Download Capital Structure (Fm) 2003 PDF

TitleCapital Structure (Fm) 2003
TagsSecurities (Finance) Cost Of Capital Leverage (Finance) Capital Structure Financial Capital
File Size667.9 KB
Total Pages29
Document Text Contents
Page 15

income approach is based on the following
assumption.

1. The cost of debt is less than the cost of 
equity.

2. There are no taxes.
3. The risk perception of the investors is not

charged by this use of debt.
 The increase in the debt financing in the capital
structures decreases the proportion of equity
capital and this results in decreases in the
weighted average cost of capital resulting in an
increase in the value of the firm. The cost of debt is
less than the cost of equity because of two
reasons:

• Debt involves less risk then equity.

• Interest being – deductible expenses.

According to this approach net income i.e.
expected profit after tax (profit to shareholders) is
estimable, based on expectation of shareholders.
Hence, Ke can be estimated. Based on this value of 
Ke, we can calculate Ko. This Ke is independent
variable and Ko is a dependent variable.

 The equation for this approach is same as:

Ko = WeKe +
WdKd

We know that equity is costlier sources of capital.
Debt is relatively cheaper. This is because lenders
take less risk. They get their interest payment
irrespective of quantum of profit or loss.

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