THEORIES OF CAPITAL STRUCTURE 1 FOR NET COMMERCE/MANAGEMENT

• THEORIES OF CAPITAL STRUCTURE  1 FOR NET COMMERCE/MANAGEMENT
  THEORIES OF CAPITAL STRUCTURE

1. THE MAIN CONTRIBUTORS TO THE THEORIES ARE DURAND, EZRA, SOLOMON AND MODIGLIANI AND MILLER. THE MAIN THEORIES ARE:-
2. NET INCOME APPROACH GIVEN BY DURAND
3. NET OPERATING INCOME APPROACH DURAND
4. THE TRADITIONAL APPROACH EZRA SOLOMON
5. MODIGLIANI AND MILLER APPROACH

• NET INCOME APPROACH
• SUGGESTED BY DURAND. THE CAPITAL STRUCTURE DECISION IS RELEVANT TO THE VALUATION OF THE FIRM. A FIRM CAN MINIMIZE THE WEIGHED AVERAGE COST OF CAPITAL AND INCREASE THE  VALUE OF THE FIRM AS WELL AS MARKET PRICE OF EQUITY SHARES BY USING DEBT FINANCING TO THE MAXIMUM POSSIBLE EXTENT.
• ACCORDING TO THIS APPROACH HIGHER DEBT CONTENT IN THE CAPITAL STRUCTURE WILL RESULT IN DECLINE OF OVERALL WEIGHTED AVERAGE COST OF CAPITAL. IT WILL INCREASE THE VALUE OF THE FIRM AND CONSEQUENTLY INCREASE THE VALUE OF THE EQUITY SHARES

ASSUMPTIONS

1.     IT IS BASED ON THE FOLLOWING ASSUMPTIONS

2. THE COST OF DEBT IS LESS THAN COST OF EQUITY
3. NO TAXES
4. THE RISK PERCEPTION OF INVESTORS IS NOT CHANGED BY THE USE OF DEBT.

• MARKET VALUE OF FIRM
• THE TOTAL MARKET VALUE OF THE FIRM CAN BE CALCULATED AS:-
• V = S+D, WHERE V =TOTAL MARKET VALUE OF THE FIRM
• S = MARKET VALUE OF EQUITY SHARES = EARNING AVAILABLE TO EQUITY SHAREHOLDERS/ EQUITY CAPITALISATION RATE
• D = MARKET VALUE OF DEBT
• OVERALL WEIGHTED AVERAGE COST OF CAPITAL
• K=EBIT/V

• DIAGRAM
• 
  
• EXPLANATION
• COST OF DEBT AND COST OF EQUITY ARE CONSTANT FOR ALL LEVEL OF LEVERAGE FOR ALL LEVEL OF DEBT FINANCING. AS THE DEBT PROPORTION GOES ON INCREASING THE OVER ALL COST GOES ON REDUCING. IT WILL APPROACH COST OF DEBT BUT IT WILL NEVER TOUCH COST OF DEBT. SOME ELEMENT OF EQUITY MUST BE THERE.

