the point at which the marginal cost of more debt is equal to or greater than a company's average cost of more debt is equal to or greater than a company's average cost of capital". However, Mr. E.W. Walker's remarks very aptly explain the utility of Modigliani and Miller's approach. According to him, "the criticisms lodged against Modigliani and Miller's thesis are valid thus limiting its use in actual situations. Nevertheless, the propositions as well as their criticisms should be carefully studied, since they will serve as an aid to understanding capital structure theory".
14 DETERMINATION OF COST OF CAPITAL Problems in determination It has already been stated that the cost of capital is one of the most crucial factors in most financial management decisions. However, the determination of the cost of capital of a firm is not an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems can briefly be summarized as follows: 1. Controversy regarding the dependence of cost of capital upon the method and level of financing There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing. In other words, according to them, a firm can change its overall cost of capital by changing its debt-equity mix. On the other hand, the modern theorists such as Modigliani and Miller argue that the firm's total cost of capital is independent of the method and level of financing. In other words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption underlying MM approach is
15 that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility. 2. Computation of cost of equity The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that a company must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. In other words, it is the rate of return which the equity shareholders expect from the shares of the company which will maintain the present market price of the equity shares of the company. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares of a company on the basis of a large number of factors, financial as well as psychological. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. Their methods and calculations differ.
16 3. Computation of cost of retained earnings and
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