____________________________________________________________________________________________________

Subject BUSINESS ECONOMICS

Paper No and Title 4, Principles of Business Finance and Accounting

Module No and Title 21, Capital Structure

Module Tag BSE_P4_M21

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Theories of Capital Structure
3.1 Net Income Approach
3.1.1 Limitations of net income approach
3.2 Net Operating Income Approach
3.2.1 Assumptions of this theory
3.2.2 Limitations of net operating income approach
3.3 Traditional approach
3.3.1 Assumptions of this theory
3.3.2 The approach
3.4 Modigliani – Miller Approach
3.4.1 Assumptions of this theory
3.4.2 The approach
3.4.3 The Arbitrage process
3.4.4 Limitations of MM approach
4. 4Practical Illustration
5. Summary

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to

 Know the various capital structure theories.

 Learn the assumptions under which the capital structure theories work.
 Identify the various constants under each theory
 Evaluate the value of firm and cost of capital under different theories.

2. Introduction
The value of the firm depends on the earnings of the firm. The earnings of the firm are divided
among three main claimants:-
i) The debenture holders - they receive their share in the form of interest.
ii) The shareholders - they receive their share in the form of dividends. They can either be
preference shareholders who receive fixed rate of dividend or equity shareholders who claim
the balance or residual earning.
iii) The third claimant is government which receives its share in the form of taxes.
However, what is worth noting is that the order of payment is not as above.
First, interest is paid to the debenture holders, and then the government gets the share in the form
of taxes and then finally comes the shareholders. Thus, interest is a deductible expense for
calculating taxes but dividends are not expenses. Dividends are paid out of profits after tax. These
earnings of the firm are capitalized at the rate equal to the cost of capital to find out the value of
the firm.
The earnings of the firm i.e. EBIT is determined by the investment decision. The more
investments are made, the more EBIT would be generated. How this EBIT is to be shared
amongst various claimants depends upon how the investments have been arranged. The capital
structure determines the mix of the investment and the share of claimants in the EBIT.
Thus the value of firm would be the sum total of value of debt holders and shareholders.
The total return on total investments doesn’t change. However if the debt component is higher the
financial leverage affects the amount available to shareholders. This will affect the value of
equity shareholders and the value of the firm.
Thus overall cost of capital i.e. weighted average cost of capital WACC can be changed by
changing the financial mix. Therefore, we can surely find a mix which gives lowest WACC and
highest value to the firm. This would give an optimal capital structure.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

3. Theories of capital structure

Different theories have been expressed regarding the relationship between the leverage, cost of
capital and value of the firm. These relationships are also expressed as theories of capital
structure. These are -
i. Net Income approach
ii. Net operating income approach
iii. Traditional approach
iv. MM approach (Modigliani& Miller approach)
These theories are based on the following assumption
1) The firm’s business risk is given and is not affected by financial mix.
2) There are only two sources of funds i.e. debt and equity.
3) The total assets of the firm are given and no change would be there in total investments.
4) Operating profits are given and would remain same.
5) Entire profits are distributed and there are no retained earnings.
6) There is no corporate or personal tax.
While discussing these theories the following notations are used:
V = Value of the firm
S = Value of equity
B = Value of debt

V = EBIT/Ko
V=S+B

I = Interest payment
EBIT = Earnings before interest or Net operating profit
NP = Net profit or profit after tax
Kd = Cost of debt after tax
Ke = Cost of equity
Ko = Overall cost of capital i.e. WACC

Also Ko = EBIT/V

3.1 Net Income Approach

This theory states that there is a relationship between capital structure and the value of the firm.
Therefore, the firm can affect its value by increasing or decreasing the debt proportion in the
overall financing mix.
The net income approach is based on following additional assumptions -
i) Kd and Ke remain constant and therefore as leverage increases Ko nears Kd.
ii) Kd is always less than Ke, thus implying that Ko will reduce with leverage.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

This theory states that as financial leverage increases the overall cost of capital WACC decrease
as Kd is assumed to be less than Ke. This results in increased returns to the shareholders thus
increasing the value of firm. On the other hand if debt will decrease in the capital structure the
overall cost will increase and reduce the value of the firm.