• EXAMPLE
• A COMPANY HAS NET INCOME OF 80,000. IT HAS RS 2,00,000,8% DEBENTURES. COST OF EQUITY IS 10%. CALCULATE THE VALUE OF THE FIRM AND OVERALL CAPITALIZATION RATE. ( NO TAX EXISTS
• ALSO COMPUTE THE VALUE OF THE FIRM AND OVERALL COST OF CAPITAL WHEN DEBT IS RAISED TO 3,00,000 DEBENTURES.
• SOLUTION
• 
• SOLUTION
• 
• NET OPERATING INCOME
• IT IS ALSO SUGGESTED BY DURAND.
• THIS APPROACH IS DIAMETRICALLY OPPOSITE TO THE NI APPROACH.
• THE ESSENCE OF THE APPROACH IS THAT CAPITAL STRUCTURE DECISIONS ARE IRRELEVANT. ANY CHANGE IN THE CAPITAL STRUCTURE DOES NOT AFFECT THE MARKET VALUE OF THE FIRM AND THE OVERALL COST OF CAPITAL REMAINS THE SAME.
• THE OVER ALL COST OF CAPITAL REMAINS CONSTANT WHETHER DEBT-EQUITY  20 :80,80:20
• THE MARKET CAPITALIZES THE VALUE OF THE FIRM AS A WHOLE AND THEREFORE THE SPLIT BETWEEN DEBT AND EQUITY IS IRRELEVANT.
• THE USE OF DEBT HAVING LOW COST INCREASES THE RISK OF EQUITY SHAREHOLDERS,THIS RESULT INCREASE IN THE EQUITY CAPITALIZATION RATE.
• THE VALUE OF EQUITY IS RESIDUAL AND IT IS CALCULATED BY DEDUCTING THE VALUE OF THE OF DEBT FROM THE TOTAL VALUE OF THE FIRM
• ACCORDING TO MARKET PRICE PER SHARE REMAINS UNAFFECTED ON ACCOUNT OF CHANGE IN DEBT EQUITY MIX
• ASSUMPTIONS
• THE MARKET CAPITALIZES THE VALUE OF THE FIRM AS A WHOLE
• BUSINESS RISK REMAINS CONSTANT
• NO CORPORATE TAXES
• TOTAL MARKET VALUE OF EQUITY=V-D=S
• DIAGRAM
• 
• EXPLANATION
• COST OF DEBT AND OVER ALL COST OF CAPITAL ARE CONSTANT FOR ALL LEVEL OF LEVERAGE. AS THE DEBT PROPORTION OR THE FINANCIAL LEVERAGE INCREASES,THE RISK OF THE SHAREHOLDERS ALSO INCREASES AND COST OF EQUITY. IN CASE OF ALL EQUITY FIRM COST OF EQUITY IS EQUAL TO OVER ALL COST OF CAPITAL. AS THE PROPORTION OF THE DEBT IS INCREASED,COST OF EQUITY ALSO INCREASES.
• OVER ALL COST OF CAPITAL REMAINS CONSTANT BECAUSE INCREASE IN COST OF EQUITY IS SET OFF TO THE BENEFITS OF DEBT FINANCING.

• VALUE OF THE FIRM
• V =EBIT/K
• V = VALUE OF THE FIRM
• EBIT = EARNING BEFORE INTEREST AND TAXES
• K= OVERALL COST OF CAPITAL
• MARKET VALUE OF EQUITY= V-D=S
• D =MARKET VALUE OF DEBT
• COST OF EQUITY =(EBIT –I)/(V-D) =
• (EARNING BEFORE INTEREST AND BEFORE TAX- INTEREST)/(MV OF FIRM-MV OF DEBT)
• EXAMPLE
• A COMPANY HAS NET INCOME OF 80,000. IT HAS RS 2,00,000,8% DEBENTURES. OVERALL CAPITALIZATION RATE IS 10%. CALCULATE THE VALUE OF THE FIRM AND COST OF EQUITY.. ( NO TAX EXIST)
• ALSO COMPUTE THE VALUE OF THE FIRM AND COST OF EQUITY WHEN DEBT IS RAISED TO 3,00,000 DEBENTURES.

• SOLUTION
• 
• SOLUTION
• MCQ
• AT OPTIMUM CAPITAL STRUCTURE MARGINAL REAL COST OF DEBT IS EQUAL TO

1. IMPLICIT COST
2. BOTH
3. NONE
4. EXPLICIT COST

• A FIRM’S CAPITAL STRUCTURE:

1. IS  THE DEBT EQUITY RATIO THAT RESULT IN THE LOWEST POSSIBLE WEIGHTED AVERAGE COST OF CAPITAL
2. IS GENERALLY A MIX OF 40% DEBT AND 60 % PERCENT EQUITY
3. IS FOUND BY LOCATING THE MIX OF DEBT AND EQUITY WHICH CAUSES THE EARNING PER SHARE  EXACTLY$1

