Answer to Question #10126 in Finance for Shanna

Question

Analyze the approaches to capital structure decisions and determine which theory is the most applicable across the widest number of scenarios. Explain your rationale

Answer 1

One of the key issues in the capital structure decision is the relationship between the capital structure and the
value of the firm. There are several views on how this decision affects the
value of the firm.

Net Income Approach (NI). According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result the average cost
of capital declines as the leverage ratio increases. This is because when the
leverage ratio increases, the cost of debt, which is lower than the cost of
equity, gets a higher weightage in the calculation of the cost of capital.

Net Operating income Approach (NOI). According to this approach: the overall capitalization rate remains constant for all levels of financial leverage, the cost of debt also remains constant for all
levels of financial leverage, the cost of equity increases linearly with
financial leverage.

Traditional or Intermediate Approach. This approach is midway between the NI and the NOI approach. The cost of debt remains almost constant up to a certain degree of leverage but rises
thereafter at an increasing rate.
MM Approach. According to this approach, the capital structure decision of a firm is irrelevant. This approach supports the NOI approach and provides a
behavioral justification for it.
This approach indicates that the capital structure is irrelevant because of the arbitrage process which will correct any imbalance i.e.
expectations will change and a stage will be reached where further arbitrage is
not possible.

We think this approach gives certain advantages as capital-structure arbitrageur seeks opportunities created by differential
pricing of various instruments issued by one corporation. Consider, for example,
traditional bonds and convertible bonds. The latter are bonds that are, under
contracted-for conditions, convertible into shares of equity. The stock-option
component of a convertible bond has a calculable value in itself. The value of
the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference between the convertible and the non-convertible bonds) grows
excessively, then the capital-structure arbitrageur will bet that it will
converge.