Algebraically, the relationship between the cost of equity, cost of overall capital and debt-equity ration are explained as follows:
Ke=Ko+ (Ko–Ki)B/S
Net income approach was developed by Durand, in this he has portrayed the influence of the leverage on the value of the firm, which means that the value of the firm is subject
to the application of debt i.e., leverage. In this approach, the cost of debt is identified as cheaper source of financing than equity share capital. The more application of debt in the capital structure brings down the overall capital, more particularly 100% application of debt finance leads to resemble the over all cost of capital as cost of debt. The weighted average cost of capital will come down due to more application of leverage in the capital structure, only with reference to cheaper cost of raising than the equity share capital cost.
Ko= Ke(S/V)+Ki(B/V)
The value of the firm is more in the case of lesser overall cost of capital due to more application of leverage in the capital structure. The optimum capital structure is that at
This another approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. How the implicit cost of debt will go up? The more application of debt leads to increase the financial risk among the investors, that warranted the equity share holders to bear additional financial risk of the firm. Due to additional financial risk, the share holders are requiring the firm to pay additional dividends over the existing. The increase in the expectations of the shareholders with reference to dividends hiked the cost of equity. Under this approach, no capital structure is found to be a optimum capital structure. The major reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant.
It is finally concluded that this approach highlights that application of leverage never
makes an attempt to enhance the value of the firm, in other words which is known as
unaffected by the application of leverage
It is the approach, attempts to explain the application of leverage does not have any
influence on the value of the firm through behavioural pattern of the investors. The
behavioural pattern of the investors is taken into consideration for explaining the value of
the firm which is unaffected by the application of debt/leverage in the capital structure
through arbitrage process. The MM approach has three different propositions:
(i) The overall capital structure of the firm is unaffected by the cost of capital an
degree of leverage
(ii) The cost of equity goes up and offset the increase of leverage in the capital structure
(iii) The cut off rate for the investment purposes is totally independent.
For discussion, the proposition is only considered for the study of usage of leverage in
the capital structure, which do not have any impact in the value of the firm.
The traditional approach is known as intermediate approach in between the Net income
approach and NOI approach. The value of the firm and the cost of capital are affected
by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of
overall capital will come down due to the application cheaper source of financing viz
Debt financing to some extent, after certain usage, the application of debt will enhance
the financial risk of the firm, which will require the share holders to expect additional
return nothing but is risk premium. The risk premium which is expected by the investors
will enhance the overall cost of capital.
The optimum capital structure "the marginal real cost of debt, defined to include both
implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before
that level, the marginal cost of debt would be less than that of equity capital, while
beyond that level of leverage, the marginal real cost of debt would exceed that of equity.
The dividend policy is the policy that facilitates the firm to decide how much should be
declared as a dividend. The declaration of dividend is normally to be taken with reference
to the future prospects of the firm. The dividends are normally decided by the board of
directors during the board meeting which may affect other important decisions of the
firm. Most of the companies never think off about the future prospects before the
declaration of the dividends to the shareholders. As a finance manager should emphasize
the importance of declaring or non declaring the dividends which are having greater
influence on the futuristic decisions of the enterprise.
Types of dividend policies:
(i) Cash dividend
(ii) Bond dividend
(iii) Property dividend
(iv) Stock dividend
Cash Dividend Policy
The dividends are paid in terms of cash. This type of dividend normally leads to cash outflow which has greater influence on the cash position of the firm. At the moment of declaring the cash dividend, future cash needs should be predetermined and dividends declared to the share
Bond Dividend Policy
Instead of paying dividend in terms of cash, some companies are issuing bond dividends, which facilitate them to postpone the immediate cash outflows. Immediately after the issuance of bonds, the bond holders are receiving the interest on their holdings besides the bond values to be paid on the due date. This method is not popular in India
Arbitrage process
Dividend Policies
Cash dividend policy

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