INTRODUCTION

 Financingdecision is raising the necessary funds

to meet our investment expenditures.
 Mostof the investment is done through borrowed
funds.
 So,
while making an investment decision it is
necessary to see whether adequate funds are
available or not.
 Because without a financing decision investment
decision is not possible and without investment
decision financing decision has no purpose
In financing decision company has to decide its capital
structure. In this the debt & equity ratio is decided. It also
termed as debt equity mix.

The capital structure or financing decision indicates the left

side (Liabilities) of the balance sheet whereas investment
decision shows right side (Assets) of the balance sheet. The
capital structure shows the proportionate relationship
between debt & equity.
 That is how these two decisions are correlated.
 In financing decision, we not only have to look at
availability of funds but also at its cost.
 We have to pay in future, that is why the cost of
capital is very significant decision.
 It (cost of capital) has two dimensional impacts like
it affects both the investment and financing decision

Capital structure does not effect the earnings of the firm, but it
can effect the share of Earning available for the equity share
holders
Illustration1.
ABC company has currently an all equity capital structure
consisting Of 25000 equity shares of Rs.100 each. The
management is planning To raise another 25 lakhs to finance a
major Programme of expansion And is considering three
alternative method of financing:
i. To issue 15000 equity shares of Rs.100 each & 10000 Rs.100
debenture @8%.
i. To issue 25000, 10% debenture of Rs.100 each
ii. To issue 25000, 10% preference share of Rs.100 each.
The company’s expected earnings before interest and taxes will be
Rs10 Lakhs. Corporate tax rate is 50%. Analysis the options and
suggest the Best alternative with reasons.
Optimum Capital Structure

A capital structure decision can influence the

value of the firm through the cost of capital
and trading on equity. The optimum capital
structure may be defined as “ that capital
structure or combination of debt and equity
that leads to the maximum value of the firm”.
 Simplicity

 Flexibility

 Minimum Cost of Capital

 Adequate Liquidity
 Minimum Risk
 Legal Requirements
 Control

 Floatation Cost
THEORIES OF CAPITAL STRUCTURE
Net income Approach:
According to this approach, a firm can minimize the weighted
average cost of capital and increase the value of firm as well
as market price of equity of shares by using debt financing to
the maximum possible extent

ASSUMPTIONS OF NI APPROACH

✓ The cost of debt is less than the cost of equity.

✓ No Taxes
✓ The risk perception of investors is not changed
by the use of debt.
 r

rE
rA =WACC

rD
D
V
 V=S+D

Where
V=Total market value of a firm
S= Market value of equity shares
(S=Earnings Available to Equity Share holders
(NI)/Equity capitalization rate)
D= Market value of Debt
(Ko = EBIT/ V)
Example
A Company expects a net income of Rs.80,000. It has
Rs.2,00,000, 8% Debentures. The Equity
capitalization rate of the company is 10%. Calculate
the value of the firm and overall capitalization rate
according to NI approach ( ignore taxes)
If the debenture is increased to RS.300000. what shall
be the value of the firm and over all capitalization
rate
 NET OPERATING INCOME APPROACH

 Suggested by Durand
 Opposite to NI Approach
 According to this: Change in capital structure of a company does
not affect the market value of the firm and the overall cost of capital
remains constant irrespective of the method of financing.
 It
implies that the overall cost of capital remain same whether the
Debt- equity is 50:50 or 20:80

NO OPTIMUM CAPITAL STRUCTURE, EVERY STRUCTURE IS

OPTIMUM
ASSUMPTIONS OF NOI APPROACH

➢ The
market capitalizes 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
 V =EBIT/ Ko

V = Value of a firm
EBIT=Net operating Income or Earnings before
interest and taxes
Ko = Overall cost of capital
Example
A company expects a net operating income of
Rs.100000. it has Rs.500000, 6% debenture. The
overall capitalization rate is 10%. Calculate the
value of the firm and the equity capitalization rate
according to Net operating income approach
If the debenture are increased to Rs.750000. what will
be the effect on the value of the firm and the equity
capitalization rate?
 THE TRADITIONAL APPROACH
➢ Intermediate Approach

➢ According to this: the value of firm can be increased

initially, or the cost of capital can be decreased by using
more debt as the debt is a cheaper source of funds than
equity. Beyond a particular point, the cost of equity
increases because increased debt increases the financial
risk of the equity shareholders.
➢ The advantage of cheaper debt at this point is offset by
increased cost of equity.
➢ After this there comes a stage, when the increased cost of
equity cannot by offset by the advantage of low-cost debt.
➢ Thus overall cost of capital, decreases up to a certain point,
remains more or less unchanged for moderate increase in
debt thereafter; and increases beyond a certain point.
MODIGLIANI AND MILLER APPROACH

 In the absence of taxes

 Arbitrage Process