Hardika Jadav

 Capital structure refer to the proportion between the

various long term source of finance in the total capital
of firm.
 A financial manager choose that source of finance
which include minimum risk as well as minimum cost
of capital.
 Sources of long
term finance

Proprietor’s borrowers
funds capital

Reserve and Long term

Equity capital
surplus Debts

Preference
capital
 Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed
capital(debentures, loans from banks, financial
institutions)
 Maximization of shareholders’ wealth is prime
objective of a financial manager. The same may be
achieved if an optimal capital structure is designed for
the company.
 Planning a capital structure is a highly psychological,
complex and qualitative process.
 It involves balancing the shareholders’ expectations
(risk & returns) and capital requirements of the firm.
 Capital structure determine the risk assumed by the
firm
 Capital structure determine the cost of capital of the
firm
 It affect the flexibility and liquidity of the firm
 It affect the control of the owner of the firm
 Trading on Equity- The word “equity” denotes the ownership of
the company.
 Trading on equity means taking advantage of equity share capital
to borrowed funds on reasonable basis.
 It refers to additional profits that equity shareholders earn
because of issuance of debentures and preference shares.
 It is based on the thought that if the rate of dividend on
preference capital and the rate of interest on borrowed capital is
lower than the general rate of company’s earnings, equity
shareholders are at advantage which means a company should go
for a judicious blend of preference shares, equity shares as well
as debentures.
 Trading on equity becomes more important when expectations of
shareholders are high.
 In a company, it is the directors who are so called elected
representatives of equity shareholders.
 These members have got maximum voting rights in a concern as
compared to the preference shareholders and debenture holders.
 Preference shareholders have reasonably less voting rights while
debenture holders have no voting rights.
 If the company’s management policies are such that they want to
retain their voting rights in their hands, the capital structure
consists of debenture holders and loans rather than equity shares.
 Flexibility of financial plan-
 In an enterprise, the capital structure should be such that there is
both contractions as well as relaxation in plans.
 Debentures and loans can be refunded back as the time requires.
While equity capital cannot be refunded at any point which
provides rigidity to plans.
 Therefore, in order to make the capital structure possible, the
company should go for issue of debentures and other loans.
 Choice of investors-
 The company’s policy generally is to have different categories of
investors for securities.
 Therefore, a capital structure should give enough choice to all
kind of investors to invest.
 Bold and adventurous investors generally go for equity shares
and loans and debentures are generally raised keeping into mind
conscious investors.
 Capital market condition-
 In the lifetime of the company, the market price of the
shares has got an important influence.
 During the depression period, the company’s capital
structure generally consists of debentures and loans.
 While in period of boons and inflation, the company’s
capital should consist of share capital generally equity
shares.

 Period of financing-
 When company wants to raise finance for short period, it
goes for loans from banks and other institutions; while for
long period it goes for issue of shares and debentures.
 Cost of financing-
 In a capital structure, the company has to look to the
factor of cost when securities are raised.
 It is seen that debentures at the time of profit earning of
company prove to be a cheaper source of finance as
compared to equity shares where equity shareholders
demand an extra share in profits.
 Stability of sales- An established business which has a growing
market and high sales turnover, the company is in position to
meet fixed commitments.
 Interest on debentures has to be paid regardless of profit.
Therefore, when sales are high, thereby the profits are high and
company is in better position to meet such fixed commitments
like interest on debentures and dividends on preference shares.
 If company is having unstable sales, then the company is not in
position to meet fixed obligations.
 So, equity capital proves to be safe in such cases.
 Sizes of a company- Small size business firms capital structure
generally consists of loans from banks and retained profits.
 While on the other hand, big companies having goodwill,
stability and an established profit can easily go for issuance of
shares and debentures as well as loans and borrowings from
financial institutions.
 The bigger the size, the wider is total capitalization.
 The optimal or the best capital structure implies the most
economical and safe ratio between various types of
securities.
 It is that mix of debt and equity which maximizes the value
of the company and minimizes the cost of capital.
 Value of a firm depends upon earnings of a firm and its cost
of capital (i.e. WACC).
 Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
 Value of firm is derived by capitalizing the earnings by its
cost of capital (WACC).
 Value of Firm = Earnings / WACC
 Thus, value of a firm varies due to changes in the earnings
of a company or its cost of capital, or both.
 Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings
 Firms use only two sources of funds –equity & debt.
 No change in investment decisions of the firm, i.e. no change
in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
 Net Income (NI) Theory

