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    Financial Management and Corporate Finance: Theories of Capital Structure: Relevance & Irrelevance Approach

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    Tanya Malviya
    The document discusses various theories of capital structure, including the net income approach, net operating income approach, traditional approach, and Modigliani & Miller approach. The net income approach argues that firm value increases with leverage up to a point. The net operating income and M&M approaches argue that capital structure is irrelevant to firm value. The traditional approach seeks a balance, suggesting an optimal capital structure depends on circumstances.

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    Financial Management and Corporate Finance: Theories of Capital Structure: Relevance & Irrelevance Approach

    Uploaded by

    Tanya Malviya
    45 views12 pages
    The document discusses various theories of capital structure, including the net income approach, net operating income approach, traditional approach, and Modigliani & Miller approach. The net income approach argues that firm value increases with leverage up to a point. The net operating income and M&M approaches argue that capital structure is irrelevant to firm value. The traditional approach seeks a balance, suggesting an optimal capital structure depends on circumstances.

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    Financial management

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    FM unit 3

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    The document discusses various theories of capital structure, including the net income approach, net operating income approach, traditional approach, and Modigliani & Miller approach. The net income approach argues that firm value increases with leverage up to a point. The net operating income and M&M approaches argue that capital structure is irrelevant to firm value. The traditional approach seeks a balance, suggesting an optimal capital structure depends on circumstances.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    45 views12 pages

    Financial Management and Corporate Finance: Theories of Capital Structure: Relevance & Irrelevance Approach

    Uploaded by

    Tanya Malviya
    The document discusses various theories of capital structure, including the net income approach, net operating income approach, traditional approach, and Modigliani & Miller approach. The net income approach argues that firm value increases with leverage up to a point. The net operating income and M&M approaches argue that capital structure is irrelevant to firm value. The traditional approach seeks a balance, suggesting an optimal capital structure depends on circumstances.

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    of 12

    Class: M.B.A.

    Year: I/ Semester-II
    Name of Paper: Financial Management
    and
    Corporate Finance

    Topic: THEORIES OF CAPITAL STRUCTURE:


    RELEVANCE & IRRELEVANCE APPROACH

    Sub Topics: Capital Structure, Net Income


    Approach, Traditional Approach, Net-
    Operating Income Approach & Modigliani &
    Miller(M&M) Approach
    CAPITAL STRUCTURE THEORIES
    Capital Structure theories establishes relationship between capital
    structure and the value of firm.
    Basic assumptions are as follows:
     Only two kinds of funds used by
    firm i.e., debt & equity.
     Taxes are not considered.
     The payout ratio is 100%.
     The firm’s total financing remains
    constant.
     Business risk is constant over time.
     The firm has perpetual life.
     Total assets of the company are
    given &do not change.
    THEORIES OF CAPITAL STRUCTURE

    Theories

    Relevance Irrelevance
    Theories Theories

    Net-Operating Modigliani &


    Net Income Miller(M&M)
    Traditiona Income
    Approach Approach
    l Approach
    Approach
    NET INCOME
    APPROACH
     The exponent of this theory is David Durand.
     As per this theory a firm can increase its value or lower the
    overall cost of capital by increasing the proportion of
    debt in the capital structure.
     The NI approach clearly underlines the importance of
    debt as it is the determinant of the value of the firm.
    Basic assumption:
     Corporate tax doesn’t exist.
     The use of debt doesn’t change the perception of the investors.
     The Cost of Debt is less than the cost of equity.
    Traditional Approach

     There exist an optimal capital structure for every firm(2:1).


     Traditional approach offers an intermediate view which is a compromise
    between NOI & NI approaches.
     The value of firm increases with increase in financial
    leverage but up to certain limit only.
     Beyond that limit the financial leverage will
    increases its average cost of capital, hence the value
    of the firm will decline.

    BASIC ASSUMPTIONS

     The cost of debt capital remains more or less constant up to certain


    degree
    of leverage but rises thereafter at an increasing rate.
     The cost of equity capital remains more or less constant or rises only
    gradually up to a certain degree of leverage and rises sharply there after.
    NET OPERATING INCOME APPROACH
     This theory has also been propounded by David Durand.
     The market value of a firm depends on its net
    operating income and business risk.
     Change in the degree of leverage merely changes the
    distribution of income and risk between debt &
    equity without affecting the total income and risk
    that influences the market value of the firm.
    MODIGLIANI & MILLER AAPPROCH
    (MM)
     There is a relationship between cost of capital
    and valuation of firm NOI approach.
    The value of Firm is dependent on its capital

    structure.

    BASIC ASSUMPTIONS

     Capital Markets are perfect.


     Investors are free to buy & sell securities.
     There are no transaction cost
     They behave rationally.
     Dividend payout ratio is 100% & there are no related earning.
     There are no corporate income taxes.
     All the firms are within the same class and have same degree of business risk.
    BASIC PROPOSITIONS OF MM APPROCH

     The overall cost of capital and the value of the firm are independent to
    its capital structure. The rA and V are constant for all degrees of
    leverage.
     rE increases in a manner to offset exactly the use of less expensive
    source of funds represented by the debt.
     The cut off rate for investment purposes s is completely independent of
    the way in which an investment is financed.

    Following formulas have been given by Miler

    Firm Market Value(V)= EBIT(Operating Profit)/KE (Cost of Equity)


    Continuation of MM Approach with arbitrage
    process
    It is clear from the previous calculation that the market value of the levered
    company is higher than its total cost of capital as compared to the
    unlevered company.
    The MM approach contends that such discrepancy in the value of the two
    identical risk equivalent company cannot prevail for long because of
    arbitrage process.
    Due to arbitrage process the investors in the levered company will start
    selling their share in the equity capital in the company B and invest in
    the company A. As the degree of risk in the unlevered company is low
    as compared to levered company.
    RELATIONSHIP BETWEEN LEVERAGE &
    VALUATION

     As per MM Approach there is no relationship between total vale of firm &


    degree of leverage.
     The cost of Capital as well as the market value of shares must be the same
    regardless of the financing mix.
     Arbitrage Process :

    D= Demand/buying in one market at lower price & S= supply in other market at higher price.
    SUMMARIZED FORM OF THEORIES OF
    CAPITAL STRUCTURE

    Net Income Net Operating M.M Approach Traditiona


    Approach income l
    Approach
    •Leverage always •Capital structure •MM concur with • This
    affects the overall is totally NOI and provide approach strikes
    cost of capital and irrelevant. behavioral support a balance
    the value of the to its basic between the two
    firm. propositions. extremes i.e.;
    •There is an ( relevance
    optimum capital •No, affects of • The arbitrage & irrelevance
    structure at which leverage process approaches)
    the value of the on overall cost of is
    firm is the highest capital and the impeded. It implies • Up to a certain
    and the cost of market value of with the judicious level increase of
    capital is lowest. the firm. use of the mix of debt reduces the
    debt & equity overall cost of
    CONCLUSION:

    The Traditional Approach provides a fairly close


    approximation of the position. The optimum
    capital structure would of course vary from case
    to case.
    In other words, an appropriate capital structure
    will depend upon the circumstances of each case
    and the factors which have the bearing on the
    determinants of an appropriate capital structure.

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