19340999-Capital-Structure.pdf - CAPITAL STRUCTURE Capital Structure Capital Structure This is concerned with the question as to whether there is an

19340999-Capital-Structure.pdf - CAPITAL STRUCTURE Capital...

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CAPITAL STRUCTURE
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Capital Structure Capital Structure This is concerned with the question as to whether there is an optimal capital mix of debt and capital which a company should try to achieve. There are three major theories: Net Income (NI) approach Traditional view Modigliani and Miller
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Net Income Approach 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 Higher financial leverage will result in the decline in the WACC Causing the increase in the value of the firm And the increase in the value of the firm
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Net Income Approach Assumptions of the NI Approach ii. There are no corporate taxes iii. The cost of debt is less than the cost of equity iv. The debt content does not change the risk perception of the investors The value of the firm V = V e + V d Where V e = Market value of equity V d = market value of debt V e = NI/r e
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Traditional View The traditional view of Capital structure There is an optimal capital structure The company can increase its total value by a suitable debt finance in its capital structure. Assumptions: c) The company pays out all its earnings as dividends d) The leverage of the company can be changed immediately by issuing debt
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Traditional View Assumptions: b) The company pays out all its earnings as dividends c) The leverage of the company can be changed immediately by issuing debt to purchase shares, or by issuing shares to repurchase debt d) The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations e) Business risk is also constant, regardless of how the company invests its funds f) Taxation, for the time being, is ignored
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