 Net Operating Income (NOI) Theory

 Traditional Theory

 Modigliani-Miller (M-M) Theory

 Net Income Approach was presented by Durand.
 The theory suggests increasing value of the firm by decreasing
the overall cost of capital which is measured in terms of
Weighted Average Cost of Capital.
 This can be done by having a higher proportion of debt, which is
a cheaper source of finance compared to equity finance.
 According to Net Income Approach, change in the financial
leverage of a firm will lead to a corresponding change in the
Weighted Average Cost of Capital (WACC) and also the value of
the company.
 The Net Income Approach suggests that with the increase in
leverage (proportion of debt), the WACC decreases and the value
of firm increases.
 On the other hand, if there is a decrease in the leverage, the
WACC increases and thereby the value of the firm decreases.
 The increase in debt will not affect the confidence levels of the
investors.
 The cost of debt is less than the cost of equity.
 There are no taxes levied.
1. The Value of the firm (V)
V= S+B
 V= Value of the firm
 S= Market value of the equity
 B= Market value of the debt

Market Value of the equity (S)

S=NI/Ke
 NI=Earnings available for the shareholders
 Ke= Equity capitalization rate

 Overall cost of capital(Ko)

EBIT/V
Particulars Amount
Net operating income(NOI) or earning before interest and Xxxx
taxes(EBIT)
Less(-) Interest on debentures Xxxx
(NI) =Earnings available for equity shareholders (EBIT-I) Xxxx
S=Market value of the equity share (NI/Ke) Xxxx
B=Market value of the debentures xxxx
V= Total value of the firm (S+B) Xxxx
Ko= Over all cost of capital (EBIT/V) xxxx
Earnings before Interest Tax (EBIT) 100,000

Bonds (Debt part) 300,000

Cost of Bonds issued (Debt) 10%

Cost of Equity 14%

EBIT 100,000

Less: Interest cost (10% of 300,000) 30,000

Earnings after Interest Tax

(since tax is assumed to be absent) 70,000

Shareholder’s Earnings 70,000

Market value of Equity (70,000/14%) 500,000

Market value of Debt 300,000

Total Market value 800,000

EBIT/(Total value of firm) 100,000/800,000

Overall cost of capital 12.5%

EBIT 100,000

Less: Interest cost (10% of 400,000) 40,000

Earnings after Interest Tax

(since tax is assumed to be absent) 60,000

Shareholder’s Earnings 60,000

Market value of Equity (60,000/14%) 428,570 (approx)

Market value of Debt 400,000

Total Market value 828,570

EBIT/(Total value of firm) 100,000/828,570

Overall cost of capital 12% (approx)

 As observed, in case of Net Income Approach, with increase in
debt proportion, the total market value of the company increases
and cost of capital decreases.
 A company expects its annual EBIT to be Rs.50,000.
 The company has Rs.200,000 in 10% bonds and the cost of
equity is 12.5(ke)%.
 Let us assume that the firm decides to retire Rs.100,000 worth of
equity by using the proceeds of new debt issue worth the same
amount.
 The cost of debt and equity would remain the same as per the
assumptions of the NI approach.
EBIT 50,000

Less: Interest cost (10% of 200,000) 20,000

Earnings after Interest Tax 30,000

(since tax is assumed to be absent)

Shareholder’s Earnings 30,000

Market value of Equity (30,000/12.5%) 240,000

Market value of Debt 200,000

Total Market value 440,000

EBIT/(Total value of firm) 50,000/440,000

Overall cost of capital 11.36%

EBIT 50,000

Less: Interest cost (10% of 300,000) 30,000

Earnings after Interest Tax 20,000

(since tax is assumed to be absent)

