital structure topic is part of financial management as you
want here we provides you theoretical knowledge of Capital structure as

The permanent long-term financing of a company, including long-term debt,
common stock and preferred stock, and retained earnings. It differs from
financial structure, which includes short-term debt and accounts payable.

The capital structure of a business is the mix of types of debt and equity the
company has on its balance sheet.

Common Assumption

1: There is only 2 type of finance: Debt and Equity.

2: There is no change in investment i.e. no change in fixed asset.

3: 100% dividend pay out ratio.

4: There is no change in operating profit of company.

5: Risk of company remain inconstant.

Net Income (NI) Approach

Net Income theory was introduced by David Durand.

According to this approach, the capital structure decision is relevant to the
valuation of the firm. This means that a change in the financial leverage will
automatically lead to a corresponding change in the overall cost of capital as
well as the total value of the firm.

Assumptions of NI approach:

1.There are no taxes.

2. The cost of debt is less than the cost of equity.

3. Company use of debt does not change the risk perception of the investors.

Net Operating Income (NOI) Approach

Net Operating Income Approach was also suggested by Durand. This
approach is of the opposite view of Net Income approach.

This approach suggests that the capital structure decision of a firm is
irrelevant and that any change in the leverage or debt will not result in a
change in the total value of the firm as well as the market price of its

Features of NOI approach:

1: At all degrees of leverage (debt), the overall capitalization rate would
remain constant. for a given level of Earnings before Interest and Taxes
(EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

2: The value of equity of a firm can be determined by subtracting the value
of debt from the total value of the firm. This can be denoted as follows

: Value of Equity = Total value of the firm - Value of debt

3: Cost of equity increases with every increase in debt and the weighted
average cost of capital (WACC) remains constant.

When the debt content in the capital structure increases, it increases the risk
of the firm as well as its shareholders.

To compensate for the higher risk involved in investing in highly levered
company, equity holders naturally expect higher returns which in turn
increases the cost of equity capital.

Traditional Approach

The Net Income theory and Net Operating Income theory stand in extreme
forms. Traditional approach stands in the midway between these two
theories. This Traditional theory was advocated by financial experts Ezta
Solomon and Fred Weston.

According to this theory a proper and right combination of debt and equity
will always lead to market value enhancement of the firm.

Modigliani Millar Approach

Modigliani Millar approach, popularly known as the MM approach is similar to
the Net operating income approach.

Basic Propositions of MM approach

1: At any degree of leverage, the company's overall cost of capital (ko) and
the Value of the firm (V) remains constant.

This means that it is independent of the capital structure.

The total value can be obtained by capitalizing the operating earnings stream
that is expected in future, discounted at an appropriate discount rate suitable
for the risk undertaken.

2: The cost of capital (ke) equals the capitalization rate of a pure equity
stream and a premium for financial risk.

This is equal to the difference between the pure equity capitalization rate and
ki times the debt-equity ratio.

3:The minimum cut-off rate for the purpose of capital investments is fully
independent of the way in which a project is financed.

Assumptions of MM approach:

1:Capital markets are perfect.

2: All investors have the same expectation of the company's net operating
income for the purpose of evaluating the value of the firm.

3: Within similar operating environments, the business risk is equal among
all firms.

4: 100% dividend payout ratio.

5: An assumption of "no taxes" was there earlier, which has been removed.

Limitations of MM hypothesis:

1: Investors would find the personal leverage inconvenient.

2: The risk perception of corporate and personal leverage may be different.

3: Arbitrage process cannot be smooth due the institutional restrictions.

4: Arbitrage process would also be affected by the transaction costs.

5: The corporate leverage and personal leverage are not perfect substitutes.

6: Corporate taxes do exist. However, the assumption of "no taxes" has been
removed later.

Arbitrage process

Arbitrage process is the operational justification for the Modigliani-Miller

hypothesis. Arbitrage is the process of purchasing a security in a market
where the price is low and selling it in a market where the price is higher.

This results in restoration of equilibrium in the market price of a security asset.
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