Essays Proper Aims Of Education

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We know, the value of the firm is ascertained by the following formula: V=S D Where, V = Value of the firm, S = Market value of equity, and D = Market value of debt.When the average cost of capital is minimum, the value of the firm will become maximum.Example 6.1: The capital structure of a company is given below: (a) 1, 00,000 Equity Shares @ Rs 10 each and its capitalization rate is 15% (b) 5,000, 10% Debentures of Rs 100 each.

We know, the value of the firm is ascertained by the following formula: V=S D Where, V = Value of the firm, S = Market value of equity, and D = Market value of debt.When the average cost of capital is minimum, the value of the firm will become maximum.Example 6.1: The capital structure of a company is given below: (a) 1, 00,000 Equity Shares @ Rs 10 each and its capitalization rate is 15% (b) 5,000, 10% Debentures of Rs 100 each.

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So it is also known as the Intermediate or Midway Approach.

According to this theory the value of the firm can be increased or the cost of capital can be decreased initially by using more debt, as the debt is a cheaper source of funds than equity.

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.

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.

The figure shows that the firm’s cost of capital, K, will decline as the debt-to-equity ratio or financial leverage increases.

As the cost of capital declines, the market price of shares increases.

To explain the relationship among capital structure, cost of capital and value of the firm various theories have been propounded by different authors. Concept: The Net Income (NI) approach was propounded by David Durand.

There are four major theories which present differing views on the relationship between use of financial leverage and common stock value. According to him the decision relating to capital structure has an impact on the valuation of the firm.

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