Shareholder’s Earnings 20,000

Market value of Equity (20,000/12.5%) 160,000

Market value of Debt 300,000

Total Market value 460,000

EBIT/(Total value of firm) 50,000/460,000

Overall cost of capital 10.87%

This proves that the use of additional financial leverage (debt) causes
the value of the firm to increase and the overall cost of capital to
decrease.
 K.M.C. Ltd. Expects annual net income (EBIT) of Rs.2,00,000
and equity capitalization rate of 10%. The company has
 Rs.6,00,000; 8% Debentures. There is no corporate income tax.
 (A) Calculate the value of the firm and overall (weighted
average) cost of capital according to the NI Theory.
 (B) What will be the effect on the value of the firm and overall
 cost of capital, if:
 (i) the firm decides to raise the amount of debentures by Rs.4,00,000 and
uses the proceeds to repurchase equity shares.
 (ii) the firm decides to redeem the debentures of Rs. 4,00,000 by issue of
 equity shares.
 EBIT of a firm Rs. 200,000. Ke = 10% , Kd = 6%
 Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
EBIT 200,000 200,000 200,000

Less: Interest cost 30,000 42,000 12,000

Earnings after Interest Tax 170,000 158,000 188,000

(since tax is assumed to be absent)

Shareholder’s Earnings 170,000 158,000 188,000

Market value of Equity 17,00,000 15,80,000 18,80,000

Market value of Debt 500,000 7,00,000 2,00,000

Total Market value 22,00,000 22,80,000 20,80,000

EBIT/(Total value of firm) 200,000/22,00, 200,000/22,8 200,000/2

000 0,000 0,80,000
Overall cost of capital 9.09% 8.77% 9.62%
 Net Operating Income Approach was also suggested by Durand.
 This approach is of the opposite view of Net Income approach.
 This approach suggests that the capital structure decision of a
firm is irrelevant and that any change in the leverage or debt will
not result in a change in the total value of the firm as well as the
market price of its shares.
 This approach also says that 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.
 Therefore, change in debt equity ratio cannot make any
change in the value 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.
 At all degrees of leverage (debt), the overall capitalization rate
would remain constant. For a given level of Earnings before Interest
and Taxes (EBIT), the value of a firm would be equal to
EBIT/overall capitalization rate.
 The value of equity of a firm can be determined by subtracting the
value of debt from the total value of the firm. This can be denoted as
follows:
Value of Equity = Total value of the firm - Value of debt
 Cost of equity increases with every increase in debt and the
weighted average cost of capital (WACC) remains constant. When
the debt content in the capital structure increases, it increases the
risk of the firm as well as its shareholders.
 To compensate for the higher risk involved in investing in highly
levered company, equity holders naturally expect higher returns
which in turn increases the cost of equity capital.
1. The overall capitalization rate remains constant irrespective of
the degree of leverage. At a given level of EBIT, value of the
firm would be “EBIT/Overall capitalization rate”
2. Value of equity is the difference between total firm value less
value of debt i.e. Value of Equity = Total Value of the Firm –
Value of Debt
3. WACC remains constant; and with the increase in debt, the cost
of equity increases. An increase in debt in the capital structure
results in increased risk for shareholders. As a compensation of
investing in the highly leveraged company, the shareholders
expect higher return resulting in higher cost of equity capital.
1. The Value of the firm (V)
V=EBIT/Ko
 V= Value of the firm
 EBIT= Earnings before Interest Tax
 Ko=Overall cost of capital
E=V-B
Market Value of the equity (E)

 V= Value of the firm

 B= Market value of the debt
 Ke= Equity capitalization rate
Ke= (EBIT-I) / (V-B)

 The validity of the NOI approach can be verified with the help
of following formula :

Ko= Kd(B/V) +Ke(S/V)

