Advanced Financial Management – 20MBAFM306 2021

Unit O1
CAPITAL STRUCTURE DECISION
Capital Structure
It is the proposition of debt and preference and equity shares on a firm’s balance sheet.

Factors Influencing Capital Structure

Internal Factors
• Size of Business
• Nature of Business
• Regularity and Certainty of Income
• Assets Structure
• Age of the Firm
• Desire to Retain Control
• Future Plans
• Operating Ratio
• Trading on Equity
• Period and Purpose of Financing
External Factors
• Capital Market Conditions
• Nature of Investors
• Statutory Requirements
• Taxation Policy
• Policies of Financial Institutions
• Cost of Financing
• Seasonal Variations
• Economic Fluctuations
• Nature of Competition

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Essentials of a Sound or Optimal Capital Structure:

• Minimum Cost of Capital
• Minimum Risk
• Maximum Return
• Maximum Control
• Safety
• Simplicity
• Flexibility
• Attractive Rules
• Commensurate to Legal Requirements

ASSUMPTIONS
1. There are only two sources of funds used by the firm: perpetual riskless debt and
ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. Dividend –payout ratio is 100 i.e. the total earnings are paid out as dividend to
shareholders and no retained earnings.
4. Total assets are not changed, investor’s decision is constant.
5. EBIT is not expected to grow.
6. Perpetual life of firm.
7. Business risk is constant over time and is independent of its capital structure and
financial risk.

CAPITAL STRUCTURE AND MARKET VALUE OF FIRM

Market value of the firm is equal to the overall cost of capital of the firm.
Therefore,
WACC or Ko = Ki(B/V) + Ke(S/V)
(OR)

Ko = EBIT/V OR V = EBIT/Ko

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SYMBOLS
S= total market value of equity.
B=total market value of debt.
I=total interest payment.
V= total market value of the firm.
NI= net income available to equity-holders.
Ke= cost of equity.
Kd =Ki= cost of debt.
Ko = overall cost of capital
FORMULAS
Ke= (NI/S)
S= (NI/Ke)
Kd= (I/B)
B= (I/Kd)
Ko= ((S/V)Ke + (B/V)Kd) {or} Ko=EBIT/V
V=(S+B)
NOTE:
Ke is always high.
Kd is always low.
Ko should not be below Kd.
CAPITAL STRUCTURE THEORIES
Different kind’s theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital & value of the firm. The important
theories are discussed below:

1. NET INCOME(NI) APPROACH

Net income (NI) approach, suggested by Durand, the capital structure decision is relevant
to the valuation of firm. i.e. change in financial leverage will lead to a corresponding change
in the overall cost of capital as well as the total value of the firm. If, therefore, the degree of
financial leverage as measured by the ratio of debt to equity is increased, the weighted
average cost of capital will decline, while the value of the firm as well as the market price of
ordinary shares will increase and vice versa.

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ASSUMPTIONS
1. There are no taxes.
2. Cost of debt is less than the equity-capitalization rate or the cost of equity.
3. Use of debt does not change the risk perception of investors.

2. NET OPERATING INCOME (NOI) APPROACH

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 firm and the market price of shares
as well as the overall cost of capital is independent of the degree of leverage.
ASSUMPTIONS
1. Cost of debt remains constant.
2. Cost of capital remains constant.
3. Cost of equity rises.

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3. MODIGLIANI-MILLER (MM) APPROACH

MM Thesis relating to the relationship b/w the capital structure cost of capital and
valuation is identical to NOI approach. NOI approach lacks behavioral significance and
operational justification for the irrelevance of the capital structure.
MM propositions support NOI approach relating to the independence of the cost of capital
of the degree of leverage at any level of debt-equity ratio.
MM approach maintains that the weighted average cost of capital does not change with a
change in the proposition of debt to equity in the capital structure. (As shown in fig)

BASIC PROPOSITION The cost of capital (Ko) and the value of the firm (V) are
independent of its capital structure. The Ko and V are constant for all degrees of leverage.

