Capital Structure Theories

Financial leverage has a magnifying effect on EPS, such that, for a given level of change in EBIT, there will be
a more than proportionate change in the same direction in the EPS. But financial leverage also increases the
financial risk, defined as the risk of possible insolvency arising out of inadequacy of available cash as well as
the variability in the earnings available to the ordinary shareholders. Given the objective of the firm to
maximise the value of the equity shares, the firm should select a financing-mix/capital structure/ financial
leverage which will help in achieving the objective of financial management. It can be legitimately expected
that if the capital structure decision affects the total value of the firm, a firm should select such a financing-mix
as will maximise the shareholders’ wealth. Such a capital structure is referred to as the optimum capital
structure. The optimum capital structure may be defined as the capital structure or combination of debt and
equity that leads to the maximum value of the firm.

https://efinancemanagement.com/financial-leverage/capital-structure-and-its-theories

1. Net Income Approach(NI)---Relevant

2. Net Operating Income Approach(NOI)---Irrelevant
3. Traditional Approach---Relevant till certain point and then irrelevant-In between NI and NOI
4. Modigliani and Miller Approach(MM)- Irrelevant

Capital Structure Theories Assumptions

1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the shareholders
and there are no retained earnings.
4. The total assets are given and do not change. The investment decisions are, in other words, assumed to
be constant.
5. The total financing remains constant. The firm can change its degree of leverage (capital structure)
either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the
equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. Business risk is constant over time and is assumed to be independent of its capital structure and financial
risk.
8. Perpetual life of the firm
 Net Income Approach
According to the Net Income (NI) Approach, suggested by the Durand , the capital structure decision is
relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a
corresponding change in the overall cost of capital as well as the total value of the firm. As the
degree of leverage increases, the proportion of a cheaper source of funds, that is, debt in the capital
structure increases. As a result, the weighted average cost of capital tends to decline, leading to an
increase in the total value of the firm. Cost of debt and cost of equity will be constant.
Debt is cheapest source of funding and equity is most expensive
Ko=wdkd(1-t)+weke
Value of firm= EBIT/K0
Value of Equity= Net Income or ESH/Ke

Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a decline
in the value of the firm.

With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will
be the one at which value of the firm is the highest and the overall cost of capital is the lowest. At that
structure, the market price per share would be maximum.
https://efinancemanagement.com/financial-leverage/capital-structure-theory-net-income-approach

Numericals on Capital Structure Theories

1. A company’s annual net operating profit (EBIT) is Rs.50,000. The company has Rs.2,00,000, 10%
debentures. The equity capitalization rate (ke) of the company is 12.5 per cent. Assume no
taxes.According to Net Income Approach:
(i) find out the value of the firm and overall cost of capital
(ii) find out the value of the firm and overall cost of capital in case the amount of debentures
increase by Rs. 1,00,000
(iii) find out the value of the firm and overall cost of capital in case the amount of debentures
decrease by Rs. 1,00,000.

Net Operating Income Approach- Irrelevant- With debt, financial risk will increase so Required
rate of return by equity shareholders will increase, Ke will increase

Another theory of capital structure, suggested by Durand, is the Net Operating Income (NOI) Approach. This
Approach is diametrically opposite to the NI Approach. The essence of this Approach is that the capital structure
decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm
and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

As per this approach, the market value is dependent on the operating income and the associated business risk of
the firm. Both these factors cannot be impacted by the financial leverage. Financial leverage can only impact the
share of income earned by debt holders and equity holders but cannot impact the operating incomes of the
firm.
It further says that with the increase in the debt component of a company, the company is faced with higher
risk. To compensate that, the equity shareholders expect more returns. Thus, with an increase in financial
leverage, the cost of equity increases.

