INTRODUCTION

The optimum capital structure may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm. Capital structure can affect the value of the company by affecting either its expected earnings or the cost of capital or both.

The first four sections of the chapter explain the major capital structure theories.
Net Income Approach Net Operating Income Approach Modigliani-Miller Approach Traditional Approach.

CAPITAL STRUCTURE THEROIES Assumptions

There are only two sources of funds used by a firm : perpetual riskless debt and ordinary shares. There are corporate taxes. This assumption is removed later. The dividend-payout ratio is 100%. That is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings. The firms total assets are given and do not change. The investment decisions are, in other words, assumed to be constant. The firms total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use by the proceeds to retire debentures or by raising more debt and reduce the equity capital. The operating profits (EBIT) are not expected to grow. All investors are assumed to have the same subjective probability distribution of the future expected EBIT for a given firm. The firms business risk is constant over time and is assumed to be independent of its capital structure and financial risk. Perpetual life of the firm.

NET INCOME APPROACH

The capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure/financial leverage will lead to a corresponding change in the overall cost capital as well as the total value of the firm. If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline, while of the firm as well as the market price of ordinary shares will increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares.

The Net Income approach to valuation is based on three assumptions.

There are no taxes. That the cost of debt is less than the equity capitalization rate or the cost of equity. That the use of debt does not change with the risk-perception of investors.

NET OPERATING INCOME (NOI) APPROACH

The net operating income (NOI) approach is diametrically opposite to the net income approach. The essence of this approach is that the leverage/capital structure decision of the firm is irrelevant. Any change the market price of shares, as the overall cost of capital is independent of the degree of leverage.

The NOI approach is based on the following propositions, Overall Cost of Capital/Capitalization Rate (Ko) is constant
The NOI approach to valuation argues that the overall capitalization rate of the firm remains constant for all degree of leverage. The value of the firm, given the level of EBIT, is determine V= EBIT Ko

Residual Value of Equity

The value of equity is a residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V). Symbolically, Total market value of equity capital (S) = V B.

Changes in Cost of Equity Capital

The equity-capitalization rate/cost of equity capital (Ko) increase with the degree of leverage. The increase in the proportion of debt in the capital structure relatively to equity shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the increased, the shareholders would expect a higher rate of return on their investments. The increase in the equity capitalization rate ( or the lowering of the price-earnings ratio, i.e. P/E ratio) would match the increase in the debt-equity ratio. The Ke would be

=Ko + (Ko Ki) B S

Cost of Debt
The cost of debt (Ki) has two parts: (a) explicit cost, represented by the rate of interest. Irrespective of the degree of leverage, the firm is assumed to be able to be borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they do not penalise the frim by charging higher interest. (b) implicit or hidden cost.

Optimum Capital Structure

The total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is, the total value of the firm will remain constant. The market price of shares will also not change with the change in the debt equity ratio. There is nothing such as an optimum capital structure. Any capital structure is optimum, according to the NOI Approach.

MODIGLIAN-MILLER (MM) APPROACH

The Modiglinian-Miller thesis relating to the relationship between the capital structure, cost of capital and valuation is askin to the net operating income (NOI) approach.