Illustration 1 EBIT of the firm is Rs.2, 00,000

Ke = 12%, Kd = 8%, Debt = B= Rs.5, 00,000
Find the value of the firm and overall cost of capital i.e. WACC

Solution:
EBIT Rs.2, 00,000
- I (Interest) 5, 00,000 x 8% 40,000
Net profits available to equity shareholders Rs.1, 60,000
Ke 12%
Value of Equity (S) 1, 60,000/12% = Rs.13, 33,333.33
Value of Firm (V) = B + S
= 5, 00,000 + 13, 33,333.33 = Rs.18, 33,333.33
WACC/ Ko = EBIT/V = (2, 00,000/18, 33, 333.33) x 100 = 10.90%
WACC can also be calculated using [Kd x (D/D+E) + Ke x (E/D+E)]
= [8% x 5, 00,000/18, 33,333.33 + 12% x 13, 33,333.33/18, 33,333.33]
BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING
ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

= 2.18182 + 8.726 = 10.91%

3.1.1 Limitations of net income approach

Net income approach is simple but it is based on unrealistic assumption that risk
perception of equity will remain constant at all degrees of leverage. The more debt
will be there in the capital mix, the equity will demand more risk premium as their
risks will increase.

3.2 Net operating income approach:

According to NOI approach the market value of the firm depends upon the operating profit and
overall cost of capital Ko. The financing mix is irrelevant and does not affect the value of the
firm.

3.2.1 Assumptions of this theory

It is based on the following additional assumptions:-
i) The investors perceive the firm as a whole and capitalizes its total earnings to find the value of
the firm, therefore Ko is constant.
ii) Kd is also taken as constant.
iii) Increase in debt increases the risk of shareholders and thus Ke increases with increase in debt.

Illustration 2 EBIT = Rs.2, 00,000

Ko = 10%, Kd = 8%, Debt = Rs.5, 00,000
Solution:
V = EBIT/Ko = 2, 00,000/10% = 20, 00,000
Further V=B+S
20, 00,000 = 5, 00,000 + S
S = Rs.15, 00,000

Amount available to equity

EBIT Rs.2,00,000
- I (Interest) 5, 00,000 x 8% 40,000
Net profits available to equity shareholders Rs.1, 60,000
Ke PAT/S
Value of Equity (S) (1, 60,000/15, 00,000) x 100 = 10.67%

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Thus we can see from the graph that Kd and Ko are constant. The value of firm will remain
constant at varying degrees of leverage.

3.2.2 Limitations of net operating income approach

The major limitation of net operating income approach is that the cost of debt remains constant
regardless of the degree of leverage.
Another drawback is as the cost of capital of the firm cannot be altered through leverage, the net
operating income approach implies that there is no optimal capital structure.

3.3 Traditional approach

The NI approach and NOI approaches hold Extreme view on relationship between the leverage
cost of capital and value of the firm.
In traditional situation both the approaches are unrealistic. The traditional view takes the middle
approach. The value of firm can be increased by increasing the leverage only to an extent.
Therefore, this is more practical and can be used to decide a point where the value of the firm will
be maximum and overall cost of capital will be minimum.

3.3.1 Assumptions of this theory

The traditional approach has the following assumptions:

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

 The cost of debt capital remains more or less constant up to a certain degree of leverage
but rises thereafter at an increasing rate.
 The cost of equity capital remains more or less constant or rises only gradually up to a
certain degree of leverage and rises sharply thereafter.
 The average cost of capital decreases upto a certain point due to the benefit of leverage
and then starts increasing. The point where it is lowest is the optimum capital structure.

3.3.2 The approach

It states that the cost of debt Kd will be less than Ke.

