Tags: Essay Of Why PeopleSpelling Activities For HomeworkFunny Poems For Kids About HomeworkProfessional And Personal Goals EssayWww.How To Write A Business PlanMark Twain Essays List
This will induce shareholders to get higher returns on their investment so that higher risks may be compensated.
From the above presentation we find that division of capitalization as equity and debt is irrelevant as the market evaluates the firm as a whole.
Under this approach, the value of equity (5) is found as a residual by subtracting the value of the debt (D) from the total value of the firm (V) i. S = V – D This is so because cost of equity rises with the degree of financial leverage and the risk proposition also increases with the increase in debt in capital structure.
This means greater use of debt financing will have a favorable effect on the company’s common stock price.
If the cost of debt and cost of equity remains constant more use of debt in the capital structure will magnify the earnings per share and thereby the market value per share.
However the overall cost of capital remains constant because increase in cost of equity is just sufficient to offset the benefit of cheaper cost of debt.
Therefore the value of the firm remains unaffected with the change in debt-equity mix.
Example 6.2: From the following information calculate the value of the firm, and cost of equity capital, under NOI approach: In between dependence and independence hypotheses offered by the two theories—NI approach and NOI approach respectively—lies another approach which is known as the Traditional Approach. Concept: The two approaches, NI approach and NOI approach, are the two extremes that show the relevance and irrelevance of the capital structure decision in influencing value of the firm.
The Traditional Approach belongs in the middle of these two approaches.
It suggests that a firm’s weighted cost of capital and common stock price are both independent of choice of financial leverage of the firm. In other words, change in financial leverage does not lead to any change in the value of the firm and both the market price of shares and overall cost of capital of the firm remain independent to the degree of financial leverage.
Explanation: Since the theory assumes that the overall capitalization rate remains constant irrespective of the degree of financial leverage the value of firm, V is determined in the following way: V = EBIT /K = Overall cost of capital.