The NOI Approach is based on the following propositions:

a) Overall Cost of Capital/Capitalisation Rate (k0) is Constant - The NOI Approach to valuation argues that the
overall capitalisation rate of the firm remains constant, for all degrees of leverage. The value of the firm,
given the level of EBIT, is determined by:
V= EBIT/ WACC

b) Residual Value of Equity - The value of equity is a residual value which is determined by deducting the total
value of debt (B) from the total value of the firm (V).
Total market value of equity capital (S) = Value of firm – Value of debt

c) Changes in Cost of Equity Capital- The equity-capitalisation rate/cost of equity capital (ke) increases with
the degree of leverage. The increase in the proportion of debt in the capital structure relative to equity
shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the
increased risk, the shareholders would expect a higher rate of return on their investments.

d) Optimum Capital Structure- The total value of the firm is unaffected by its capital structure. No matter what
the degree of leverage is, the total value of the firm will remain constant. There is nothing such as an
optimum capital structure. Any capital structure is optimum, according to the NOI Approach.

Value of firm=EBIT/ K0
 https://efinancemanagement.com/financial-leverage/capital-structure-theory-net-operating-income-
approach

2. A company’s expected annual net operating income (EBIT) is Rs 50,000. The company has Rs 2,00,000, 10%
debentures. The overall capitalization rate (overall cost of capital) is 12.5 per cent(i) Find out the value of
the firm and equity capitalization rate according to Net Operating Income Approach, (ii) find out the
value of the firm in case the amount of debentures increase by Rs. 100000 and (iii) find out the value of
the firm in case the amount of debentures decrease by Rs. 100000.

Traditional Approach(Kd, Ke, K0 will change)

While the NI Approach takes the position that the use of debt in the capital structure will always affect the
overall cost of capital and the total valuation, the NOI Approach argues that capital structure is totally irrelevant.
The Traditional Approach is midway between the NI and NOI Approaches. It is also known as the Intermediate
Approach. It resembles the NI Approach in arguing that cost of capital and total value of the firm are not
independent of the capital structure. But it does not subscribe to the view (of NI Approach) that value of a firm
will necessarily increase for all degrees of leverage. In one respect it shares a feature with the NOI Approach that
beyond a certain degree of leverage, the overall cost increases leading to a decrease in the total value of the
firm. But it differs from the NOI Approach in that it does not argue that the weighted average cost of capital is
constant for all degrees of leverage.
The crux of the traditional view relating to leverage and valuation is that through judicious use of debt-equity
proportions, a firm can increase its total value and thereby reduce its overall cost of capital. The rationale
behind this view is that debt is a relatively cheaper source of funds as compared to ordinary shares. With a
change in the leverage, that is, using more debt in place of equity, a relatively cheaper source of funds replaces a
source of funds which involves a relatively higher cost. This obviously causes a decline in the overall cost of
 capital. If the debt-equity ratio is raised further, the firm would become financially more risky to the investors
who would penalise the firm by demanding a higher equity-capitalisation rate (ke).
it is clear that the optimal debt-equity ratio must be less than 2.67 since at this ratio, the value of the firm is Rs
2,75,000, while at a debt-equity ratio of 1.08 it is Rs 2,88,235.
https://efinancemanagement.com/financial-leverage/capital-structure-theory-traditional-approach

3. Assume a firm has EBIT of Rs.40,000. The firm has 10 per cent debentures of Rs.1,00,000 and its
current equity capitalization rate is 16 per cent.
a)Calculate the current value of the firm and its overall cost of capital ?
b) In case the firm is considering increase in debentures by Rs.50,000 and using proceeds to retire
equity, cost of debt would increase to 11 per cent and cost of equity to 17 per cent?
c)In case the firm is considering increase in debentures by Rs.1,00,000 instead of Rs.50,000 and using
proceeds to retire equity, cost of debt would increase to 12.5 per cent and cost of equity to 20 per cent?

4. In case a firm has 20 per cent debt and 80 per cent equity in its capital structure, and the cost of debt is
10 per cent and cost of equity is 15 per cent, what is the overall cost of capital according to the
Traditional approach? What is the overall cost of capital when debt increases to 50 per cent and the
cost of debt increases to 11 per cent and cost of equity to 16 per cent? Further, what is the overall cost of
capital when debt increases to 70 per cent and the cost of debt increases to 14 per cent and cost of equity
to 20 per cent?