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• THE TERM CAPITAL STRUCTURE REFERS TO

1. LONG TERM DEBT,PREFERRED STOCK AND COMMON STOCK EQUITY
2. CURRENT ASSETS AND CURRENT LIABILITIES
3. TOTAL ASSETS MINUS LIABILITIES
4. SHAREHOLDER’ EQUITY

·         ANSWER IS LONG TERM ,PREFERRED STOCK AND COMMON STOCK EQUITY

• A CRITICAL ASSUMPTIONS OF THE NET OPERATING INCOME APPROACH TO VALUATION IS

1. THAT DIVIDEND INCREASES AT CONSTANT RATE
2. THAT K REMAINS CONSTANT REGARDLESS OF CHANGES IN LEVERAGE
3. THAT INTEREST EXPENSES AND TAXES ARE INCLUDED IN THE CALCULATION
4. THAT DEBT AND EQUITY LEVEL REMAIN UNCHANGED

·         THE RIGHT ANSWER IS THAT K REMAINS CONSTANT REGARDLESS OF CHANGES IN LEVERAGE

• THE COST OF MONITORING MANAGEMENT IS CONSIDERED TO BE AN

1. BANKRUPTCY COST
2. AGENCY COST
3. TRANSACTION COST
4. INSTITUTIONAL COST

·         THE RIGHT ANSWER IS AGENCY COST

• THE USE OF PERSONAL BORROWING TO CHANGE THE OVERALL AMOUNT OF FINANCIAL LEVERAGE TO WHICH AN INDIVIDUAL IS EXPOSED IS CALLED

1. DIVIDEND RECAPTURE
2. HOMEMADE LEVERAGE
3. THE WEIGHTED AVERAGE COST OF CAPITAL
4. PRIVATE DEBT PLACEMENT
5. PERSONAL OFFSET

·         ANSWER IS HOME MADE LEVERAGE

• A GEERAL RULE FOR MANAGERS TO FOLLOW IS TO SET THE FIRM’ CAPITAL STRUCTURE SUCH THAT

1. THE FIRM’S VALUE IS MINIMIZED
2. THE FIRM’S VALUE IS MAXMIZED
3. THE FIRM’S BONDHOLDERA ARE MADE WELL OFF
4. THE FIRM SUPPLIERS OF RAW MATERIALS ARE SATISFIED
5. THE FIRM’ S DIVIDEND PAYOUT IS MAXIMIZED

·         THE RIGHT ANSWER IS THE FIRM’S VALUE IS MAXMIZED

• A LEVERED FIRM IS A COMPANY THAT HAS

1. ACCOUNT PAYABLE AS THE ONLY LIABILITY ON THE BALANCE SHEET
2. HAS SOME DEBT IN THR CAPITAL STRUCTURE
3. HAS ALL EQUITY IN THE CAPITAL STRUCTURE
4. ALL OF THE ABOVE

·         THE RIGHT ANSWER IS HAS SOME DEBT IN THR CAPITAL STRUCTURE

·         A MANAGER SHOULD ATTEMPT TO MAXIMZE THE VALUE OF THE FIRM BY

1. CHANGING THE CAPITAL STRUCTURE  IF AND ONLY IF THE VALUE OF THE FIRM INCREASES
2. CHANGING THE CAPITAL STRUCTURE IF ONLY IF THE VALUE OF THE FIRM INCREASES TO THE BENEFITS OF INSIDE MANAGEMENT
3. CHANGING THE CAPITAL STRUCTURE AND ONLY IF THE VALUE OF THE FIRM INCREASES ONLY TO THE BENEFITS THE DEBENTURE HOLDERS
4. CHANGING THE CAPITAL STRUCTURE IF ONLY IF THE VALUE OF THE FIRM INCREASES ALTHOUGH IT DECREASES THE STOCK HOLDER’S VALUE.

•  THE RIGHT ANSWER IS CHANGING THE CAPITAL STRUCTURE  IF AND ONLY IF THE VALUE OF THE FIRM INCREASES
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