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Capital Structure 55
Market value of equity = 8,00,000
Market value of debentures = 2,50,000
Value of the firm = 10,50,000
Calculation of overall capitalization rate
Overall cost of capital (K o
) =
Earnings
Valueof the firm
EBIT
V
= 1,00,000
10,50,000 ×100
= 9.52%
(b) Calculation of value of the firm if debenture debt is raised to Rs. 3,00,000.
Rs.
Net income 1,00,000
Less: Interest on 8% Debentures of Rs. 4,00,000 32,000
Equity Capitalization rate 68,000
10%
Market value of equity = 68,000 × 100
10 = 6,80,000
= 6,80,000
Market value of Debentures = 4,00,000
Value of firm = 10,80,000
Overall cost of capital = 1,00,000
10,80,000 ×10
= 9.26%
Thus, it is evident that with the increase in debt financing, the value of the firm has
increased and the overall cost of capital has increased.
Net Operating Income (NOI) Approach
Another modern theory of capital structure, suggested by Durand. This is just the opposite
to the Net Income approach. According to this approach, Capital Structure decision is
irrelevant to the valuation of the firm. The market value of the firm is not at all affected by
the capital structure changes.
According to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the overall cost of capital.