Earnings before Interest Tax (EBIT)
100,000
Bonds (Debt part)
300,000
Cost of Bonds issued (Debt)
10%
WACC
12.5%
EBIT 100,000
WACC 12.5%
Market value of the 100,000/12.5% 800,000
company(EBIT/WACC)
Total Debt 300,000
Total Equity(Total market 800,000-300,000 500,000
value – total debt)
Shareholders earnings 100,000-10% of 300,000 70,000
(EBIT – Interest on Debt)
Cost of equity 70,000/500,000 14%
((EBIT-I) / (V-B))
Ko= Kd(B/V) +Ke(S/V) 12.5=10(300,000/800,000)+14(500,000/800,000
)
EBIT 100,000
WACC 12.5%
Market value of the 100,000/12.5% 800,000
company(EBIT/WACC)

Total Debt 400,000

Total Equity(Total market 800,000-400,000 400,000
value – total debt)
Shareholders earnings 100,000-10% of 60,000
(EBIT – Interest on Debt) 400,000
Cost of equity 60,000/400,000 15%
((EBIT-I) / (V-B))
Ko= Kd(B/V) +Ke(S/V) 12.5=10(400,000/800,000)+15(400,000/800,000
 Let us assume that a firm has an EBIT level of Rs.50,000,
cost of debt 10%, the total value of debt Rs.200,000 and the
WACC is 12.5%. Let us find out the total value of the firm
and the cost of equity capital (the equity capitalization rate).

EBIT 50,000
WACC 12.5%
Market value of the 50,000/12.5% 400,000
company(EBIT/WACC)
Total Debt 200,000
Total Equity(Total market 400,000-200,000 200,000
value – total debt)
Shareholders earnings 50,000-10% of 30,000
(EBIT – Interest on Debt) 200,000
Cost of equity 30,000/200,000 15%
((EBIT-I) / (V-B))
Ko= Kd(B/V) +Ke(S/V) 12.5=10(200,000/400,000)+15(200,000/400,0
00)
 Let us now assume that the leverage increases from
Rs.200,000 to Rs.300,000 in the firm's capital structure. The
firm also uses the proceeds to re-purchase its equity stock
so that the market value of the firm remains the same at
Rs.400,000.
EBIT 50,000
WACC 12.5%
Market value of the 50,000/12.5% 400,000
company(EBIT/WACC)
Total Debt 300,000
Total Equity(Total market 400,000-300,000 100,000
value – total debt)
Shareholders earnings 50,000-10% of 20,000
(EBIT – Interest on Debt) 300,000
Cost of equity 20,000/100,000 20%
((EBIT-I) / (V-B))
Ko= Kd(B/V) +Ke(S/V) 12.5=10(300,000/400,000)+20(100,000/400,0
00)
 The above example proves that a change in the
leverage does not affect the total value of the firm,
the market price of the shares as well as the overall
cost of capital.

 Modigliani Millar approach, popularly known as the MM
approach is similar to the Net operating income approach.
 The MM approach favors the Net operating income approach and
agrees with the fact that the cost of capital is independent of the
degree of leverage and at any mix of debt-equity proportions.
 The significance of this MM approach is that it provides
operational or behavioral justification for constant cost of capital
at any degree of leverage.
 Whereas, the net operating income approach does not provide
operational justification for independence of the company's cost
of capital.
 This approach was devised by Modigliani and Miller during
1950s. The fundamentals of Modigliani and Miller Approach
resemble that of Net Operating Income Approach.
 Modigliani and Miller advocate capital structure irrelevancy
theory. This suggests that the valuation of a firm is irrelevant to
the capital structure of a company.
 Whether a firm is highly leveraged or has lower debt component
in the financing mix, it has no bearing on the value of a firm.
 Modigliani and Miller Approach further states that the market
value of a firm is affected by its future growth prospect apart
from the risk involved in the investment.
 The theory stated that value of the firm is not dependent on the
choice of capital structure or financing decision of the firm.
 If a company has high growth prospect, its market value is higher
and hence its stock prices would be high.
 If investors do not see attractive growth prospects in a firm, the
market value of that firm would not be that great.
 Capital markets are perfect.
 All investors have the same expectation of the company's net
operating income for the purpose of evaluating the value of the
firm.
 Within similar operating environments, the business risk is equal
among all firms.
 100% dividend payout ratio.
 An assumption of "no taxes" was there earlier, which has been
removed.
 Proposition 1: With the above assumptions of “no taxes”, the
capital structure does not influence the valuation of a firm. In
other words, leveraging the company does not increase the
market value of the company. It also suggests that debt holders in
the company and equity shareholders have the same priority i.e.
earnings are split equally amongst them.
 Proposition 2: It says that financial leverage is in direct
proportion to the cost of equity. With an increase in debt
component, the equity shareholders perceive a higher risk to
for the company. Hence, in return, the shareholders expect a
higher return, thereby increasing the cost of equity. A key
distinction here is that proposition 2 assumes that debt-
shareholders have upper-hand as far as the claim on
earnings is concerned. Thus, the cost of debt reduces.
Value of the Firm VL = VU VL = VU + tD

