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Fundamentals of Financial Management, Third Edition by Vyuptakesh Sharan

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14.2 THE IRRELEVANCE APPROACH

Those who believe in perfect market conditions are of the view that the issue of capital structure is irrelevant, implying that any change in capital structure has no influence on the value of corporate wealth. For the first time, it was Durand (1952) who explained the capital structure theory which is known as the net operating income (NOI) approach. His theory can be explained with the help of a simple example. Suppose a company has 100,000 shares of Rs 10 each. The expected level of net operating income or the operating profit is Rs 100,000. The dividend pay-out ratio is 100%. This means that the dividend or the cost of equity capital,

    Ke = Rs 100,000/1,000,000 = 0.10 = 10%

If the NOI is capitalised at the ...

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