SFMBV IMP QUESTIONS ANSWERS
Q1) The right combination of debt in the capital structure may result into optimisation and
hence value maximization. Give your opinion about optimum capital structure. Can a firm
truly achieve optimization of capital structures? What is the right combination of debt that a
firm must employed? Give your view in the context of NI and NOI approach?
Answer:
Combination of various component of capital is called capital structure. The over all cost of
capital may reduce as the proportion of debt increases in the capital structure because cost of
debt is less than cost of equity, while on the other hand risk of the firm increases with the
increase in the fixed contractual obligation, which again increases the weighted average cost of
capital .
The firm may use only equity, or only debt, or a combination of equity +debt, or a combination
of equity + debt + preference shares or may use other similar combinations to form capital
structure.
Ideal capital structure
• It minimize cost of capital.
• It reduce risks.
• It give required flexibility.
• It provide required control to the owners.
• It enable the company to have adequate finance.
• It maximize the value of the firm ultimately the wealth of the shareholders.
Capital Structure Theories
I. Net Income Approach (NI)
II. Net Operating Income Approach (NOI)
JAYANT SIR ( 8017687282 ) Page 1
, Net Income Approach (NI Approach)
• Suggested By David Durand in 1959.
• The earning of the firm after the payment of all other expenses except interest on debt is
called Net Operating Income (NOI) and the earning available for equity shareholders after the
payment of interest is called as “Net Income (NI).
• Therefore, Net Income = Net Operating Income (NOI) - Interest on debt (I).
• According to NI approach capital structure decision is relevant for the value of the firm.
• Change in the capital structure will corresponding bring change in the overall cost of capital.
• According to this approach, “a high debt equity ratio in the capital structure (called financial
leverage) will result in decline in the overall cost of capital (WACC) of the firm and increase
value of firm.”
• According to NI Approach, change in the financial leverage (debt/equity ratio) of a firm will
lead to a corresponding change in the WACC and also the value of the firm.
• The NI Approach suggests that with the increase in leverage (proportion of debt), the WACC
decreases and the value of firm increases and vice versa.
• Under NI approach, higher use of debt in capital structure will result in reduction of WACC. As
a consequence, value of firm will be increased
• Value of firm = Earnings WACC
• Earnings (EBIT) being constant and WACC is reduced, the value of a firm will always increase.
• The capital structure is said to be optimum at that stage of debt-equity mix where the overall
cost of capital is minimum. As per this approach the cost of capital is minimum at 100% level of
debt, therefore the capital structure is optimized at the 100% debt level.
Assumptions
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity (Kd < Ke ) i.e. the capitalization rate of debt is
less than the capitalization rate of equity. This prompts the firm to borrow.
(iii)The debt capitalization rate and the equity capitalization rate remain constant over the time.
JAYANT SIR ( 8017687282 ) Page 2
Q1) The right combination of debt in the capital structure may result into optimisation and
hence value maximization. Give your opinion about optimum capital structure. Can a firm
truly achieve optimization of capital structures? What is the right combination of debt that a
firm must employed? Give your view in the context of NI and NOI approach?
Answer:
Combination of various component of capital is called capital structure. The over all cost of
capital may reduce as the proportion of debt increases in the capital structure because cost of
debt is less than cost of equity, while on the other hand risk of the firm increases with the
increase in the fixed contractual obligation, which again increases the weighted average cost of
capital .
The firm may use only equity, or only debt, or a combination of equity +debt, or a combination
of equity + debt + preference shares or may use other similar combinations to form capital
structure.
Ideal capital structure
• It minimize cost of capital.
• It reduce risks.
• It give required flexibility.
• It provide required control to the owners.
• It enable the company to have adequate finance.
• It maximize the value of the firm ultimately the wealth of the shareholders.
Capital Structure Theories
I. Net Income Approach (NI)
II. Net Operating Income Approach (NOI)
JAYANT SIR ( 8017687282 ) Page 1
, Net Income Approach (NI Approach)
• Suggested By David Durand in 1959.
• The earning of the firm after the payment of all other expenses except interest on debt is
called Net Operating Income (NOI) and the earning available for equity shareholders after the
payment of interest is called as “Net Income (NI).
• Therefore, Net Income = Net Operating Income (NOI) - Interest on debt (I).
• According to NI approach capital structure decision is relevant for the value of the firm.
• Change in the capital structure will corresponding bring change in the overall cost of capital.
• According to this approach, “a high debt equity ratio in the capital structure (called financial
leverage) will result in decline in the overall cost of capital (WACC) of the firm and increase
value of firm.”
• According to NI Approach, change in the financial leverage (debt/equity ratio) of a firm will
lead to a corresponding change in the WACC and also the value of the firm.
• The NI Approach suggests that with the increase in leverage (proportion of debt), the WACC
decreases and the value of firm increases and vice versa.
• Under NI approach, higher use of debt in capital structure will result in reduction of WACC. As
a consequence, value of firm will be increased
• Value of firm = Earnings WACC
• Earnings (EBIT) being constant and WACC is reduced, the value of a firm will always increase.
• The capital structure is said to be optimum at that stage of debt-equity mix where the overall
cost of capital is minimum. As per this approach the cost of capital is minimum at 100% level of
debt, therefore the capital structure is optimized at the 100% debt level.
Assumptions
(i) There are no corporate taxes.
(ii) The cost of debt is less than the cost of equity (Kd < Ke ) i.e. the capitalization rate of debt is
less than the capitalization rate of equity. This prompts the firm to borrow.
(iii)The debt capitalization rate and the equity capitalization rate remain constant over the time.
JAYANT SIR ( 8017687282 ) Page 2