WACC WACC = (B / VL ) (1 – tc )
rb + (S / VL ) re
re = ru + (B / S) (1 – tc )
Cost of Equity re = ru + (ru - rb) B / S
(ru – rb)
 M&M Proposition I:
Value of unlevered firm = value of levered firm
 Proposition I: VL = VU
 Vu= S= (EBIT) / ru
 VL= [Interest + (EBIT - Interest)] / ru
 S = VL – B

 Where
 Vu= value of unlevered firm
 VL = Value of levered firm
 B= value of debt
 S= value of equity
 Ru /Ra= cost of capital for all-equity firms in this risk class
 Proposition II: re = ru + (B/S ) (ru – rb)
 M&M Proposition II:
re = ru + (ru - rb) B / S
rb = cost of debt
re = cost of equity
ru = cost of capital for all-equity firms in this risk class
B = value of debt
S = value of stock or equity.
Investment Alternative Initial investment = 5,000
Value of debt =1000 for levered firm
EBIT = 1,000 forever
re /ru =10% for equity hold co.

Required return on unlevered equity

Financing Alternatives
Unlevered Levered
Equity 5,000 4,000
1,000
Debt (rb = 5%)
cash flow Unlevered Levered
EBIT 1,000 1,000
–Interest –50= (.05)1,000
EBT 1,000 950
–Tax (0%) ---- ----
Net income 1,000 950
Cash flows debt + equity 1,000 1,000
 Proposition I: VL = VU
VU = S = (EBIT) / ru = 1,000 / .1 = 10,000
VL = [Int + (EBIT - Int)] / ru =1,000 / .1 = 10,000
S = VL – B = 10,000 – 1,000 = 9,000
Þ Capital structure: irrelevant without corporate taxes
 Proposition II: re = ru + (B/S ) (ru – rb)
re = .10 + (1,000 / 9,000) (.10 – .05) = 10.556%
 WACC = (B / VL ) (1 – tc ) rb + (S / VL ) re =
(1000/10000)(0.05)+(9000/10000)(.10556)=0.005+.095004=10%

 Observation: Though Re of the firm increases from 10% to 10.556% and

the overall cost of capital remain same.
 Imperfections do exist in capital market The assumption of
perfect capital market is practically not correct. Imperfections are
bound to exist in capital market due to many varied factors.
Because of imperfections in capital market, arbitrage may fail to
work and market value of levered and unlevered firm may vary.

 The assumptions of rate of interest fails in practice The

hypothesis assumes that firms and individuals can lend and
borrow funds at the same rate of interest. Firm have always
higher creditworthiness hence they can borrow at cheaper rate of
interest than individuals.
 Personal leverage is not a substitute for corporate leverage The
hypothesis assumes that personal or homemade leverage is a perfect
substitute for corporate leverage which is not correct. This is because in
case of shareholders the liability is limited to the extent of their
investments only. Where as an individuals liability is unlimited. Thus,
it is more risky to create personal leverage and invest in the unlevered
firm than investing directly in the levered firm.

 The assumption of the absence of transaction cost is also not correct

Transaction cost of buying and selling securities does exist. Due to
transaction cost, it is necessary to invest more amounts to earn the
same return.

