The presentation contains details on Net Income, Net Operating, Traditional and Modigliani & Miller Approach; valuation of shares i.e., different models for valuation of shares in particular CAPM; Efficient Market Hypothesis (EMH) & forms of hypothesis

1. Swaminath S
M.Com., PGDFBA, PGDFM, PGDMM, NET & JRF, SLET, (MBA), (Ph.D)
Assistant Professor,
Government First Grade College,
Sakharayapattana, Chikmagalur1
17.10.2018
@

2.  An overview of Capital Structure Theories
and practical considerations.
 An overview of Valuation of Shares and
Models for Valuation of Shares.
 Efficient Market Hypothesis (EMH) and
practical consideration in valuation of shares.
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Financial
Structure
Asset
Structure
Capital
Structure
Balance Sheet
• Capital structure with equity shares only.
• Capital structure with equity shares and preference shares.
• Capital structure with equity shares and debentures.
• Capital structure with equity shares, preference shares and debentures.
Patterns of Capital Structure:
 Capital Gearing Ratio – low gear & high gear
 Trading on Equity
 Leverages

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Risk
Risk Averter
Risk Taker
Risk Neutral
Low Risk = Low Returns
High Risk = High Returns
Moderate Risk = Moderate Returns
Optimum Leverage Low Risk = High Returns
CAPITAL STRUCTURE
THEORIES
1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Approach
4. Modigliani & Miller Approach (M&M)
Maximize the value of the firm and to reduce the cost of capital.Objective -

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Assumptions:
• The cost of debt is less than the cost of equity.
• There are no taxes.
• The risk perception of the investors is not changed by the use of debt.
Use of Debt Ko S V
The reason for
assuming cost of debt to
be less than the cost of
equity are that interest
rates are usually lower
than dividend rates due
to element of risk and
the benefit of tax as the
interest is a deductible
expenses.
Capital structure decision is relevant to the valuation of the firm
Kd

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Assumptions:
• The overall cost of capital remains constant;
• There are no corporate taxes;
• The market capitalizes the value of the firm as a whole.
Capital structure decision is irrelevant to the valuation of the firm
Use of Debt Ko Ke V S
There is nothing
as an optimal
capital structure
and every capital
structure is the
optimum capital
structure.
Kd

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Use of Debt KoKe V
The value of the firm can be increased initially or the cost of capital can be decreased by
using more debt as the debt is a cheaper source of fund than equity. Beyond a particular
point, the cost of equity increases because increased bet increase the financial risk of
equity shareholders. Traditional approach, also known as Intermediate approach.
Kd S

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Theory of Relevance –
Taxes are exists
Theory of Irrelevance
– No Taxes
Debt-equity mix is irrelevant in the determination of the total value of the firm. M&M
approach states that the financing decision of a firm does not affect the market value
of a firm in a perfect capital market.
Use of Debt KoKeKd
Assumptions:
• There are no corporate taxes.
• There is a perfect market.
• Investors act rationally.
• The expected earnings of all the firms have identical risk
characteristics.
• The cut-off point of investment in a firm is capitalization rate.
• All earnings are distributed to the shareholders.
VS

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Two Identical Firms – Except their Capital Structure – cannot have different
Market Values / Cost of Capital – Arbitrage Process – Personal Leverage – against
Corporate Leverage

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Value of the firm will increase or the cost of capital will decrease with the use of debt
on account of deductibility of interest charges for tax purposes. Thus, the optimal
capital structure can be achieved by maximizing the debt mix in the equity of a firm.
Use of Debt Ko VS
Unlevered FirmsLevered Firms

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Valuation of shares is the process of knowing the value of company’s shares.
1. Assets Approach – Capital-intensive company and large amount investment on
capital assets.
Amalgamation, Absorption or Liquidation of Companies.
Net assets = Total assets - Total liabilities = Total equity and reserves
Price of share = Net assets / Number of ordinary shares in issue
2. Income Approach
a. Discounted Cash Flow – Future cash flow to determine fair value
Price of a share = Total discounted cash flows / Number of ordinary shares in issue
b. Price Earning Capacity – Based on historical earnings
3. Market Approach – Market value of shares are considered – listed stocks
4. Dividend Yield Method / Price Ratio Method:
Cost of Equity Shares (Ke) = Dividend Per Equity (D) / Market Price (MP)

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5. Dividend Yield plus Growth in Dividend Method:
Cost of Equity Share (Ke) = Dividend Per Equity (D) / Market Price (MP) + Rate of
Growth in Dividends (G)
6. Earning Yield Method:
Cost of Equity Share (Ke) = Earnings Per Share (EPS) / Market Price Per Share (MP)
8. Capital Asset Pricing Model:
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
7. Dividend Valuation Models:
1) Zero growth 2) constant growth (Gordon)
P = D1 ⁄ r P = D1 ⁄ (r-g)

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1. The EMH is an investment theory - Eugene Fama’s research work - 1970 –
book:- “Efficient Capital Markets: A Review of Theory and Empirical Work”.
2. “the current price [of an investment] should reflect all available
information…so prices should change only based on unexpected new
information.”
Assumptions:-
1. One idea critical to the validity of the efficient markets hypothesis:
2. The belief that all information relevant to stock prices is freely and widely
available, “universally shared” among all investors.
3. Large number of both buyers and sellers in the market,
4. Price movements always occur efficiently (i.e., in a timely, up-to-date manner).
Thus, stocks are always trading at their current fair market value.
Random Walk Theory
Normal
&
Abnormal Profit

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1. Statistical Test for Independence
2. Trading Test – cost based
1. Event Test
2. Regression / Time Series Test
1. Insiders
2. Exchange Specialists
3. Analysts
4. Institutional Money Managers
Fama (1970) an “efficient market” is defined as a market where share prices
always fully reflect all available information about the company or firm.

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