TRADITIONAL APPROACH OF CAPITAL STRUCTURE

  TRADITIONAL APPROACH OF CAPITAL STRUCTURE FOR NET COMMERCE/MANAGEMENT
THEORY OF CAPITAL STRUCTURE

FINANCIAL MANAGEMENT

1.       KNOWN AS INTERMEDIATE APPROACH. THE TRADITIONAL VIEW HAS EMERGED AS COMPROMISE TO THE EXTREME OF NET INCOME AND NET OPERATING INCOME APPROACH THIS THEORY IS GIVEN BY EZRA SOLOMON.

2.       ACCORDING TO THIS THEORY, THE VALUE OF THE FIRM CAN BE INCREASED INITIALLY OR THE COST OF CAPITAL CAN BE DECREASED BY USING MORE DEBTS AS DEBT IS CHEAPER SOURCE OF FUND THAN EQUITY. THUS OPTIMUM CAPITAL STRUCTURE CAN BE REACHED BY A PROPER DEBT EQUITY MIX. BEYOND A PARTICULAR POINT, COST OF EQUITY INCREASES THE FINANCIAL RISK OF EQUITY SHAREHOLDERS.

3.       OVERALL COST OF CAPITAL DECREASES UP TO A CERTAIN POINT, REMAINS MORE OR LESS UNCHANGED FOR MODERATE INCREASE INDEBT THEREAFTER AND INCRASES BEYOND A CERTAIN POINT

   

  EFFECT OF CHANGES IN CAPITAL STRCTURE ON OVER ALL COST OF CAPITAL AND VALUE OF THE FIRM

  AS PER EZRA SOLOMON:-

1.       FIRST STAGE:- THE USE OF DEBT IN CAPITAL STRUCTURE INCREASES THE V AND DECREASES THE K₀ BECAUSE K, K_E REMAINS CONSTANT OR RISE SLIGHTLY WITH DEBT BUT IT DOES NOT OFFSET THE BENEFIT OF LOW COST DEBT. COST OF DEBT K_DREMAINS CONSTANT OR RISES AT VERY LOW RATE.

2.            SECOND STAGE:-DURING THIS STAGE THERE WILL BE RANGE IN WHICH THE V WILL BE MAXIMUM AND K₀ WILL BE MINIMUM. DUE TO INCREASE IN FINANICAL RISK OFFSET THE ADVANTAGE OF USING LOW COST OF DEBT

3.       THIRD STAGE:-THE V WILL DECREASE AND K₀   WILL INCREASE. BECAUSE FURTHER INCREASE OF DEBT IN THE CAPITAL STRUCTURE BEYOND ACCEPTABLE LIMIT INCREASES THE FINANCIAL RISK.

  CMPUTATION OF MARKET VALUE OF SHARES AND FIRM

1. S = (EBIT-I)/ K_E
2.  V=S+D
3. K₀ = EBIT/V
4.    D= VALUE OF DEBT
5.    V=  MARKETVALUE OF THE FIRM

_6.         S= MARKET VALUE OF THE EQUITY,EBIT=EARNING BEFORE INTEREST AND TAXES

7. TRADITIONAL APPROACH

  EFFECT OF LEVERAGE ON COST OF CAPITAL

  D

  

  

  

 CRITICISM

1. PREFERENCE OVER LEVERED FIRM AS COMPARED TO UNLEVERED FIRMS. THEY PAY PREMIUM FOR SHARES OF THE LEVERED FIRMS
2. NO SUFFICIENT EVIDENCE FOR THE ASSUMPTION THAT INVESTOR ‘S PERCEPTION ABOUT RISK OF LEVERAGE IS DIFFERENT AT DIFFERENT LEVEL OF LEVERAGE
3. TAX DO EXIST . EXISTENCE OF CAPITAL STRUCTURE CAN BE SUPPORTED ON THE GROUND THAT:-
4. TAX DEDUCTIBILITY OF INTEREST CHARGES
5. OTHER MARKET IMPERFECTIONS