Thus, the benefits of lower cost of debt are offset by the higher cost of equity. Skip to content. The Net approach suggest that the market value of the firm is not affected by the capital structure changes and overall cost of capital remains constant like NI approach, it is also based upon certain assumptions which are : The market capitalizes the value of the firms as a whole.
Thus, the split between debt and equity is not important. The debt capitalization race K 0 remains constant and there is no corporate tax. Graphically, it can be represented as follows: Under the NOI approach when low cost debt is introduced in the capital structure, its advantages are exactly offset by the increased cost of equity in such a way that the resultant cost of capital remains same.
Traditional Approach 4. Modigliani-Miller Approach Some of the solved numerical problems of capital structure theories are presented below with solutions to have a better understanding on the theories. Solution: Net Income Rs.
It has Rs. Calculate the value of the firm and overall capitalization rate according to the Net Income Approach ignoring income-tax. If the debenture debt increased to Rs. Solution Net Operating Income Rs. Traditional Theory Approach Illustrations 1 Compute the value of the firm, value of shares and average cost of capital from the following information : Net Operating Income Rs.
Solution: No Debt Rs. Category: Finance , Numerical problems. Tags: capital structure , Finance. Affiliate Marketing: Meaning and Concept. June 14, at pm. September 25, at pm. Accordingly, overall capitalisation rate is used to calculate the value of the firm.
The split of capitalisation between debt and equity is not significant. Thus, the benefits of lower cost of debt are offset by the higher cost of equity. Thus, under the NOI approach the total value of the firm as stated above is determined by dividing the net operating income EBIT by the overall capitalisation rate and market value of equity S can be found out by subtracting the market value of debt B from the overall value of the firm V.
In other words. While the above two approaches represent extreme views about the impact of financial leverage on value of firm and cost of capital, traditional approach offers an intermediate view which is a compromise between the NOI and NI approaches. This approach resembles the NI approach when it argues that the value of the firm can be increased and cost of capital can be reduced by the judicious mix of debt and equity share capital but it does not subscribe to the view of NI approach that the value of the firm will increase and cost of capital will decrease for all the degrees of financial leverage.
Further, the traditional approach differs from the NOI approach because it does not hold the view that the overall cost of capital will remain constant whatever be the degree of financial leverage. Traditional theorists believe that up to certain point a firm can by increasing proportion of debt in its capital structure reduce cost of capital and raise market value of the stock.
Beyond the point further induction of debt will lead the cost of capital to rise and market value of the stock to fall. Thus, through a judicious mix of debt and equity a firm can minimise overall cost of capital to maximise value of stock. They opine that optimal point in capital structure is one where overall cost of capital begins to rise faster than the increase in earnings per share as a result of application of additional debt.
Traditional view regarding optimal capital structure can be appreciated by categorizing the market reaction to leverage in following three stages:. The degree of leverage means the proportion of debt. The net income approach assumes that change in the degree of leverage will alter the overall cost of capital WACC and hence the value of the firm. Whereas the operating income approach assumes that degree of leverage of the firm is irrelevant to the cost of capital i.
How the cost of capital remains constant irrespective of change in the degree of leverage especially when the debt is the cheaper source of finance? If the debt is increased, the risk of bankruptcy will increase.
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