CAPITAL STRUCTURE COST OF CAPITAL AND VALUATION

INTRODUCTION

The discussions in the preceding Chapter have shown mat financial leverage has a magnifying effect on EPS such that, for a given level of change in EBIT, there will be a more than proportionate change in the same direction in the EPS. But financial leverage also increases me financial risk, default as the risk of possible insolvency wing out of inadequacy of available cash as well as the variability in the earnings available to the ordinary shareholders. Given the objective of the firm to maximize the value of the equity shares, the firm should select a financing mix/capital structure/ & financial leverage which will help in achieving the objective of financial management. As a corollary, capital structure should be examined from the viewpoint of its impact on the value of the firm. It can be legitimately exceed that if the capital structure decision affects the total value of the firm, a should select such a financing-mix as will maximize the shareholders wealth, Such a capital structure referred to as the optimum capital structure. The optimum capital structure may be defined as me capital structure or combination of debt and equity that leads to the maximum value of firm.

The importance of an appropriate capital structure is, thus, obvious. There is a viewpoint that strongly supports the close relationship between leverage and value of a firm. There is an equally strong body of opinion which believes that financing-mix or the combination of debt and equity no impact on the shareholders wealth and the decision on financial structure is irrelevant. In other words, there is nothing such as optimum capital structure.

In theory, capital structure can affect the value of a company by affecting either its expected earnings or the cost of capital, or both. While it is true that financing-mix cannot affect the total ting earnings of a firm, as they are determined by the investment decisions, it can affect the earnings belonging to the ordinary shareholders. The capital structure decision can influence the value of the firm through the earnings available to the shareholders. But the leverage largely influence the value of the firm through the cost of capital. In exploring the relationship between leverage and value of a firm in this chapter we are concerned with the relationship between leverage and cost of capital from the standpoint of valuation. While Section 1 deals with assumptions, definition and symbols relating to capital structure theories, the next four Sections the Chapter explain the major capital structure theories, namely: (i) Net Income Approach, (ii) Net Operating Income Approach, (iii) Modigliani-Miller (MM) Approach, and (iv) Traditional Approach. The last Section summaries the main points.

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