[Solved] Which of the following is not an approach to the Capital Str (2024)

Capital structure represents only long-term funds and excludes all short-term loans and advances. It is a set of patterns in which a company decides to finance its activities with a particular combination of debt, equity, or securities.

4 Types of Capital Structure Approaches:

1)Net Operating Income Approach (NOI):

• In this approach, the market value of a business is not affected by the capital structure changes and it is ascertained by capitalizing the net operating income at the overall cost of capital.
• The overall cost of capital is considered to be constant in this approach.
• In this approach, the total value of business remains constant irrespective of the debt-equity mix.

2) Net Income Approach (NI):

• In this approach, capital structure is important as a change in it will lead to changes in the capital cost, and the value of the firm.
• Here, as the degree of leverage increases, the ratio of a less expensive source of fund i.e. debt increases, while that of equity decreases.
• Therefore, the cost of capital declines leading to an increase in the value of a firm.

3)Modigliani and Miller Approach:

• It is similar to Net Operating Income Approach.
• In this approach, the market value of a business is not affected by the capital structure changes and the value of the business remains constantirrespective of the debt-equity mix.
• It is based on the idea that the total investment value of a company depends upon its profitability and risk and is invariant with respect to relative changes in the capital structure.

Therefore, Gross Profit Methodis not an approach to the Capital Structure.

4) Traditional Approach:

• This method is midway between NI and NOI approaches.
• Through a judicious combination of debt and equity, a firm can increase its value and reduce the cost of capital.
• After a certain point, the risk to the investors will increase and also the financial risk which will cause an increase in cost and decline in value. At this point, the capital structure will be optimum.

Gross Profit Method:

• It is a technique used to estimate the amount of ending inventory.
• Gross profit equals net sales minus the cost of goods sold.