Introduction The Net Income Approach ‘The Net Operating Income Approach Traditional Approach and MM Hypothesis Problems on all the Approaches @ Scanned with OKEN Scanneri Capital structure refers to the mix of different sources of long-term financing that a company ed SETS represents hey proportion of debt and equity In a compa primary components of capital structure-are debt and equity, and combination of these two elements influences a company's financial risk, cost of capital, and ov: stability. — The capital structure decision is significant for a company as it affects various aspects o1 financial management, including: Capital Structure 41. Risk: The t increases financial risk due to interest obligations and potential finan: distress if the company is unable to meet its debt obligations. Equity, on the other hand, invol. sharing ownership but does not require fixed interest payments. 2. Cost of Capital: The cost of capital is influenced by the mix of debt and equity. Debt often ha lower cost because of tax deductibility, but it comes with the obligation to make interest paymen Equity involves a cost in the form of the required rate of return by investors. 3.’ Financial Flexibility: The choice between debt and equity affects a company's financ flexibility. Debt adds financial obligations, while equity provides more flexibility but. dilut ownership. 4. Ownership and Control: Equity represents ownership in the company, and the issuance of ne equity can dilute existing shareholders’ ownership. Debt, while involving financial obligation does not dilute ownership or impact control. 5. Market Perception: The market's perception of a company's capital structure can influence i stock price and credit rating. Investors and creditors may view a company more favorably if maintains a balanced and sustainable capital structure. @ Scanned with OKEN Scanneretme ontrol: Capital structure should be designed in such a manner that existing shareholders to hold majority stack. 1 2. Risk Capital structure should be designed in such ‘a manner that financial risk of the company not increases beyond tolerable limit. 3. Cost: Overall cost of capital remains minimum. — e Practically itis difficult to achieve all of the above three goals together hence a finance manager has tomakea balance among these three objectives. - However, the objective of a company is to maximise the value of the company and it is prime objective while deciding the optimal capital structure. Capital Structure decision refers to deciding the forms offinancing (which sources to be tapped); their actual requirements (amount to be funded) and theirrelative proportions (mix) in total capitalization. Value of the frm = corr. Overall cost of capital / Weighted average cost of capital Ko=, Of debt x weight of debt) + (Cost of equity x weight of equity) XD/(D4S)} + {KexS(D+S)}] 1 Melsthe weighted average cost of capital (WACC) 1 Kelsthecost ofdett Disthe market value of debt Market value of equity ‘costof equity @ Scanned with OKEN ScannerAd Ginenmanune Capital structure dactalon will decide walght of debt and equity and ultimately averall cost «. Capital as well as Value of the firm, So capital structure Is relevant in maximizing value of the firm an minimizing overall cost of capital, Whenever funds are to be ralsed to finance Investments, capital structure decision Is Involved. ¢ demand for ralsing funds generates a new capital structure since a decision has to be made as to th quantity and forms of financing. The process of financing or capital structure decision Is depicted in th figure below. [> Replacement + Modernisation Capital Budgeting Decision |—>| 4 nn a Expansion L—» Diversification Intornal funds Neod to Raise Funds |—>l > oom J Ln» External equity [ Copnnl Structure Decision Devired Dott Payout Existing Capital Equity Mix Structure Effect on Cost of Gi @ Scanned with OKEN Scannerthe following approaches explain the relationship between cost of capital, capital structure and wwe ee itiona @ netiname (tt) Approach? (b) Traditional approach. > (c)NetOperating Income (NOI) approach, (4) Modigliani-Miller (MM) approach ‘According to this approach eppital structure decision is relevant to the value of the firm. An increasein financial leverage will lead to decline in the weighted average cost of capital (WAC), while the value OF the firm as well as market price of ordinary share will increase, Conversely, a