5. A company’s current operating income is Rs.4 lakhs. The company has Rs.10 lakhs 10% debt
outstanding. Its cost of equity is estimated to be 15 per cent.
(i) Determine the current value of the firm using the Traditional Valuation approach.
(ii) Calculate the overall capitalization rate and both types of leverage ratios: Debt/Equity and
Debt/Value of firm.
(iii) The firm is considering increasing its leverage by raising additional Rs.5,00,000 debt suing
proceeds to retire that amount of equity. As a result of increased financial risk, cost of debt is
likely to increase to 12 per cent and cost of equity to 18 per cent. Would you recommend the
plan?

6. Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (I) at 10% and
equity capitalisation rate (ke) below, calculate the total market value of each firm:

Firms EBIT I ke (%)

X Rs.200000 Rs.20000 12
Y 300000 60000 16
 Z 500000 200000 15
W 600000 200000 18
Also determine the weighted average cost of capital.

7. A company wishes to determine the optimal capital structure. From the following selected information
supplied to you, determine the optimal capital structure of the company.

Situation Debt (Rs.) Equity (Rs.) After-tax cost Ke (%)

of debt (%)
1 400000 100000 9 10
2 250000 250000 6 11
3 100000 400000 5 14

Modigliani and Miller Approach(No Numericals)- Capital Structure Decision of the firm is Irrelevant

The MM proposition supports the NOI Approach relating to the independence of the cost of capital of the
degree of leverage at any level of debt-equity ratio. They offer operational justification for this and are not
content with merely stating the proposition.

Assumptions

The proposition that the weighted average cost of capital is constant irrespective of the type of capital
structure is based on the following assumptions:

a) Perfect capital markets: The implication of a perfect capital market is that (i) securities are infinitely
divisible; (ii) investors are free to buy/sell securities; (iii) cost of borrowing for firms and investors are
same (iv) there are no transaction costs; (v) SYMMETRIC INFORMATION- information is perfect, that is,
each investor has the same information which is readily available to him without cost; and (vi) investors
are rational and behave accordingly.
b) Given the assumption of perfect information and rationality, all investors have the same expectation of
firm’s net operating income (EBIT) with which to evaluate the value of a firm-Common Assumption
c) Business risk is equal among all firms within similar operating environment- Common Assumption
d) The dividend payout ratio is 100 per cent- Common Assumption
e) There are no taxes. This assumption is removed later-Common Assumption

https://www.investopedia.com/terms/m/modigliani-millertheorem.asp

https://study.com/academy/lesson/the-modigliani-miller-theorem-definition-formula-
examples.html

Basic Propositions
There are three basic propositions of the MM Approach:
 The overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure.

Dadar Townside
Cheap Expensive(Same product is having 2 different prices in 2 markets-Arbitrage)
Buy Sell
Demand increases Supply increases
Price increases Price decreases
Till the price is same in two markets

Justification:(Arbitrage)
A(Levered-D+E) B(Unlevered-Equity)
Value of company-More Value of Company-Less
Price-more Price-less
Overvalued Undervalued
SELL BUY
Supply increases, price decreases Demand increases, price increases
Till the time price becomes equal
Capital structure is irrelevant, after a point of time prices will become equal
Value of a company depends on performance of the company

The MM Approach illustrates the arbitrage process with reference to valuation in terms of two firms
which are exactly similar in all respects except leverage so that one of them has debt in its capital
structure while the other does not. The investors of the firm whose value is higher will sell their shares
and instead buy the shares of the firm whose value is lower. The behaviour of the investors will have the
effect of (i) increasing the share prices (value) of the firm whose shares are being purchased; and (ii)
lowering the share prices (value) of the firm whose shares are being sold. This will continue till the
market prices of the two identical firms become identical. Thus, the switching operation (arbitrage)
drives the total value of two homogeneous firms in all respects, except the debt-equity ratio, together.

 As the company starts using debt, the ke increases and the equity-investor is to be compensated for it.
The higher the employment of debt in financing company’s assets, the higher is the financial risk as well
as the financial risk premium. MM proposition II is in conformity with the NOI approach

 The cut off rate of the investment decision of the firm depends upon the risk class to which the firm
belongs, and thus is not affected by the financing pattern of this investment.

