Approaches of Capital Structure
3. Traditional Approach
As
per traditional theory, the financial risk increases with the increase in
amount of debt. Therefore, Cost of equity will increase. As a result, the
overall cost of capital will rise with the increase in amount of debt.
As
per traditional approach, a firm should make a judicious use of both the debt
and the equity to achieve a capital structure which may be called an optimal
capital structure.
This
theory states that value of firm increases with the increase in financial
leverage but upto a certain limit only. Beyond this limit, increase in
financial leverage will increase its weighted average cost of capital and
decline the value of firm.
Assumptions
Capital
structure theories are based on certain assumption to analysis in a single and convenient
manner:
•
There are only two sources of funds used by a firm; debt and shares.
•
The firm pays 100% of its earning as dividend.
•
The total assets are given and do not change.
•
The total finance remains constant.
•
The operating profits (EBIT) are not expected to grow.
•
The business risk remains constant.
•
The firm has a perpetual life.
•
The investors behave rationally
ABC
Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory
expects to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000.
In choosing a financial plan, ABC Ltd., has an objective of maximizing earnings
per share (EPS). The company proposes to issuing ordinary shares and raising
debit of Rs. 3,00,000 and Rs. 10,00,000 of Rs. 15,00,000. The current market
price per share is Rs. 250 and is expected to drop to Rs. 200 if the funds are
borrowed in excess of Rs. 12,00,000. Funds can be raised at the following
rates.
–up
to Rs. 3,00,000 at 8%
–over
Rs. 3,00,000 to Rs. 15,000,00 at 10%
–over
Rs. 15,00,000 at 15%
Assuming
a tax rate of 50% advise the company.
Ans.
The
secure alternative which gives the highest earnings per share is the best.
Therefore the company is advised to revise Rs. 10,00,000 through debt amount
Rs. 20,00,000 through ordinary shares.
4. Modigliani- Millar Approach
Modigliani
and Miller approach states that the financing decision of a firm does not
affect the market value of a firm in a perfect capital market. In other words
MM approach maintains that the average cost of capital does not change with
change in the debt weighted equity mix or capital structures of the firm.
Modigliani
and Miller approach is based on the following important assumptions:
•
There is a perfect capital market.
•
There are no retained earnings.
•
There are no corporate taxes.
•
The investors act rationally.
•
The dividend payout ratio is 100%.
•
The business consists of the same level of business risk.
Value
of the firm can be calculated with the help of the following formula:
EBIT (1-t)
ko
Where
EBIT
= Earnings before interest and tax
K
o = Overall cost of capital
t
= Tax rate
Ques: There are two firms ‘A’ and ‘B’ which are exactly identical
except that A does not use any debt in its financing, while B has Rs. 2,50,000
, 6% Debentures in its financing. Both the firms have earnings before interest
and tax of Rs. 75,000 and the equity capitalization rate is 10%. Assuming the
corporation tax is 50%, calculate the value of the firm.
Solution
The
market value of firm A which does not use any debt.
Vu = EBIT
ko
=
75,000
10/100
=75,000×100/10
=
Rs. 7,50,000
The
market value of firm B which uses debt financing of Rs. 2,50,000
Vt
= Vu + t
Vu
= 7,50,000, t = 50% of Rs. 2,50,000
=
7,50,000 + 1,25,000
=
Rs. 8,75,000
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