decrease in theleverage will cause an increase in the overall cost of capital and a consequent decline in the value as wellasmarket price of equity shares. Cost of i fl Ke Leverage @ Scanned with OKEN Scannera Pen nue neuer From the above diagram, Ke and Kd are assumed not to change with leverage. As debt increase it causes weighted average cost of capital (WAC) to decrease. ‘The value of the firm on the basis of Net Income Approach can be ascertained as follows: @ ValueofFim(V)=S+D = a ad Where, V = Value ofthe firm eo —" “S=FiStket value of equity D = Market value of debt NI ) Market value of equity (S) = ———— 7 “Where, NI = Eamings avallable for equity shareholders Ke = Equity Capitalization rate Under, NI approach, the value ofthe firm will be maximum at a point where weighted average co of capital (WAC) is minimum. Thus, the theory suggests total or maximum possible debt financing f minimising the cost of capital. The overall cost of capital under this approach is: eeIT Value of the firm /fo, Overall cost of capital = \\/ Thus according to this approach, the firm can increase its total value by decreasing its overall co: of capital through increasing the degree of leverage. The significant conclusion of this approach is that pleads for the firm to employ as much debt as possible to maximise its value. Rupa Ltd.'s EBIT is % 5,00,000. The company has 10%, 20 lakh debentures. The equit capitalization rate i.e. Keis 16%. —_—_— ‘You are required to calculat () Matket value of equity and value of firm ~~ (ii) Overall cost of capital. Solution: (i) Statement showing value of firm BIT 5,00,00° Less: Interest on debentures (10% of € 20,00,000) 2,00,00° Earnings available for equity holders i.e. Net Income (NI) 3,00,000 Equity capitalization rate (Ke) 16% @ Scanned with OKEN Scannerorketvalue of equity (S) = - marketvalue of debt (D) 20,00,000 Fqalvalueof firmV=S+D 36,75,000 EBIT _5,00,000 Value of firm ~ 38,75,000 ~ **" < (ay_ overall cost of capital = his approach favors that as a result of financial leverage up to some point, the cost of capital comes down, and value of the firm increases. However, beyond that point, reverse trends emerge. The jicple implication of this approach is that the cost of capital is dependent on the capital structure and thereisan optimal capital structure that minimizes cost of capital. aa tnderthis approach: 1, Therateofinterest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases. 2, Theexpected rate by equity shareholders remains constant or increases gradually. After that, the equity shareholders start perceiving a financial risk and then from the optimal point the expected rate increases speedily. 3, _Asaresult of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure. y Ka Kye dK (6 ° Degree of Leverage Optimum capital structure occurs at the point where value of the firm is highest and the cost of capitalis the lowest. According to net operating income approach, ‘ ct Modglan-Miller supports the net operating income approach but provi “ese bach strikes a balance between these extremes. @ Scanned with OKEN Scannerneue : Advanced Fin: Main Highlight of Traditional Approach ‘The firm should strive to reach the optimal capital strut judicious use of the both debt and equity in capital structure. Att ‘cost of capital will be minimum and the value of the firm will be maximum. icture and Its total valuation throug! ‘he optimal capital structure, the over 2 Indra Ltd, has EBIT of 2,00,000. The company makes use of debt and equity 0,000 and the firm's equity capitalization rate ls 15%. capital. The firm | WB ceenturs You are required to compute: (i) Current value of the firm (ii) Overall Solution: (i) Calculation of total value of the firm EBIT 1,00,(, Less: Interest (@10% on 5,00,000) 50,1) Earnings available for equity holders 50, Equity capitalization rate i.e. Ke iy ders _ 50,000 v ©) ____ Earnings avalable for equity holders . 50,000 . 5,35 353 a ee Soles Value of equity (S) 015-0 Value of Debt (given)D © 5,00,() Total value of the fim V = D + § (5,00,000 + 3,33,333) 8,33, s D) ,, EBIT (ii) Overall cost of capital K. = «(3) «(8) or \ y vA pea) “OY 28s 2233). oka (zzaee ip ih, BV 40 8,33,333 8,33,333 aco : os = gas gag [ 60,000 + 50,000] = 12% x Determine the optimal capital structure of a company from the following information: Options | CostofDebt(Kd)in% | CostofEquity(Ke) in % Percentage of Debt on z total value (Debt +Equity) 1 M1 13.0 0.0 2 11 13.0 01 @ Scanned with OKEN ScannerNouae MU ces 116 14.0 0.2 12.0 15.0 0.3 13.0 16.0 0.4 15.0 18.0 Os 18.0 20.0 06 solution: Note that the ration given in this question is not debt to equity ratio. Rather than it is the debt to. value ratio. Therefore, If the ratio Is 0.6, it means that capital employed comprises 60% debt and 40% equly. _ KyxDxK,xS D+S Inthis question total of weight is equal to 1 in all cases, hence we need nottto divide by it. 2) 3) 4) y= 12%X0.3 + 15% x0. 