 Corporate tax does exist The assumption of non-existence of corporate

tax is also not correct. Practically interest charges are tax deductible.
This makes the cost of borrowing cheaper than the annual rate of
interest. Tax advantage results in large return in case of a levered firm
if return on investment is more than the rate of interest.
 The Modigliani and Miller Approach assumes that there are no
taxes. But in the real world, this is far from the truth. Most
countries, if not all, tax a company. This theory recognizes the
tax benefits accrued by interest payments. The interest paid on
borrowed funds is tax deductible.
 In 1963 M.M. in their article discussed the existence of corporate
tax and its impact on tax liability and value of the levered firm.
They held that because of deductibility of interest charges for tax
computation, the value of the levered firm would be higher than
that of the unlevered firm.
 M&M Proposition I:

VL = VU + t C B
 VU = EBIT (1 – tC) / ru
 VL = VU + t C B
 S = VL – B
 M&M Proposition II:

re = ru + (B / S) (1 – tc ) (ru – rb)
where
tc = Corporate tax rate
Other variables are as previously defined.
Investment and financing alternatives - same as before
Debt=1000
After-tax cost of capital for unlevered firm ru = 10%; tC =
34%
Cash flow Unlevered Levered
EBIT 1,000 1,000
–Interest ----- –50= (.05)1,000
EBT 1,000 950
–Tax (34%) – 340 – 323
Net income 660 627
Cash flow debt + 660 677(627+50)
equity
 Proposition I: VL = VU + tC B
VU = EBIT (1 – tC) /ru 660 / .1 6,600
VL= VU + t C B 6,600+(0.34*1000) 6,940
S= VL – B 6940-1000 5,940.

Proposition II: re = ru + (B / S ) (1 – tc ) (ru – rb )

re = .10 + (1,000 / 5,940) (1 – .34) (.10 – .05) = 10.556%

WACC = (B / VL ) (1 – tc ) rb + (S / VL ) re

= (1,000 / 6,940) (1 – .34) (.05) +(5,940 / 6,940) (.10556) =9.51%.

Observation: Though Re of the firm increases from 10% to 10.556% and the
overall cost of capital decreases from 10% to9.56% with tax effect.
 Modigliani and Miller /approach indicates that value of a
leveraged firm (a firm which has a mix" of debt and
equity) is the same as the value of an unleveraged firm
(a firm which is wholly financed by equity) if the
operating profits and future prospects are same "That
is, if an investor purchases shares of a leveraged firm, it
would cost him the same as buying the shares of an
unleveraged firm.
 It is the mix of Net Income approach and Net Operating
Income approach.
 Hence, it is also called as intermediate approach. According to
the traditional approach, mix of debt and equity capital can
increase the value of the firm by reducing overall cost of capital
up to certain level of debt.
 Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the
minimum level, it starts increasing with financial leverage.
 The traditional approach to capital structure advocates that there
is a right combination of equity and debt in the capital structure,
at which the market value of a firm is maximum. As per this
approach, debt should exist in the capital structure only up to a
specific point, beyond which, any increase in leverage would
result in the reduction in value of the firm.
 It means that there exists an optimum value of debt to
equity ratio at which the WACC is the lowest and the
market value of the firm is the highest. Once the firm
crosses that optimum value of debt to equity ratio, the cost
of equity rises to give a detrimental effect to the WACC.
Above the threshold, the WACC increases and market value
of the firm starts a downward movement..
Particulars Case 1 Case 2 Case 3 Case 4 Case 5
Weight of
10% 30% 50% 70% 90%
debt
Weight of
90% 70% 50% 30% 10%
equity
Cost of
10% 11% 12% 14% 16%
debt
Cost of
17% 18% 19% 21% 23%
equity
16.3% 15.9% 15.5% 16.1% 16.7%
WACC
 As observed, with the increase in the financial leverage of the
company, the overall cost of capital reduces, despite the
individual increases in the cost of debt and equity respectively.
The reason being that debt is a cheaper source of finance.

 Now, look at the situation in case 3 to case 5, the company

increases its financial leverage further and as a result, the debt is
increased from 50% to 90% and equity from 50% to 10%. The
cost of debt and equity rise further. The new WACC is increased
from 15.5% to 16.7%. As observed, with the increase in the
financial leverage of the company, the overall cost of capital
increases.