Criticism
 The Modigliani-Miller theory of capital structure was criticized because the assumption that capital markets
are perfect is completely unrealistic.
 There are transactions costs in the real world.
 The cost of borrowing is not the same for individuals and firms. The cost of borrowing depends on the
individual credit rating of the borrower. Personal leverage and corporate leverage are, therefore, not perfect
substitutes.
 Many critics of the Modigliani-Miller theory of capital structure believe that assumptions are unrealistic and
that the market value of a firm as well as WACC depends on financial leverage.
 Taxes-Finally, if corporate taxes are taken into account, the MM Approach will fail to explain the relationship
between financing decision and value of the firm. Modigliani and Miller themselves are aware of it and have,
in fact, recognised it.
Without tax, Value of levered firm= value of Unlevered firm-Justified through Arbitrage
With tax, Value of Levered Firm = Value of Unlevered Firm+ Debt*Tax rate

Modigliani and Miller with corporate taxes Propositions

The Modigliani and Miller Approach assumes that there are no taxes, but in the real world, this is far from the
truth. 
MM agree that the value of the firm will increase and cost of capital will decline with leverage, if corporate taxes
are introduced in the exercise. Since interest on debt is tax-deductible, the effective cost of borrowing is less
than the contractual rate of interest. Debt, thus, provides a benefit to the firm because of the tax-deductibility
of interest payments. Therefore, a levered firm would have greater market value than an unlevered firm.
Specifically, MM state that the value of the levered firm would exceed that of the unlevered firm by an amount
equal to the levered firm’s debt multiplied by the tax rate.
Symbolically, Value of Levered Firm = Value of Unlevered Firm+ Debt*Tax rate

Since the value of the levered firm is more than that of the unlevered firm, it is implied that the overall cost of
capital of the former would be lower than that of the latter

https://xplaind.com/161503/modigliani-and-miller-mm-approach

The implication of MM analysis in this case is that the value of the firm is maximised when its capital structure
contains only debt. In other words, a firm can lower its cost of capital continually with increased leverage.
However, the extensive use of debt financing would expose business to high probabilities of default; it would
find it difficult to meet the promised payments of interest and principal. Moreover, the firm is likely to incur
costs and suffer penalties if it fails to make payments of interest and principal when they become due. Legal
expenses, disruption of operations, and loss of potentially profitable investment opportunities may result. As the
amount of debt in the capital structure increases, so does the probability of incurring these costs. Consequently,
there are disadvantages of debt; and excessive use of debt may cause a rise in the cost of capital owing to the
increased financial risk and may reduce the value of the firm.

Again, we find that MM’s proposition is unjustified when leverage is extreme, that is, when the firm uses
virtually 100 per cent debt and no equity. Clearly, the optimal capital structure is not one which has the
maximum amount of debt, but, one which has the desired amount of debt, determined at a point and/or range
 where the overall cost of capital is minimum. Modigliani and Miller also recognise that extreme leverage
increases financial risk as also the cost of capital. They suggest that firms should adopt ‘target debt ratio’ so as
not to violate limits of leverage imposed by the creditors. This suggestion indirectly admits that there is a safe
limit for the use of debt and firms should not use debt beyond that limit/point. It implies that the cost of capital
rises beyond a certain level on the use of debt. There is, therefore, an optimal capital structure
8. Company X and Company Y are in the same risk class and are similar in every respect except that Firm
X uses debt while firm Y does not. The levered firm has Rs.9,00,000 debentures carrying 10 per cent
interest. Both firms earn 20 per cent operating profit on their total assets of Rs.15 lakhs. Assume perfect
capital markets, rational investors so on; a tax rate of 35 per cent and capitalization rate of 15 per cent
for an all equity firm.
(i) Compute the value of the firms X and Y using Net Income Approach.

Company X and Company Y are in the same risk class and are similar in every respect except that Firm
X uses debt while firm Y does not. The levered firm has Rs.9,00,000 debentures carrying 10 per cent
interest. Both firms earn 20 per cent operating profit on their total assets of Rs.15 lakhs. Assume perfect
capital markets, rational investors so on; a tax rate of 35 per cent and capitalization rate of 15 per cent
for an all equity firm.

(ii) Compute the value of each firm and the overall cost of capital (ko) for firms X & Y using the Net
Operating Income Approach.

9.

(iii) Compute the value of the firms X and Y using Net Income Approach.

