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BRILLIANT’S Capital Structure Theories 351

3. Declining Value: Beyond the acceptable 3. _yë` _| {JamdQ>: EH$ gr_m Ho$ níMmV² crdaoO _|
limit of leverage, the value of the firm decreases H$_r Ho$ gmW \$_© H$s d¡ë`y KQ>Vr h¡ Ed§ brdaoO _| d¥{Õ Ho$
with leverage or the cost of the capital increases gmW-gmW H¡${nQ>b H$s H$m°ñQ _| ^r d¥{Õ hmoZo bJVr h¡Ÿ&
with leverage. This happens because investors
BgH$m _w»` H$maU `h h¡ {H$ Omo{I_ _| d¥{Õ hmoZo Ho$ H$maU
perceive a high degree of financial risk and BÝdoñQ>g© H$s Ano{jV àË`m` Xa ^r ~‹T> OmVr h¡ VWm S>oãQ>
demand a higher equity capitalization rate,
which offsets the advantage of low-cost debt. H$s bmo H$m°ñQ> H$m bm^ g_Vm na àË`m` H$s ~‹T>r hþB© Xa go
g_m`mo{OV hmo OmVm h¡Ÿ&
Y

Cost of Capital (Percent) Stage I Stage II Stage III

Leverage
X
o
According to traditional theory, a firm can Q´>o{S>eZb AdYmaUm Ho$ AZwgma, H$moB© \$_© S>oãQ> H¡${nQ>b
change its overall cost of capital by increasing {‘³g _| n[adV©Z H$aHo$ ny§Or H$s Hw$b bmJV H$mo à^m{dV
or decreasing the debt-equity mix. If a firm H$a gH$Vr h¡Ÿ& `{X H$ånZr {S~oÝMg© na 15% H$s Xa go
pays 15% on its debentures which are issued ã`mO XoVr h¡ Vmo H$a Ho$ nyd© H$s F$U bmJV 15% _mZr
and redeemable at par then cost of debentures
would be 15% before tax. If the rate of tax is Om`oJr Am¡a `{X H$a H$s Xa 50% h¡ Vmo H$a Ho$ níMmV²
50% it would be 7.5%. Similarly, other sources `h Xa 7.5% _mZ|JoŸ& Bgr àH$ma H$mof Ho$ AÝ` gmog}g _|
of funds involve cost. But the cost of different H$m°ñQ> em{_c hmoVr h¡Ÿ& H$mof Ho$ àË`oH$ òmoV H$s bmJV
sources of funds is not the same. Loans are g_mZ Zht hmoVrŸ& gm_mÝ`V… S>oãQ> H$s H$m°ñQ>, Bp³dQ>r H$s
cheaper than equity, because the interest rates VwbZm _| H$_ _mZr OmVr h¡ Š`m|{H$ ã`mO H$s Xa| H$_ hmoVr
are generally lower and have tax advantages. h¢ Ed§ H$a H$m bm^ {_bVm h¡Ÿ& `hr H$maU h¡ {H$ A{YH$m§e
Interest is charged as an expense while divi-
dend is apportioned out of profit. Thus, a firm H$ån{Z`m± brdaoO AWm©V² ñWm`r ã`mO H$s {g³¶y[aQ>rO H$s
should try to reach the optimum capital and _mÌm ~‹T>mH$a AnZo H¡${nQ>b ñQ´>ŠMa H$mo AmXe© H$aZo H$m
increase its share price by leverage. à`mg H$aVr h¡Ÿ&
Suppose, a company has a total capital of _mZ cr{OE, `{X {H$gr H$ånZr H$s Q>moQ>b H¡${nQ>b
` 1 lac consisting only equity share capital. ` 1 bmI h¡ VWm `h nyU©V… Bp³dQ>r eo¶g© Ho$ ê$n _| h¡Ÿ&
Suppose that shareholders expect a 16% re- _mZm {H$ Bp³dQ>r H¡${nQ>b H$o eo¶a hmoëS>g© H$ånZr go
turn from the equity share capital. So, the cost 16% àË`m` H$s Anojm aIVo h¢Ÿ& AV… H¡${nQ>b H$s H$m°ñQ>
of capital can be taken as 16% after tax. If this H$a Ho$ níMmV² 16% _mZr Om`oJr Š`m|{H$ eo¶a H¡${nQ>b
company raises ` 40,000 from equity share na {S>~oÝMg© H$a Ho$ níMmV² hr {X`m OmVm h¡Ÿ& BgHo$ ñWmZ
capital and ` 60,000 from 15% debentures, its na `{X H$ånZr F$U Ed§ g_Vm H$m {_lU H$aoŸ& CXmhaU
cost of capital will go down. This is because Ho$ {b`o, ` 40,000 g_Vm d ` 60,000 Ho$ 15%
not only the expected return is low (15%) but F$UnÌ Omar H$ao Vmo H¡${nQ>b H$s H$m°ñQ> _| H$_r hmoJrŸ&