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‡ Financing decision is raising the necessary
funds to meet our investment expenditures.
‡ Most of the investment is done through
borrowed funds.
‡ So, while making an investment decision it is
necessary to see whether adequate funds are
available or not.
‡ Because without a financing decision
investment decision is not possible and without
investment decision financing decision has no
purpose
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×n financing decision company has to decide its capital

structure. ×n this the debt & equity ratio is decided. ×t
also termed as debt equity mix.

The capital structure or financing decision indicates the

left side (Liabilities) of the balance sheet whereas
investment decision shows right side (Assets) of the
balance sheet. The capital structure shows the
proportionate relationship between debt & equity.
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‡ That is how these two decisions are

correlated.
‡ ×n financing decision, we not only have to
look at availability of funds but also at its
cost.
‡ We have to pay in future, that is why the
cost of capital is very significant decision.
‡ ×t (cost of capital) has two dimensional
impacts like it affects both the investment
and financing decision
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Theories of Capital Structure

Net income Approach:
According to this approach, a firm can
minimize the weighted average cost of capital
and increase the value of firm as well as market
price of equity of shares by using debt
financing to the maximum possible extent.
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Assumptions of N× Approach
‡ The cost of debt is less than the cost of
equity.
‡ No Taxes
‡ The risk perception of investors is not
changed by the use of debt.
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üractical üroblem
‡ A Company expects a net income of
Rs.50,000. ×t has Rs.2,00,000, 8%
Debentures. The Equity capitalization rate
of the company is 10%. Calculate the value
of the firm and overall capitalization rate
according to N× approach ( ignore taxes)
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Net Operating ×ncome Approach
‡ Suggested by Durand

‡ Opposite to N× Approach

‡ According to this: Change in capital structure of a company

does not affect the market value of the firm and the overall cost
of capital remains constant irrespective of the method of
financing.

‡ ×t implies that the overall cost of capital remain same whether

the Debt- equity is 50:50 or 20:80

‡ NO OüT×MUM CAü×TAL STRUCTURE, EVERY STRUCTURE

×S OüT×MUM
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Assumptions of NO× Approach

‡ The market capitalizes the value of

the firm as a whole;
‡ The business risk remains constant at
every level of debt equity mix
‡ There are no corporate taxes
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V #EB×T/ Ko

V = Value of a firm
EB×T=Net operating ×ncome or Earnings before
interest and taxes
Ko = Overall cost of capital
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The Traditional Approach

‡ ×ntermediate Approach

‡ According to this: the value of firm can be increased

initially or the cost of capital can be decreased by
using more debt as the debt is a cheaper source of
funds than equity. Beyond a particular point, the cost
of equity increases because increased debt increases
the financial risk of the equity shareholders.
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‡ The advantage of cheaper debt at this point is offset by

increased cost of equity.

‡ After this there comes a stage, when the increased cost

of equity cannot by offset by the advantage of low cost
debt. Thus overall cost of capital, decreases up to a
certain point, remains more or less unchanged for
moderate increase in debt thereafter; and increases
beyond a certain point.
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