Other Capital Structure Theories/Costs.

https://www.wallstreetmojo.com/financial-distress/
Bankruptcy Costs: MM assume that there are no bankruptcy costs. However, in practice, excessive use of debt
would involve such costs. These costs expose businesses to high probabilities of default. A firm would find it
difficult to meet the obligations relating to payments of interest and repayment of principal.

Trade-off Theory: The preceding arguments on the use of debt as a means of corporate finance have led to the
genesis of the trade-off theory on capital structure. It trades off the advantage of debt financing (interest tax
shields) against the costs of financial distress (consisting of higher interest rates and bankruptcy costs).

https://www.wallstreetmojo.com/agency-cost/

Asymmetric Information: This is a situation where there is imperfect knowledge. In particular, it occurs where
one party has different information to another.
Asymmetric information is a problem in financial markets such as borrowing and lending. In these markets, the
borrower has much better information about his financial state than the lender. The lender has difficulty
knowing whether it is likely the borrower will default. To some extent, the lender will try to overcome this by
looking at past credit history and evidence of a reliable salary. However, this only gives limited information. The
consequence is that lenders will charge higher rates to compensate for the risk. If there was perfect information,
banks wouldn’t need to charge this risk premium.

Signalling Theory-MM assume that there is an information symmetry about the firm’s prospects between
management and investors/shareholders (i.e., symmetric information). Symmetric information refers to the
situation in which shareholders and managers have identical information about a firm’s prospects.In reality, this
is not true. Managers, in general, have more information about business operations and future prospects of a
firm than its investors. This situation is technically called asymmetric information. The empirical evidence
suggests that the greater the asymmetry in information between the inside managers and outside investors, the
greater is the likely share price reaction to a financing announcement.In operational terms, asymmetric
information has an important impact on the capital structure decisions. Asymmetric information is a situation
in which managers have more information about operations/ prospects of a firm than its investors.

Signaling theory is useful for describing behavior when two parties (individuals or organizations) have
access to different information. Typically, one party, the sender, must choose whether and how to
communicate (or signal) that information, and the other party, the receiver, must choose how to interpret
the signal.
Eg-A company with a lengthy history of dividend increases each year might be signaling to the market that its
management and board of directors anticipate future profits. Dividends are typically not increased unless the
board is certain the cost can be sustained.

Example

Let us assume that the management of a firm (through its Research and Development) has discovered a
new product, leading to a very profitable investment opportunity. Its execution needs additional
financing. In case the corporate decides to sell equity shares when profits start accruing from the new
product, their prices would rise sharply and the new subscribers would be as much benefited as the
current shareholders. Evidently, the existing shareholders would have benefited more, if the additional
financing would not have been through the equity. The issue of equity shares has created a situation in
which the existing shareholders have to share the benefits from increased earnings of a new product with
the new subscribers. In other words, it would be more beneficial to the existing shareholders if the
management uses debt instead of equity to raise the required funds. The decision of issuing debt in such
a favourable situation is consistent with the basic objective of financial management to maximise the
wealth of the existing shareholders.

In view of the above, it is expected that a corporate with very favourable prospects would avoid selling
shares. The required funds should be raised through other means, including debt even beyond the normal
target capital structure. The operational implication is that debt financing is a positive signal suggesting
that the management believes that the share prices are under-valued. In view of the above, shareholders
more often interpret the announcement of a share issue as a negative signal that the firm’s prospects (as
perceived by the management) are not bright and as a result share prices decline.In brief, as per the
signalling theory, debt issues are considered as “good news” and share issues as “bad news”.

Pecking-Order Theory: The pecking-order theory enumerates the preferred order of financing normally followed
by most of the corporates in practice. The firms prefer internal financing/ retained earnings to external
financing. The key principle of pecking-order theory is in conformity with the, signalling theory, the presence of
asymmetric information and the need to incur flotation costs for new issues. The rationale for the preference for
retained earnings is that selling securities to raise funds externally involves flotation costs and which the
corporates would like to avoid. The most profitable companies within an industry tend to have the least amount
of debt/leverage. In view of their large earnings, more often than not, they never need external financing.

https://corporatefinanceinstitute.com/resources/knowledge/finance/pecking-order-theory/
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