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BRILLIANT’S Capital Structure Theories 347

The value of the firm is determined as \$_© H$s d¡ë`y Bg àH$ma {ZYm©[aV H$s OmVr h¡:
follows:
EBIT
V =
K o
In this way, the overall value of the firm Bg àH$ma, \$_© H$s Hw$b d¡ë`y pñWa ahVr h¡Ÿ& BgH$m
remains constant. The split of capital between Bp³dQ>r Ed§ S>oãQ> _| {d^mOZ H$m H$moB© _hÎd Zht h¡Ÿ& B{ŠdQ>r
debt and equity is not significant. The value of
H$s d¡ë`y {ZYm©[aV H$aZo Ho$ {b`o \$_© H$s Hw$b d¡ë`y (V) _|
equity is determined by deducting the total
value of debt (B) from the total value of the go F$U H$s d¡ë`y (B) KQ>m Xr OmVr h¡& AWm©V²
firm(V). Thus,
S = V – B

Changes in Cost of Equity (K ) B{ŠdQ>r H$s H$m°ñQ> _| n[adV©Z (K )
e
e
If the proportion of debt in capital struc- `{X H¡${nQ>b ñQ´>ŠMa _| S>oãQ> Ho$ AZwnmV H$mo ~‹T>m`m
ture is increased, the financial risk to the ordi- OmE Vmo Bp³dQ>r eo¶a hmoëS>g© H$m ’$m¶Z|{e¶b Omo{I_ ^r
nary shareholders will increase. To compen-
sate for the increased risk, the shareholders ~‹T>oJmŸ& Bg Omo{I_ Ho$ ~Xbo eo¶a hmoëS>g© AnZo BÝdoñQ>‘|Q>
would expect a higher rate of return on their na ~‹T>r hþB© Xa go Am°{S>©Zar H$s Anojm H$a|JoŸ& Bg àH$ma
investment. The increase in equity capitaliza- S>oãQ> Bp³dQ>r aoemo _| d¥{Õ d B{ŠdQ>r H$s H¡${nQ>b Xa _| d¥{Õ
tion rate would match the increase in the debt
equity ratio. Thus, _| g_ê$nVm Am OmEJrŸ& AV…,

B
K = K + (K – K)
e o o i S

Optimum Capital Structure AmXe© H¡${nQ>b ñQ´>ŠMa
The total value of the firm is not affected \$_© H$s Hw$b d¡ë`y na H¡${nQ>b ñQ´>ŠMa H$m H$moB©
by change in capital structure and the market à^md Zht n‹S>Vm VWm S>oãQ> Bp³dQ>r aoemo _| n[adV©Z H$aZo
price of shares will also not change with the go eo¶g© H$s ‘mH}$Q> àmBO _| ^r H$moB© n[adV©Z Zht hmoVmŸ&
change in debt-equity ratio. Hence, there is
nothing such as an optimum capital structure. Bg H$maU H¡${nQ>b ñQ´>ŠMa H$m H$moB© AmXe© ñdê$n Zht h¡Ÿ&
In other words, any capital is optimum AÝ` eãXm| _|, Bg AdYmaUm Ho$ AZwgma H$moB© ^r H¡${nQ>b
according to this approach. ñQ´>ŠMa AmXe© H$hm Om gH$Vm h¡Ÿ&
Illustration 4.2.7

The operating income of a firm is ` 50,000. The cost of debt is 10%. Outstanding debt is
` 2,00,000. If the overall cost of capital is 12.5%, what would be the total value of the firm and the
equity capitalization rate?
EH$ g§ñWm H$s Am°naoqQ>J B§H$‘ < 50,000 h¡& S>oãQ> H$s H$m°ñQ> 10% h¡& AmCQ>ñQ>¢qS>J S>oãQ> < 2,00,000 h¡& ¶{X
H¡${nQ>b H$s g§nyU© bmJV 12.5% h¡ Vmo g§ñWm H$m Hw$b ‘yë¶ VWm B{³dQ>r H¡${nQ>bmBOoeZ aoQ> ³¶m hmoJm?