NTA UGC NET - Commerce: Unit 04: Business Finance (Part 03)

 

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Unit 04

Business Finance

Part 03

 

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MCQ: Net Income approach was suggested by
 

a. Durand
 

b. Franco Modigliani
 

c. Benjamin Graham ( father of value investing,)
 

d. Merton Miller
 

 

CAPITAL STRUCTURE
 

Capital Structure means a combination of all long-term sources of finance.
 

Include Equity Share Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other such long-term sources of finance.
 

Financial leverage is the extent to which a business firm employs borrowed money or debts.
 

 

Capital structure theories are –
 

The capital structure theories explore the relationship between your company's use of debt and equity financing and the value of the firm.

 

1) Net Income Approach (NI)
 

2) Net operating Income Approach (NOI)
 

3) Traditional Approach
 

4) Modigilini & Miller Model. (M& M)
 

 

Certain assumptions are there
 

1) Two sources of funds- debt & equity
 

2) No corporate and personal tax
 

3) All profit distributed as there is no retained earnings.
 

 

1) NET INCOME APPROACH

 
Suggested by Durand

Change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company.
 

The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases.
 

On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

 

 

2) NET OPERATING INCOME APPROACH
 

Suggested by Durand
 

Opposite to NI approach.
 

Believes that the value of a firm is not affected by the change of debt component in the capital structure
 

The WACC and the total value of a company are independent of the capital structure decision or financial leverage of a company.
 

 

3) TRADITIONAL APPROACH

 
It said that both NI approach and NOI approach is unrealistic.
 

It takes a mid- way between the NI approach (value of the firm increase by increasing debt) and NOI approach (value of the firm remain the constant)
 

There exist an optimal debt to equity ratio where the overall cost of capital is the minimum and market value of the firm is the maximum.
 

Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC

 

 

4) MODIGLIANI AND MILLER APPROACH

 
This approach was devised by Franco Modigliani and Merton Miller during the 1950s
 

Two propositions: 

 

1 - When there are no taxes: 

This suggests that the valuation of a firm is irrelevant to the capital structure of a company
 

The market value of a firm is solely dependent on the operating profits of the company.
 

2- When tax information is available:

 financial leverage boosts the value of a firm and reduces WACC 

 

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