Ques. MM approach to capital structure is the superior model over the operating approach Do you agree?

If yes, give reason. Is capital structure determination a static concept? Should corporate sector in India make same alternation in their existing capital structure in the light of new economic order around the global? If yes, why? Ans. Yes, MM approach to capital structure is the superior model over the operating approach because it is relating to the relationship between the capital structure, cost of capital and valuation. The MM proposition supports the NOI approach relating to the independence of full cost of capital of the degree of leverage at any level of debt-equity ratio. The significance of their hypothesis lies in the fact that it provides behavioural justification for constant overall cost of capital and therefore, total value of the firm .In other words the MM approach maintains that the weighted average (overall) cost of capital does not change with the change in the proportion of debt to equity in the capital structure (or degree of leverage).They offer operational justification for this and are not content with merely stating the proposition. MM approaches considers the three basic propositions. 1. The overall cost of capital (k0) and the value of the firm (v) are independent of its capital structure. The k0 and v are constant for all degree of leverage. The total value is given by capitalising the expected stream of operating earnings at a discount rate appropriate for its risk class. 2. The second proposition of the MM approach is that the Ke is equal to the capitalisation rate of a pure equity stream plus a premises for financial risk equal to the difference between the pure equity-capitalisation rate (Ke) and Ki times the ratio of debt to equity .In other words ,Ke increases in a manner to offset exactly the use of a less expensive source of fund represented by debt. 3. The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. 4. This approach contend that the total value of homogeneous firms that differ only in respect of leverage cannot be different because of the operations of arbitrage. The arbitrage refers to the switching over operations, that is the investors switch once from the overvalued firm (levered firm) to the under-valued firm (Unlevered). The essence of arbitrage is that the investors (arbitragers) are able to substitute personal or homemade leverage for corporate leverage. 5.The MM contend that with corporate taxes, debt has a definite advantage as interest paid on debt is tax deductible and leverage will lower the overall cost of capital. The value of levered firm (Vi) would exceed the value of the unlevered firm (Vu) by an amount equal to levered firms debt multiplied by tax rate. Capital structure determination is not a static concept. It is flexible and vary according to the market situation and firm requirement and legal obligation etc.

Capital Structure Practices in India 1. Indian corporates employ substantial amount of debt in their capital structure in terms of the debt-equity ratio as well as total debt to total assets ratio. Nonetheless the foreign controlled companies in India use less debt than the domestic companies. The dependence of the Indian corporate sector on debt as a source of finance has over the years declined particularly since the mid nineties. 2. The corporate enterprise in India seems to prefer long term borrowings over short term borrowings. Over the years, they seem to have substituted short term debt for long term debt. The foreign controlled companies use more long term loans relatively to the domestic companies. 3. As a result of debt-dominated capital structure the Indian corporates are exposed to a very high degree of total risk as reflected in high degree of operating leverage and financial leverage. The foreign controlled companies however are exposed to lower overall risk as well as financial risk. 4.The debt service capacity of the sizeable segment of the corporate borrower as measured by a. Interest coverage ratio b. Debt service coverage ratio is inadequate and unsatisfactory 5. Retained Earnings are the most favoured source of finance. There is significant difference in the use of internally generated funds by the highly profitable corporates relative to the low profitable firms. 6. Loan from financial institutions and private placement of debt are the next most widely used source of finance. The large firms are more likely to issue bonds in the market than small corporates. 7.The Hybrid securities is the least popular source of finance amongst corporate India. They are more likely to be used by low growth firms. Preference shares are used more by public sectors units and low growth corporates. 8.Equity capital as a source of funds is not preferred across the board. These are some of the alteration which should be consider in the existing capital structure of Indian corporate sector. Indian corporate sector still concentrate on debts mainly long term so it should think about equity capital and other source of finance also like hybrid securities.