Explain the scope and significance of capital structure theory. What effect it has on value of firm to its owners and cost of capital to the firm. Explain and critically evaluate competing theories of...

Question 1: - Explain the scope and significance of capital structure theory. What effect it
has on value of firm to its owners and cost of capital to the firm?
Solution:
Capital structure is the composition of the company‟s sources of financing. Capital structure
means to decide that how company assets are financed. There are different types of capital
sources used by company to finance assets of firm like debt, prefe
ed Stock, and common
equity.
According to Gerestenbeg “Capital Structure of company refers to composition of its
capitalization and it include all long term capital sources i.e. loans, reserves, shares & Bonds”.
According to Schwart “Capital structure of business can be measured by the ratio of various
kinds of permanent loan and equity capital to total capital.”
Capital Structure theory & Optimum Capital Structure
Determination of optimum capital structure is difficult because number of factors influenced
capital structure. There is no one definite model because of varying circumstances of various
usiness undertakings. That‟s why companies use different capital structure.
There are some important capital structure theories which tell the effect of capital structure on
value of firm and overall cost of capital.
 Net income approach
 Net operating income approach
 Traditional theory
 Modigliani and Miller‟s [MM] capital-structure theory
 Trade –Off theory
 Pecking order theory
Scope and Significance of capital structure theory
All the above theories tell us theoretical relation between cost of capital & value of firm. All
theories tell us about optimum capital structure. A firm‟s optimal capital structure is defined as
the structure that would maximize its stock price.
Different capital structure theories tell us about the optimum capital structure however
practically it is very difficult to achieve because there are number of factors influence capital
structure and it is very difficult to calculate fall in market value of equity share on account of
increase in risk due to high debt content in capital structure. (Ha
is, 1991)
Different factors which effect capital structure but primary factor is risk
Risk: - There are two types of risk
 Business Risk
 Financial Risk
Business Risk
It represents the amount of risk that is inherent in the firm‟s operations even if it uses
No debt financing. Business risk varies from industry to industry and among firms in a given
Industry. Further, business risk can change over time. Business risk depends on a number of
factors, the more important of which Demand variability, Sale Price variability, Input cost
variability etc.
Financial Risk
Financial risk is the risk on Equity shareholders as a result of the decision to finance with debt.
There are many other factors which influence the capital structure decision:-
1) Trading on Equity (or Leverage or EBIT/EPS analysis):- Use of other sources of
fund with fixed cost such as debt & preference share capital along with owners‟ equity
capital structure is known as trading on Equity.
Advantage of Debt &
Preference Capital
Disadvantage of Debt &
Preference Capital
No debt effect
If Rate of return > cost of debt
then difference goes to
shareholders
Financing risk is there if uses
more debt.
No Financing risk is there
Interest paid on debt is tax
deductible hence tax saving
EPS decreases if rate of return
on investment < Rate of
Interest
EPS decreases because same
earnings to divide among
increased equity shares as
esult of additional equity
shares in lieu of debt
2) Cost of capital: - Cost of source of finance is minimum return expected by its
suppliers.
Expected return depends on degree of risk.
Source of Finance Degree of risk Return Expected
Debt Lower than other Lower than other
Preference Higher than debt lower than
equity
Higher than debt lower than
equity
Equity Higher highe
3) Other factors: - Many Other factors like cash flow, control, flexibility, Size of
company, nature of Business, market condition, corporate taxes etc. Also effect optimum
capital structure
Effect of theories on value of firm to its owners and cost of capital to the firm
Capital structure is major part which affects the value of firm, EBIT of firm and hence value of
share. Capital structure theory explains the relation between cost of capital, value of firm and
capital structure of firm.
Net Income approach
This approach is given by “Durant David” and according to this theory capital structure decision
is very relevant for the valuation of firm. This theory tells us that effective capital structure
always leads to a change in overall cost of capital and hence also changes overall value of firm.
Net Operating Income Approach
It is one of modern theory suggested by Durand. This theory says that capital structure decision
is totally i
elevant to the valuation of the firm. It says that market value of firm is not changed
y changing capital structures. According to this approach capital structure has nil effect on the
market prices of share and on overall cost of capital.
Traditional Approach
This approach is called as intermediate approach because it is a mixture of Net income approach
& Net operating income approach. This approach says that proper mix of capital structure(i.e.
oth equity and debt can increase the value of firm by reducing overall cost of capital but
eduction in cost of capital is possible up to certain level of debt.
Modigliani & Miller Approach
This approach says that capital structure of firm has nil effect on the market value of firm in a
perfect capital market. According to this approach value of levered firm (i.e. with debt) can
neither be greater not lower than that of value of unlevered firm (i.e. without debt)
Trade off theory & Pecking order theory
There are many factors which are explained above which also affects optimum capital structure.
These both theories help to address some of imperfections / factors by deleting some of
assumptions in Modigliani & Miller Approach. These theories explain effect of capital structure
within same industries.
Question 2: - Explain and critically evaluate competing theories of capital structure and its
debate?
Solution:-
Capital Structure theory & Optimum Capital Structure
Determination of optimum capital structure is difficult because number of factors influenced
capital structure. There is no one definite model because of varying circumstances of various
usiness undertakings. That‟s why companies use different capital structure. There are many
capital structure theories which tell us effect of capital structure on value of firm and overall cost
of capital. There are major two theories which help in determination of optimum capital
structure.
 Net income approach
 Net operating income approach
 Modigliani and Miller‟s [MM] capital-structure theory
 Traditional theory
Net Income Approach
This approach is given by “Durant David”. According to this theory of capital structure, capital
structure affects both value of firm and cost of capital. It means optimum capital structure helps
in increasing the value of firm. According to this approach value of firm can be increased and
overall cost of capital can be decreased by using more debt finance.
This theory is based on following assumptions:-
 There is nil corporate tax.
Capital
Structure
Theories
Modern
Approach
Net Income
Approach
Net Operating
Income
Approach
Modigliani and
Miller's
Approach
Tradational
Approach
 Cost of using debt is less than cost of using equity i.e. d eK K
 Use of debt does not affect the risk perception of the investo
As per this theory Value of firm & Value of equity share are determined as under
Value of Firm
V E D 
Where E = Equity Value i.e. market value of equity
Where D = Debt Value i.e. Market value of Debt
Market Value of Equity is
Net Income Available to equity Shareholders
(Equity Capitalisation Rate)e e
NI
E
K K
 
Here earning available to equity shareholder is simply calculated by deducting interest paid on
debt from operating income because there is no corporate taxes.
Net Operating Income Approach
This is also one of modern theory suggested by Durand. As per this approach capital structure
decision is totally i
elevant to the valuation of the firm. It says that market value of firm is not
changed by changing capital structures. According to this approach capital structure has nil effect
on the market prices of share and on overall cost of capital. It is totally opposite to Net Income
Approach. As per NOI theory Value of firm depends on net operating profit or earnings before
interest and tax or weighted average cost of capital (WACC).
Net operating income theory is based on following assumptions:
 There is no change in overall cost of capital.
 There is nil corporate tax
Here Value of firm is directly calculated as
Earning Before interest and tax
Value of Firm
(Overall cost of capital)o o
EBIT
K K
 
This theory is based on belief that when firm incorporates more debt in capital structure there is
demand for increasing cost of capital. So this theory says that increase in expected rate of...