Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. This is their proposition I and can be expressed as follows: According to this proposition the average cost of capital is a constant and is not affected by leverage. If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. Thus, by making personal borrowing the investor is introducing leverage in capital structure of firm A. Planning a capital structure is a highly psychological, complex and qualitative process.
From firm A is Rs. Both the firms have income before interest and taxes of Rs. The traditional view of optimal structure is set forth graphically in figure 14. Thus, there are some distinct variations in this theory. Net Operating Income Approach 3. The example demonstrates that the excessive use of debt greatly increases financial risk and completely offsets the advantage of using the lower cost debt.
This variation in Traditional Approach is depicted as under: Other followers e. Thus, it is needless to say that the optimal capital structure is the minimum cost of capital, if financial leverage is one, in other words, the maximum application of debt capital. The after-tax capitalisation rate is 10%. David Durand identified the two extreme views — the Net income and net operating approaches. The cost of debt and the cost of equity are assumed to be 10% and 15% respectively. The split of capitalisation between debt and equity is not significant.
Thus, firms using financial leverage within certain limits are valued higher by the market than similar companies with lower financial leverage. This arbitrage process will continue till the opportunity of making same amount of return with investment outlay exists. The total assets are given and do not change. However, this state of affairs cannot exist for a long time as the rational investors according to M-M approach will substitute personal leverage for corporate leverage and adjust their portfolios to take advantage of price differential and thereby improve their earnings. There will not effect of increasing debt on cost of capital.
Debt is cheap source of finance because its interest is deductible from net profit before taxes. Thus, so as to have optimal capital structure a firm must have only debt in its capital structure. The empirical results point to the existence of complementarity between the tradeoff hypothesis and the financing deficit variable, while no meaningful effect was detected for market conditions on debt ratio. Please do send us the Traditional Approach problems on which you need Help and we will forward then to our tutors for review. At that optimal structure, the marginal real cost of debt explicit and implicit is the same as the marginal Real cost of equity in equilibrium. If the value of the firm can be affected by capital structure or financing decision a firm would like to have a capital structure which maximizes the market value of the firm.
Business risk is constant over time and is assumed to be independent of its capital structure and financial risk. According to our findings, although several elements impact on capital structure temporarily, firms from all countries rebalance their leverage following equity issuances. Traditional Approach So, to conclude. Solution: It may be noted from the above that the total value of firm B which is levered is higher than the unlevered firm A. Cost of debt K i, remains constant or rises only modestly. The source of information is the Superintendence of Companies, Securities, and Insurances which is an Ecuadorian government institution. The value of the firm and cost of equity capital will be as shown above.
It implies that capital structure decision has no relevance to valuation of the firm. The Net Income Operating Approach, we know, supply proper justification for the irrelevance of the capital structure. The optimal capital structure for the firm would be in situation 2 which has debt-equity ratio of 1:1 because cost of capital in this situation is the minimum. Both the firms earn Rs. We examine factors of the financial performance of the Ecuadorian commercial firms during the period of 2011-2016. Minimize the overall cost of capital. Thus, the basic, proposition of this approach are enumerated below: a The cost of debt capital, K d, remains constant more or less up to a certain level and thereafter rises.
Solution: Now assume that the management raises the amount of debt from Rs. It provides advantages to some extent and beyond that reasonable level, it increases the company's risk as well the overall cost of capital. If a firm fails to service the debt during the loan periods it is very likely to collapse and will therefore not survive to reap the benefits of leverage during the loan periods. The equity capitalization rate of firm L is higher 16% than that of firm U 12. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. This behaviour of the investors will result in rise in the share prices of the firm whose shares are being sold. The following illustration will explain how arbitrage process will drive value of two firms of the same risk class together.