Generally capital is raised from the prime source are Equity, Debt Then the questions are what should be the proportion of equity and debt in the capital structure of a company. There exist conflicting theories on the relationship between capital structure

THEORIES OF CAPITAL STRUCTURE Different kinds of theories are have been Net Income Approach(NI) Net Operating Income Approach(NOI) The Traditional Approach Modigliani and Millar Approach(MM)

David Durand David Durand has presented two different models of capital structure, NI approach : which argues that debt will influence the value of the firm NOI approach: which explains that debt will not influence the value of the firm

NI approach According to NI approach the overall cost of capital as well as the total value of the firm would change with change in debt in the capital structure. When debt is there in the capital structure the cost of capital will decrease and market value of the firm will increase

Assumptions cost of equity and cost of debt would remain constant. There are no taxes. The cost of debt is less than cost of equity i.e, Kd is lesser than Ke.

Ex: A Ltd has an annual net operating income of 7,000 Rs. it has 30,000 8% debt. The equity capitalization rate of the company is 10% find The effect of a change in the financial leverage

on the firms' weighted average cost of capital and its value can be shown if a debt of 60,000 instead of Rs. 30,000 is employed Thus an increase in the proportion of debt caused the overall cost of capital to decrease and the value of the company to increase.

Net Operating Income Approach (NOI) approach it is contrary to the NI approach. It argues that the capital structure changes don’t influence the value of the firm. Assumptions The market capitalises the value of the firm as a whole The business risk remains constant at every level of debt equity mix There are no corporate taxes

EX: A com has an annual net operating income of 6,000 it has Rs. 20,000 of 10% debt. The Ko 15% In order to examine the impact of leverage it can be assumed that the above company enhances the amount of debt from 20,000 to Rs 30,000 at 10% and uses the proceeds to repurchase equity shares. The cost of equity Ko is 15%

A company expects a net operating income of it has % Debentures the overall capitalisation rate is 10% calculate the value of the firm and the equity capitalisation rate according to the net operating income approach If the debenture debt is increased to 7,50,000 what will be the effect on the value of the firm and the equity capitalisation rate

Traditional approach Authors like Ezra Soloman and Alexander have presented an intermediary approach on capital structure. It argues that cost of capital and valued of the firma are influenced by the capital structure decision. But, it does not agree with the view that the value of the firm increases for all degrees of leverage. It compromise between the NI approach and NOI approach

NOI Investment Equity capitalization rate If the firm uses no debt 10% If the firm uses debentures 11% If the firm uses debentures 13% Assume that debentures can be raosed at 5% rate of interest whereas debentures can be raised at 6% rate of Interest.

:Ex.Stage I A ltd has net operating income of 5,400 Its cost of equity is 14% It has 8% debentures of 15,000Rs. The market value of the firm and overall cost of capital would be

Stage II: To study the impact of changes in leverage on the value of the firm it can be assumed that the firm is considering to increase its leverage by issuing Rs 10,000 additional debentures and using the proceeds to repurchase that amount of equity. It is also assumed, with the increase of leverage the cost of equity rose to 15% and cost of debt to 9%.

Stage III It can also be assumed that the firm issues additional 5,000 debentures in addition to 25,000 and uses the proceeds to repurchase the shares of same amount. When debt rises, the cost of equity Ke would rise to 18% and cost of debt Kd also increases to 12%.