For all equity firm Ko will be equal to Ke. So if debt is introduced at a lower cost, the overall cost
will come down as Ko or WACC will reduce with small degree of leverage the risk of equity will
also not increase and therefore Ke will remain constant upto this level.
But, if leverage is increased further Ke may start increasing. But the benefit of leverage will be
more than the increase in Ke; therefore, Ko will still come down.
Beyond this point, the Ke will increases with increase in leverage but its adverse effect will not be
compensated with benefit of leverage.
So at this point there is no point of raising money through debt as it will increase the WACC, Ko
and reduce the value of firm. The debts also start demanding more as their risk also increases.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Illustration 3 ABC Ltd. having an EBIT of Rs.2, 00,000 is all equity firm with Ke of 12.5%. It
is thinking of rendering part of capital with debt financing. It is completed through two options:
Option 1 Debt of Rs.6, 00,000 @ 10% p.a. Ke will increase to 13% at this level
Option 2 Debt of Rs.8, 00,000 @ 11% p.a. this will increase the risk of equity and Ke will
increase to 14.5%.
Should the firm opt to redeem its capital? If yes, which option should the firm exercise?

Solution:

Thus it is better if the firm employs some degree of leverage. It should borrow Rs.6, 00,000 @
10% and redeem equity. It will be able to reduce its WACC from 12.5% - 11.926%. But if it tries
to raise more debt it will be available at a higher rate of 115 and K e will also start demanding
more return for higher risk. It will lead to increased overall cost and reduce its value. Therefore,
the firm should raise debt only to the extent of Rs.6 lakhs @ 10% rate of interest.

3.4 Modigliani – Miller Approach:

This model propagates that capital structure and its composition has no effect on the value of the
firm. They have shown that the finance leverage does not matter and the cost of capital and value
of firm are independent of the capital structure.
They have restated the NOI approach and have added to it the behavioral justification for their
model.
3.4.1 Assumptions of this theory
The model is based on the following additional assumptions:-
i) Capital markets are perfect and complete information is available to all the investors.
ii) The investors are rational informed and can borrow and lend funds at the same rate.
iii) Securities are infinitely divisible there are no transaction costs.
iv) There is no corporate Income tax.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Investors can substitute personal leverage in the corporate i.e. personal leverage and corporate
leverage are perfect substitutes.

3.4.2 The approach

Let us understand the approach with the following illustration -
llustration 4 Let us take two firms, one is Firm A which is leveraged firm and the other Firm B
which is unleveraged. The firms are alike in all respect except that the Firm A has 10% debt of
Rs.5, 00,000 in its capital structure.
On the other hand firm B is all equity firm. Both the firms have an EBIT of Rs.2, 00,000 and
equity capitalization rate of 20%.
Under the given circumstances the WACC of the two firms shall be as follows:
Solution:

Thus NOI approach has been substantial. But as per MM approach this situation cannot persist in
the long run. Investors will starts selling the shares in the leveraged firm as they will get increased
value and start buying shares in unleveraged firm with personal loans and increase their value in
unlevered firm. So equilibrium will be restored. The investor will do so as he sees an arbitrage
opportunity here. Arbitrage means increasing returns without increasing risk or investment.

3.4.3 The Arbitrage process

Let us take an investor X who has 10% equity stake in firm. Firm A has Rs.1, 50,000 as net
profits for shareholders and the value of its equity shares is Rs.7, 50,000. So Mr. X has an income
of Rs.15, 000 and can sell his share in firm A for Rs.75, 000. Mr. X does the same i.e. he sells the
shares in firm A for Rs.75, 000. He now raises Rs.50, 000 from market at 10% interest.
He now has Rs.1, 25,000 to invest in stake of 12.5% i.e. (1, 25,000/ 10, 00,000) x 100. He will
now get an income of 12% i.e. Rs.2, 00,000.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Rs.25, 000 from Firm A from this income he pays interest of Rs.5, 000 (50,000 @ 10% which he
borrowed). He is left with Rs.20, 000 as income. So we can see that Mr. X has increased his
income or return without any risk on investment.
Since all investors are rational and will continue with the process of arbitrage the price of shares
of firm A will go down thereby reducing its value and shares of firm B will go up increasing the
value of firm B till equilibrium is reached.
Thus, leverage is irrelevant in determining the value of the firm or cost of capital.

