The following illustration will explain how arbitrage process will drive value of two firms of the same risk class together. The value of the company in that case will be, as shown below.
Net operating income approach can also be illustrated with the help of a diagram. Although the value of the firm Rs. The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of leverage is made.
As a result, the Overall cost of capital Ko tends to increase at increasing rate and the value of the firm decreases. In other words, using more debt capital with a corresponding reduction in cost of capital, the value of the firm will increase.
Modigliani-Miller approach Net Income Approach NI According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. If two firms are identical in all respects but differ in their debt-equity ratios, then the share price will remain same.
Calculation of new value of the Firm Please note: Explicit cost remains fixed as it represents interest and the firm is assumed to borrow at a given rate. The optimal capital structure is the one at which total value of the firm is highest and the cost of capital the lowest.
According to this approach all the capital structures are optimum.
Modigliani and Miller argued that any rational choice of debt and equity results in the same cost of capital under their assumptions and that there is no optimal mix of debt and equity financing.
Borrowing is easy for the firms but for individuals it is not so easy. What would be the value of Company. The graph is based on the information given in Illustration 1.
The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline. The business risk is assumed to be constant and independent of capital structure and financial risk.
Both these factors cannot be impacted by the financial leverage. The value of the firm V will also be the maximum at this point. Securities can be bought and sold without any transaction costs; and v. As a result, vague rules of thumb were developed which both firms and financial institutions tended to follow blindly.
There is long-term debt and common stock in capital. This possibility is shown in figure This approach of breaking down a problem has been appreciated by majority of our students for learning Net Income Approach concepts.
Thus, the basic, proposition of this approach are enumerated below: In other words, Ko and Fare invariant to the Degree of financial leverage. Capital structure theories notes Published in: Education. 0 Comments 5 Likes Net Income Approach As suggested by David Durand, this theory states that there is a relationship between the Capital Structure and the value of the firm.
M Hypothesis can be explained in terms of two propositions of Modigliani and Miller. They are: i. The. Capital Structure - Free download as Powerpoint Presentation .ppt /.pptx), PDF File .pdf), Text File .txt) or view presentation slides online.
Suggested by David Durand Capital structure affect the value of the firm Change in the capital structure causes a corresponding change in the overall cost of capital and the total value of the firm. The theory (suggested by David Durand) states that a company may increase market value by lowering its cost of capital, at this point capital structure of the company will be optimal and share price will be at the maximum limit.
This theory was propounded by “David Durand” and is also known as “Fixed ‘Ke’ Theory”. According to this theory a firm can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum “David Durand” and is also known as “Fixed ‘Ke’ Theory”.
This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weighting in the calculation of the cost of capital. This approach has been suggested by David Durand.
Effect of change in the capital structure: (Increase in debt capital) Let us assume that the firm decides to retire $, worth of equity by using the proceeds of new debt issue worth the same amount.David durand the cost of capital