Capital Structure Theories Modem Approach Traditional Approach Net Income Net Operating income Modigliandien Approach Approach Approach Fig. 5.1 Capital Structure Theories Traditional Approach It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt. Traditional approach states that the K decreases only within the responsible limit of financial leverage and when reaching the minimum level, it starts increasing with financial leverage. Assumptions Capital structure theories are based on certain assumption to analysis in a single and convenient manner: There are only two sources of funds used by a firm; debt and shares. The firm pays 100% of its earning as dividend. The total assets are given and do not change, The total finance remains constant. t4 The operating profits (EBIT) are not expected to grow. The business risk remains constant. The firm has a perpetual life. The investors behave rationally, Exercise 1 ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory expects to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000. In choosing a financial plan, ABC Ltd., has an objective of maximizing earnings per share (EPS). The company proposes to issuing ordinary shares and raising dcbit of Rs. 3,00,000 and Rs. 10,00,000 of Rs. 15,00,000. The current market price per share is Rs. 250 and is expected to drop to Rs. 200 if the funds are borrowed in excess of Rs. 12,00,000. Funds can be raised at the following rates. -up to Rs. 3,00,000 at 8% over Rs. 3,00,000 to Rs. 15,000,00 at 10% -over Rs. 15,00,000 at 15% Assuming a tax rate of 50% advise the company