JAIIB Exam | Advance Financial Management | Chapter 24 | Module C [FREE EPDF]

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📌 Capital Structure Theories

1️⃣ Net Operating Income Approach

• Suggests that the value of a firm is independent of its capital structure.
• Changes in debt or equity do not impact the firm’s overall value.
• Only the operating income determines the company’s valuation.
• Key Takeaway: The firm should focus on maximizing operating income rather than worrying about debt or equity ratios.

2️⃣ Traditional Position Approach

• Initially, using more debt reduces the cost of capital due to tax benefits.
• At a certain point, the cost stabilizes and then starts increasing as risk rises.
• Key Takeaway: There’s an optimal debt-to-equity ratio that minimizes cost and maximizes firm value.

📌 Understanding Cost of Capital

What is Cost of Capital?

It is the cost a company incurs to acquire funds. For companies, it represents the required return to satisfy investors. For investors, it’s the minimum return they expect.

Components of Cost of Capital

• Cost of Debt – Interest paid on borrowed funds.
• Cost of Preference Capital – Fixed dividend paid to preference shareholders.
• Cost of Equity – Expected return demanded by equity investors.

📌 Weighted Average Cost of Capital (WACC)

Formula:

WACC = (Cost of Equity × Equity %) + (Cost of Debt × Debt %) + (Cost of Preference Capital × Preference Share %)

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