TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

Affiliated to Institution of G.G.S.IP.U, Delhi

FINANCIAL

MANAGEMENT

BBA – 309

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

UNIT 2- OUTLINE

• Capital Structure Theories

NI Approach

NOI Approach

Traditional Approach

MM Approach

• Cost of Capital

• Leverage

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

CAPITAL STRUCTURE

• CAPITAL STRUCTURE : Capital structure can be

defined as the mix of owned capital (equity,

reserves & surplus) and borrowed capital

(debentures, loans from banks, financial

institutions)

• Maximization of shareholders’ wealth is prime

objective of a financial manager. The same may be

achieved if an optimal capital structure is designed

for the company.

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

CAPITAL STRUCTURE THEORIES

ASSUMPTIONS –

Firms use only two sources of funds – equity & debt.

No change in investment decisions of the firm, i.e. no change

in total assets.

100 % dividend payout ratio, i.e. no retained earnings.

Business risk of firm is not affected by the financing mix.

No corporate or personal taxation.

Investors expect future profitability of the firm.

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

Capital Structure Theories – A) Net Income Approach (NI)

ke

kokd

Debt

Cost

kd

ke, ko

As per NI approach, higher use

of debt capital will result in

reduction of WACC. As a

consequence, value of firm will

be increased.

Value of firm = Earnings

WACC

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

Capital Structure Theories – B) Net Operating Income (NOI)

ke

ko

kd

Debt

Cost

Cost of capital (Ko) is

constant.

As the proportion of debt

increases, (Ke) increases.

No effect on total cost of

capital (WACC)

Value of firm remains

constant.

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

Capital Structure Theories – C) Modigliani – Miller Model (MM) MM Model proposition –

• Value of a firm is independent of the capital structure.

• In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.

• Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt

= Expected EBIT

Expected WACC

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

Capital Structure Theories – D) Traditional Approach

ke

ko

kd

Debt

Cost

Traditional approach

(‘intermediate approach’) is a

compromise between these two

extreme approaches.

Traditional approach confirms

the existence of an optimal

capital structure; where WACC

is minimum and value is the

firm is maximum.

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

COST OF CAPITAL • It is the minimum rate of return that a firm must

earn on its investment for the market value of the firm to remain unchanged. It is also known as minimum required rate of return.

• SPECIFIC COST OF CAPITAL :

Cost of Debt (Kd)

Cost of Preference Capital (Kp)

Cost of Equity Capital (Ke)

Cost of retained earnings (Kr)

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

LEVERAGE

• Leverage refers to a relationship between two interrelated variables.

• Leverage = % in independent variable

% in dependent variable

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

TYPES OF LEVERAGE

• OPERATING LEVERAGE : It means the use of fixed operating cost by the firm. Due to which firm’s profit increases with every increase in Sales. It is measured by ----

• DOL (Degree of Operating Leverage) =

% in EBIT

% in Sales

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

TYPES OF LEVERAGE

• FINANCIAL LEVERAGE : It means the use of fixed financing cost by the firm. As a result, the value of EPS either increases or decreases with every change in EBIT. It is measured by ---

• DFL ( Degree of Financial Leverage) =

% in EPS

% in EBIT

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

TYPES OF LEVERAGE

• COMBINED LEVERAGE : It is ascertained to measure the effect of change in Sales on change in EPS.

• DCL (Degree of Combined Leverage) = DOL X DFL

= % in EPS

% in Sales

TRINITY INSTITUTE OF PROFESSIONAL STUDIES Sector – 9, Dwarka Institutional Area, New Delhi-75

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