5) Ky=13%X0.4 + 16% x0. 6) Ky=15%X0.5 + 18% x0. Ky= 11% x0+ 13% x1 = 13% Ky=11%Xx0.1 + 13% x0. Kq= 11.6% x0.2 + 14% x0.8= 13.52% 12.8% 14.1% 7) Ky=18%X0.6 + 20% x 0.4 = 18.8% Decision: 2nd option is the best because it has lowest WACC. NOI means earnings before interest a decisions of the firm are irrelevant. 41 7@ rep ye tax (EBIT), According to this approach, capital structure ‘Any changeln the leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of leverage. As a result, the division between debt and equity is irrelevant. As per this approach, an increase in the use of debt which is apparently cheaper is offset by an Increase Tm the equity capitalisation rate. This happens because equity investors seek higher ‘compensation as they are opposed to greater risk due to the existence of fixed return securities capital structure, Ke Kw Ky the Leverage (Degree) @ Scanned with OKEN Scanner‘The above diagram shows that Ko (Overall capitalisation rate) and (debt - capitalisation rate) ; constant and Ke (Cost of equity) Increases with leverage. ‘Amita Ltd's operating income (EBIT) is ¥ 5,00,000. The firm's cost of debt Is 10% and currently firm employs ¢ 15,00,000 of debt. The overall cost of capital of the firm Is 15%. You are required to calculate: rs Total value of the firm. (i) Cost of equity. Solution: (i) Statement showing value of the firm Net operating income/EBIT 5,00,0) Less: Interest on debentures (10% of ¥ 15,00,000) (1,50,00 Earnings available for equity holders 3,50,0 Total cost of capital (KO) (given) 15 ; EBIT _ 5,00,000 Value of thefirm “= “9 5 (ji) Calculation of cost of equity | Market value of debt (D) 15,00,00 18,33,32 Market value of equity (s) S = V- D = %33,33,333 - %15,00,000 Earnings available for equity holders Value of equity(S) _EBIT - Interest paid on debt __3,50,000 _ “~~ Market value of equity 18,33,333 18.09%, sananees Alpha Limited and Beta Limited are identical except for.cépital structures. Alpha Ltd. has 50 p: ‘ent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (+ vefcentages are in market-value terms). The borrowing fate for both companies is 8 per cent in an ax world, and capital markets are assumed to be perfect. | a) (i)/ Ifyouown2 per cent ofthe shares of Alpha Ltd., Determine your return ifthe company ha: net operating income of £3,60;000 and the overall capitalisation rate of the company, KO is 18 percent? e calculate the implied required rate of return on equity? Y Beta Ltd. has the same net operating income as Alpha Ltd. (i) Determine the implied require n of Beta Ltd.? (i) Analyse why does itdiffer from thatof Alpha Ltd.? @ Scanned with OKEN Scanner_ —+> 7. 7...) qc a sonstion® _ NOI _ 3,60,000 ; cs Fer = 250.000 . 20,00,000 “gy Return on Shares on Apa id Value ofthe company £ verte of de (50%) 20,00,000 uarketvalue of shares (50%) z netoperating income 3,60,00% 60,000 tnterestion debt (8% x 710,00,000) ip0'000 Earnings available to shareholders ; a0,000 2% shares (2 ie Returnon res (2% x € 2,80,000) 5,600 1 red . 2,80, 000 (i Implied required rate of return on equity * ¥9, 90,000 {77 ()_Coletation of implied at of etun ? otal value of company 20,00,000 Morket value of debt (20% x £20,00,000) 4,00,000 Market value of equity (80% x *20,00,000) 16,00,000 a Net operating income Aviod eb 096 3,60,000 Intereston debt (896x £4,00,000)"" “* * ‘ 32,000 Earnings available to shareholders 3,28,000 3,28,000 ( Implied required rate of return on equity “76 90,000 20.5% capital structure. ‘Astheequity ye use the net operating income ‘of not employing (®_tistowerthan the Alpha Ltd. because Beta Ltd. uses less debt in its ‘capitalisation is a linear function of the debt-to-equity ratio when w approach, the decline in required equity return offsets exactly the disadvantage ‘somuch in the way of “cheaper” debt funds, @ Scanned with OKEN ScannerPte dante cunt —anaapajoaa OOO The NOI approach Is definitional or conceptual and lacks behavioural significance. It