UGC NET COMMERCE July 2018 Q43
0. Which of the following is not an approach to the Capital Structure?
- Option : A
- Explanation : Theories of Capital Structure: As per as the concept of capital structure is concerned a number of eminent scholars have made their valuable contribution with regard to relationship between capital structure, cost of capital and value of the firm. The main contributors of the theories are David Durand, Ezra Solomon, Modigliani and Miller etc., some important theories is discussed below:
∎ Net Income Approach: The net income approach has been suggested by Durand. Under this approach capital structure decision is relevant to the valuation of the firm. A firm can minimize the weighted average cost of capital and increase the market price of the equity shares by using the debt content in its capital structure. This theory presumes the following assumptions:
(i) The cost of debt is less than the cost of equity
(ii) There are no corporate taxes
(iii) The use of debt content does not change the risk perception of the investors as a result the equity capitalization rate of the company and the debt capitalization rate of the company remains constant with changes in leverage.
∎ Net Operating Income Approach: This approach is also suggested by Durand. It is dramatically opposite to the net income approach. According to this approach any changes in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remain constant irrespective of the mode of financing. The implication of the above statement is that the overall cost of capital remains the same whether the debt equity mix is 50:50 or 20:80 or 40:60 under this theory all the structures are optimum capital structures. This theory presumes the following assumptions:
(i) The debt capitalization rate is a constant.
(ii) The market capitalizes the value of the firm as a whole and therefore the split between debt and equity is not important.
(iii) Corporate taxes do not exist.
(iv) The use of the debt fund having low cost increases the risk of equity shareholders, but it could result in increase the equity capitalization rate.
∎ Traditional Approach: The traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in the reduction in value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement. This theory presumes the following assumptions:
(i) The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
(ii) The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders start perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
(iii) As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.
∎ Modigliani-Miller Approach: The basic premise of the Modigliani and Miller thesis was that there is no optimal capital structure, and moreover, that capital structure would not be able to affect the firm’s value. The reason is summarized by the compensatory effect of the market value of the firm’s stock that would decrease any time the firm incurs more debt and gets into a higher level of risk. It is because the firm’s market value is actually the sum of the market value of debt and market value of stock.
Modigliani and Miller separate between the firm’s value and its cost of capital, on one hand, and the form of capital structure on the other. They attribute the firm value to its ability to obtain the highest expected return on investment, utilizing the best capitalization rate, given that:
(i) The capitalization is for the firm’s pure equity stream for a certain class with a proper consideration of the potential financial risk.
(ii) The capitalization rate would not be related to the type of securities that would be utilized for investment.
(iii) Finally, their argument gave a lot of weight to the personal arbitrage and its ability to change the dynamics of the financial leverage.