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ASSUMPTIONS
1. PERFECT CAPITAL MARKETS: implications of this is:
 Securities are infinitely divisible
 Investors are free to buy/sell securities
 Investors can borrow without restrictions on the same terms and conditions as firms
can
2. 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.
3. The dividend payout ratio is 100%
4. There are no taxes. This assumption is removed late

ARBITRAGE PROCESS
The operational justification for the MM hypothesis is the arbitrage process. The term
‘arbitrage’ refers to an act of buying an asset/security in one market at lower prices and
selling it in another at higher price. This process is essentially a balancing operation.
MM approach illustrates the process with reference to valuation in terms of two firms
which are exactly similar in all respects except leverage, so that one firm has debt in its
capital structure while the other does not. Such firms are perfect substitutes according to
Modigliani and Miller. The total value of homogenous firms which differ only in respect of
leverage cannot be different because of the operation of arbitrage. 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. Investors will be able to earn the same return at lower outlay with the same
perceived risk or lower risk. The behavior of the investors will have the effect of
1. Increasing the share price of the firm whose shares are being purchased.
2. Lowering the share price of the firm whose shares are being sold.
This will continue till the market prices of two identical firms become identical. Thus
arbitrage drives the total value of two homogeneous firms in all respect, except the debt-
equity ratio. This process as already indicated, ensures to the investors the same return at
lower outlay as he was getting by investing in the firm whose total value was higher and

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yet, his risk is not increased. This is so because the investors would borrow in the same
proportion of the degree of leverage present in the firm. The use of debt by the investor for
arbitrage is called as ‘Home-made’ leverage. The essence of the arbitrage argument of MM
is that the investors are able to substitute home-made leverage for corporate leverage that
is the use of debt by the firm itself.
Home-made leverage: it can replicate the firm’s capital structure, thereby causing investors
to be indifferent to it.
LIMITATIONS
 The arbitrage process, in turn, is based on assumption of perfect suitability of home-
made leverage with corporate leverage.
 The process is, however, not realistic and exercise is based upon it’s purely theoretical
and not practical relevance.

4. TRADITIONAL APPROACH
The traditional approach is the midway b/w the NI and NOI approaches. It takes some
features of both these approaches. It is also known as “INTERMEDIATE” approach.
The crux of this approach is that through a judicious combination of debt and equity, a firm
can increase its value (V) and reduce its cost of capital (Ko) up to a point. However, beyond
that point, the use of additional debt will increase the financial risk of the investors as well
as of the lenders and as a result it causes a rise in Ko. At such point, the capital structure is
optimum.
ASSUMPTIONS
1. Cost of capital declines, remains constant and then rises.
2. Cost of debt declines, remains constant and then rises.
3. Cost of equity remains constant and then rises.

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EBIT-EPS Analysis

A scientific basis for comparison among various financial plans and shows ways to
maximize EPS. A tool of financial planning that evaluates various alternatives of financing a
project under varying levels of EBIT. Suggests the best alternative having highest EPS and
determinesthe most profitable level of EBIT’.

A firm has various options regarding the combinations of various sources to finance its
investment activities. 1. The firms may opt to be an 2. All-equity firm (and having no
borrowed funds)or 3. Equity-preference firm (having no borrowed funds)or 4. any of the
numerous possibility of combinations of equity, preference shares and borrowed funds.
Given a level of EBIT, a particular combination of different sources of finance will result in a
particular EPS and therefore, for different financing patterns, there would be different
levels of EPS.

Significance of EBIT-EPS Analysis

 Financial Planning
 Comparative Analysis
 Performance Evaluation
 Determining Optimum Mix

Limitations of EBIT-EPS Analysis:

1. No Consideration for Risk

2. Contradictory Results:

3. Over-capitalization:

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ROI & ROE analysis.

Analysts across the globe use ratios such as Return on Equity (ROE) and Return on
Investment (ROI) to identify the investment potential. Although both the metrics define the
health of investment, result of both might not always go in the same direction. It is possible
that a company might have higher ROE but poor ROI, or vice versa. Thus, to understand
which metric to use when, it is crucial to understand the difference between ROI vs ROE.

Return on Equity (ROE)

ROE represents the financial performance of the company, or the money that the company
makes on the basis of the individual’s total ownership stake. The formula to calculate
ROE is net income divided by shareholder’s equity. The formula for
calculating shareholders equity is Asset of the company – Debt.

The purpose of calculating ROE is to find out how effectively the company is utilizing the
assets to earn profits. Net income, in this case, is the total income, net of expense and taxes
for a given period.

ROE could be positive or negative, but it being good or bad depends on the industry
standards. If a company is outperforming peers, then we can say that the company is
performing better than others. However, investors mostly take S&P500 as a benchmark
and compare the return of their investment against the same.

Return on Investment (ROI)

ROI is another financial ratio that calculates the return on investment. The formula for
calculating the ROI is Net income/ Cost of investment Or Investment Gain/ Investment
Base. The first formula is most commonly in use for the calculation of ROI. We can also
calculate ROI for company by dividing EBIT (Earnings Before Interest and Tax) by Total
Investments.

ROI is a straight forward financial ratio. It helps to get a quick understanding of where the
entity stands from the point of view of return. Moreover, this ratio is universally
understood and gives a decent picture of the investment, along with helping investors to
understand and decide the next course of action.

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