doc provide operational justification for irrelevance of capital structure:~However, Modigliani-m approach provides behavioural justification for constant overall cost of capital and therefore, value oftthe firm. na —~— MM Approach — 1958: without tax This approach describes, in a perfect capital market where there is no transaction cost and taxes, the value and cost of capitatota company remairrunchanged Irrespective of change in the capi structure, The approach is based on further additional assumptions like: | markets are perfect. Allinformation is freely available and there are no transaction cost: + Allinvestors are rational. * Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk. + Non-existence of corporate taxes. Based on the above assumptions, Modigliani-Miller derived the following three propositions: () Total market value of a firm is equal toits expected net operating income divided by the discour rate appropriate to its risk dass decided by the market. Value of levered firm (V,) = Value of unlevered firm (V,) Net Operating Income(NOT) K (ii) Afirm having debt in capital structure has higher cost of equity than an unlevered firm. The cost c' equity will include risk premium for the financial risk. The cost of equity in a levered firm is Value of a firm =: determined as under: Debt Kye Ke -K) poe Equity (iii) The structure of the capital (financial leverage) does not affect the overall cost of capital. The cost of capital is only affected by the business risk. @ Scanned with OKEN Scannerei Ko Kyand Ky Ke Kg o Kw & £ 5 § Ka 5 a Degree Leverage Itis evident from the above diagram that the average cost ‘of the capital (Ko) is a constant. and not affected by leverage. The operational justification of | Modigliani-Miller hypothesis is explained through the functioning of the arbitrage process and substitution of corporate leverage by personal leverage. Arbitrage refers to buying asset or security at lower price in one market and selling tat a higher’ price in another market. As a result, equilibrium is attained in different markets. This is illustrated by taking two identical firms of sitich one has debt in the capital structure while the other does not. Investors of thefirm whose value is higher will sell their shares and instead buy the shares ofthe firm whose valueis lower. They be able toeam the same return at lower outlay with the same perceived risk or lower risk. They would, therefore, be better off. The value of the I according this approach. The two must be equal. debtin the firm's capital structure. The approach considers capital structure of a firm as & whole pie divided into equity, debt and other securities. No matter how the capital structure ofa frmis divided (among debt, equity etc), there isa conservation of investment value. Since the total investment value of a corporation depends upon itsunderlying profitability and risk, itis invariant with respect to relative changes in the firm's financial capitalisation, ‘According to MM, since the sum financing mix, the total value of the firm stays the same. ‘The shortcoming of this approach is that the arbitrage process as suggested PY Modigliani-Miller Wilfalto work because of imperfections in capital market, existence of transaction cost and presence of corporate income taxes. MM Approach- 1963: with tax 4 In 1963, MM model was amended by incorporating tax, they recognis® Wilincrease, or cost of capital will decrease where corporate taxes exist. As levered firm can neither be greater nor lower than that of an unlevered firm There is neither advantage nor disadvantage in using of the parts must equal the whole, therefore, regardless of the ‘ed that the value of the firm ‘a result, there will besome @ Scanned with OKEN ScannerBeteneecnaneae caer ea difference in the earnings of equity and debt- holders in levered and unlevered firm and value «; levered firm will be greater than the value of unlevered firm by an amount equal to amount of dei, multiplied by corporate tax rate. MM has developed the formulae for computation of cost of capital (K,), cost of equity (K,) for th, levered firm. Where, Keg = Cost of equity ina levered company Keu =Costof equity in an unlevered company Kd = Cost of debt t =Taxrate (i) Value of a levered company = Value of an unlevered company + Tax benefit Or, V,=V, +1 Debt (il) Costof equity in a levered company (K,) = K,, + (Ka~ Ky) Dabit + Equity (iii) WACC ina levered