3.4.4 Limitations of MM approach

The major limitation of MM approach is the assumptions that underline it. These assumptions are
unrealistic and unattainable. Markets are not perfect. Transactions are not cost free. Infact the
investors also do not behave in a perfectly rational manner.
The following limitations are:-
1. Corporate and personal borrowings are at different rates. It is not possible for individuals to
borrow at the same rate at which companies borrows.
2. Personal leverage is not a substitute of the corporate gearing.
3. The leverage capacity of the firms is higher than the individual.
4. Personal borrowings are cumbersome and it creates inconveniences as there are many
formalities involved.
5. In real life there are transactions costs.
6. There are legal restriction in buying and selling securities by institutional investors.
7. Complete information is not available in the market.
8. There are corporate and personal taxes.

Later on, MM hypotheses relaxed the assumption that there are no corporate taxes and it is
realized that a value of levered firm increase because the levered firm has to pay less taxes
(interest is deductible in calculating profits for tax purposes). Thus a levered firm has larger share
of EBIT to the debt and equity shareholders.
The value of levered firm will be equal to the value of unlevered firm plus tax shield. The tax
shield is the tax benefit which accrues to levered firm and is given by B (tax rate).

4. Practical Illustrations

Illustration 5 Z Ltd. with EBIT of Rs.3, 00,000 is evaluating the various possible capital
structure. Some of the capital structure is given below. Which one of the following given
structure would you recommend?

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Solution:

Thus it is traditional approach where Kd and Ke both are increasing with increased leverage as
risks are increasing we have to choose that capital structure which increases the value of firm and
reduces overall cost of capital.

Capital Structure

The 1st plan will be the best. The firm should go for a debt of Rs.3, 00,000 @ 10% p.a.

Illustration 6 X Ltd. and Y Ltd. belong to the same risk class. Ke for the firms is 12.5%. X Ltd.
has raised Rs.50, 00,000 while Y Ltd. has raised Rs.70, 00,000 by issuing 10% debt. Find the
value of these two firms applying the NI approach. But firms have an EBIT of Rs.12, 00,000.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

Solution:

Illustration 7: A company current operating income is Rs.4 lakhs. The firm has Rs.10 lakhs of
10% debt outstanding. It cost of equity capital is estimated to the 15%.
Solution:
1) Value of the firm using traditional valuation approach
(Rs.)
EBIT 4, 00,000
I (10, 00,000 @ 10%) 1, 00,000
Profit after tax 3, 00,000
Ke 15%
S = N.P. /Ke 3, 00,000/15% = 20, 00,000
B 10, 00,000
V=S+B 30, 00,000

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE
____________________________________________________________________________________________________

2) Ko = 13.33% = EBIT/V = 4, 00,000/30, 00,000 = 13.335

3) B = 10, 00,000 + 5, 00,000 = Rs.15, 00,000
Ko = 12%
Ke = 18%

4. Summary
 The value of the firm depends on the earnings of the firm. The earnings of the firm are
divided among three main claimants:-
 The debenture holders
 The shareholders
 The third claimant is government

 The earnings of the firm i.e. EBIT is determined by the investment decision.
 The value of firm would be the sum total of value of debt holders and shareholders.
 Overall cost of capital i.e. weighted average cost of capital WACC can be changed by
changing the financial mix.
 Different theories have been expressed regarding the relationship between the leverage,
cost of capital and value of the firm. These relationships are also expressed as theories of
capital structure. These are,

i. Net Income approach

ii. Net operating income approach
iii. Traditional approach
iv. MM approach (Modigliani& Miller approach)

 This theory states that there is a relationship between capital structure and the value of
the firm. Therefore, the firm can affect its value by increasing or decreasing the debt
proportion in the overall financing mix.
 According to NOI approach the market value of the firm depends upon the operating
profit and overall cost of capital Ko. The financing mix is irrelevant and does not affect
the value of the firm.

 Traditional approach
The NI approach and NOI approaches hold. Extreme view on relationship between the
leverage cost of capital and value of the firm.
 Modigliani – Miller Approach:
This model propagates that capital structure and its composition has no effect on the value
of the firm. They have shown that the finance leverage does not matter and the cost of
capital and value of firm are independent of the capital structure.

BUSINESS PAPER No. : 4, PRINCIPLES OF BUSINESS AND ACCOUNTING

ECONOMICS MODULE No. : 21, CAPITAL STRUCTURE