company (Kog)= K,, (1 - tL) K,, = WACCofa levered company K,, = Costof equity in an unlevered company t. =Taxrate ; Debt L = Debit + Equity ‘There are two company N Ltd. and M Ltd., having same earnings before interest and taxesi.e. EB!’ of € 20,000. M Ltd. is a levered company having a debt of €1,00,000 @ 7% rate of interest. The cost 0 equity of N Ltd. is 10% and of M Ltd. is 11.50%. ‘Compute how arbitrage process will be carried on? Solution: i 5 Company Mita. Nite. EBIT (NOI) £20,000 £20,000 Debt(D) £1,00,000 Ke 11.50% 10% kd 7% @ Scanned with OKEN Scannera Tey as NOI - Interest 1e of equity (5) = NOI - Interest valu (S)> Cost oF equity = 20,000 - 7,000 - 11.50% 20,000 10% vM= 1,13,043 + 1,00,000{v=s+ D} =%2,13,043 n= 2,00,000 = 1,13,043 wu =2,00,000 y soit “asbitrage Process: are Oya nage ey Ifyou have 10% shares of M Ltd., Your value of investment in equity shares is 10% of £1,13,043 jue. €11,304.30 and retum will be 10% of (220,000 - 27,000) = 7 1,300. ‘Attemate Strategy will be: Sell your 10% share of leve: ed firm for ® 11,304.30 and borrow 10% of levered firms debt i.e. 10% of 1,00,000and invest the money i.e, 10% in unlevered firms stock: Total resources /Money we have = 211,304.30 + £10,000 = 21,304.3 and you invest 10% of 12,00,000 =€ 20,000 Surplus cash available with you is = 221,304.3 - 220,000 = ¢ 1,304.3 Your return = 10% EBIT of unlevered firm - Interest to be pi ie. = 10% of & 20,000 - 7% of 10,000 = 22,000 - 2700 = 1,300 i.e. your retum is same i.e. 1,300 which you are getting from N Ltd. before investing in M Ltd. but stillyou have 1,304.3 excess money available with you. Hence, you are better off by doing arbitrage. on borrowed funds In the above example you have not invested entire amount received from “sale of shares of levered company plus amount borrowed’. You maintained same level of earning and reduced investment, Alternatively, you could have invested entire amount in unlevered company. In that case yourannual earnings would have increased. An example for the sameisaas follows: Following data is available in respect of two companies having same business ris| employed = €2,00,000 ,EBIT = z 30,000 Capital Ke= 12.5% : Sources Levered Company (#) | Unlevered Company() Debt (@10%) 1,00,000 Nil Equity 1,00,000 200000 : Investor is holding 15% shares in levered company. Calculate increase in annual earnings of "vestorifhe switches his holding from Levered to Unlevered company. L: @ Scanned with OKEN Scanner& e ‘Solution: 1. Valuation of firms Particulars Levered Firm (®) | Unlevered Firm (. EBIT 30,000 30,00 Less: interest 10,000 N Earnings available to Equity Shareholder/Ke 20,000 30,001 12.5% 12.5%, Value of Equity 1,60,000 2,40,001 Debt 1,00,000 Ni Value of Firm 2,60,000 2,40,00) Value of Levered company is more than that of unlevered company therefore investor will sell hi shares in levered company and buy shares in unlevered company. To maintain the level of risk he wil borrow proportionate amount and invest that amount also in shares of unlevered company. 2. Investment & Borrowings Sell sharesin Levered company (1,60,000x15%) 24,001 Borrow money (1,00,000x15%) 15,001 Buy shares in Unlevered company 39,001 3. Changein Return Income from shares in Unlevered company (39,000 x 12.5%) Less: interest on loan (15,000 x 10%) Net Income from unlevered firm ‘Income from Levered firm (24000 x 12.5%) Incremental Income due to arbitrage ‘There are two companies U Ltd. and L Ltd., having same NOI of 20,000 except that L Ltd. is levered company having a debt of 1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18% respectively. COMPUTE how arbitrage process will work. Solution: ; Company ULtd. LLtd. NOI 20,000 % 20,000 Debt capital - %1,00,000 Kg 7 7% kK 10% 18% BIT ~ Interest Value of equity capital (s) ( K } 2,00,000 72,222 @ Scanned with OKEN Scanner8 %2,00,000 @1,72,222 (872,222+ 34,00,000) qotalvalueofthefirm V=S+D Assume you have 10% shares of unlevered firm i.e. invest mentof 10% of€ 2,00,000 =£20,000 and Return @ 10% on 20,000. Investment will be 10% of, vailable for equit 1,000. i fe ity . aa ill be 10% of earnings avail il Alternative strategy: Sell your shares in unlevered firm for ¥ 20,000 and buy 10% shares of levered firm's equity plus “2 Le, 10% equity of levered firm = 7,222 10% debt of levered firm = 10,000 Total investment = 17,222 Your resources are ® 20,000 Surplus cash available = Surplus - Investment = 20,000 - 17,222 = % 2,778 Your retum on investmentis: 7% on debt of 10,000 700 10% on equity i.e. 10% of earnings available for equity holders i.e. (10% x 13,000) 1,300 Total return 2,000 i.e. in both the cases the retum received is % 2,000 and still you have excess cash of 2,778. Hence, you are better off i.e. you will start selling unlevered company shares and buy levered company’s shares thereby pushing down the value of shares of unlevered firm and increasing the value of levered firm till equilibrium is reached. In the above example we have not invested entire amount received from “sale of shares of Unlevered company”. We have also ned same level of earning and reduced investment. Alternatively, we could have invested entire amount in Levered company. In that case annual earnings would have increased. An example for the same is as follows: Following data is available in respect of two companies having same business risk: Capital employed = % 2,00,000 ,EBIT = % 30,000 Sources Levered Company (2) _—_Unlevered Company/(%) Debt (@10%) 1,00,000 Nil Equity 1,00,000 200000 Ke 20% 12.5% en Investors, holding 15% shares in Unlevered company. CALCULATE increase in annual earnings of “stor he switches his holding from Unlevered to Levered Company. @ Scanned with OKEN Scannerln haneue meaner Solution: 1. Valuation of firms Particulars Levered Firm (2 | Unlevered Firm( EsIT 30,000 30,001 Less: interest 10,000 N Earnings available to Equity Shareholder/Ke 20,000 30,00 20% 12.5 Value of Equity 1,00,000 2,40,00 Debt 1,00,000 N Value of Firm 2,00,000 2,40,00 Value of Unlevered company Is more than that of Levered company therefore investor will sell hi shares In unlevered company and buy shares in levered company. Market value of Debt and Equity « Levered company are in the ratio of € 1,00,000 : %1,00,000, i.e., 1:1. To maintain the level of risk he wi lend proportionate amount (50%) and invest balance amount (50%) in shares of Levered company. 2. Investment & Borrowings z Sell shares in Unlevered company (240000x15%) 36,001 Lend money (36000 x50%) 18,001 Buy shares in Levered company (36000 x50%) 18,000 Total 36,000 3. Changein Return Income from shares in Levered company (18000 20%) 3,600 Interest on money lent (18000 x 10%) 1,800 Total Income after switch over . 5,400 Income from Unlevered firm (36000 x 12.5%) 4,500 Incremental Income due to arbitrage 900 2 @ Scanned with OKEN ScannerPOINTS TO REMEMBER | Modigliani and Miller ‘The cost a company incurs for using equity capital, often influenced by financial leverage. a aaa ce tf ne ig Of debt to increase the return on equity, impacting the cost of pital Economists Franco Modigliani and Merton Miller, who developed the Modighiani-Miéhneorei, Optimal Capital Structure —/ The mix of debt and equity that minimizes the cost of capital and Maximizes the firm's value. Total Value of the Firm The overall market value of a company, considering both debt and equity. Optimal Capital Structure | The balance between debt and equity that minimizes the WACC. Capitalization Rate The rate used to convert expected future income into present value, Market Price of Equity The value of a firm's equity in the stock market. Weighted Average Cost of | The average cost of capital considering both debt and equity. Capital (WACC) Maximizing Shareholder | A primary goal of financial management, achieved through optimal Wealth capital structure decisions. Capital Structure Irrelevande The proposition that, under certain conditions, capital structure does Perfect Capital Markets Independence of Capital Structure ‘The Net Income Approach The Net Operating Income Approach Traditional Approach not affect the value of a firm. : ‘The assumption of frictionless and efficient markets. ‘The idea that firm's value is independent of how itis financed. ‘A theory suggesting that the capital structure decision impacts the value of a firm, with debt being favorable due to interest tax shields. Proposes that the value of a firmisinfluenced by the relationship ‘between overall cost of capital and net operating income Suggests that the value of a firm is independent of its capital structure, and any increase in debts offset by an increase in ‘the cost of equity. The propositions by Modigliani and Miller, which include the theory of irrelevance (in a perfect market, capital structure [Link] impact firm value) and the impact of taxes on value (debt can provide tax @ Scanned with OKEN Scanner