CAPITAL STRUCTURE THEORIES

Capital is the major part of all kinds of business activities, which are decided by the size, and
nature of the business concern. Capital may be raised with the help of various sources. If the
company maintains proper and adequate level of capital, it will earn high profit and they can
provide more dividends to its shareholders.

Capital Structure/ Financing Mix.(2Marks):

Capital structure refers to the permanent financing of the company, represented by owned
capital and loan/debt capital (i.e., Preferred Shares, Equity Shares, Reserves and Long-
term Debts).In other words; it includes all long-term funds invested in the business in the
form of Long-term Loans, Preference Shares and Debentures, including Equity Capital
and Reserves.. It is also referred to as the degree of debts in the financing or capital of a
business firm.

Financial structure (2Marks)

The financial structure of a firm comprises of the various ways and means of raising funds.

In other words, financial structure includes all long-term and short-term liabilities.

Optimum capital structure (2Marks)

Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and thereby the value of the firm is maximum.

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

Capital Structure Theories (2Marks)

The capital structure of a company/firm plays a very important role in determining the value of a
firm. There are various theories that propagate the ‘ideal’ capital mix/capital structure for a firm.
Capital Structure Theories refer to those theories which explain the relationship between
the value of firm, overall cost of capital and capital structure.(2 Marks)

Critical theories or approaches to capital structure or financing mix can be grouped as under

a) Relevance Theories and b) Irrelevance Theories

a) Relevance Theories: These theories are those which state that there is a positive the
relationship between Capital Structure, the weighted average cost of capital, and the firm’s
total value. These include Net Income Approach and Traditional Approachheories

b) Irrelevance Theories: These are those theories that advocate that there is no positive
relationship between the Capital Structure, the overall cost of capital, and the firm’s total
value. These include Net Operating Income Approach and

Assumptions of Capital Structure Theories(5Marks)

Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:

a. There are only two sources of funds used by a firm; debt and shares.

b. The firm pays 100% of its earning as dividend.

c. The total assets are given and do not change.

d. The total finance remains constant.

e. The operating profits (EBIT) are not expected to grow.

f. The business risk remains constant.

g. The firm has a perpetual life.

h. The investors behave rationally

Net Income Approach (NI Approach) (5Marks)

Net income approach was first suggested by the David Durand in 1952, and he was a
proponent of financial leverage.

According to this approach, the capital structure decision is relevant to the valuation of the
firm. In other words, a change in the capital structure leads to a corresponding change in
the overall cost of capital as well as the total value of the firm.

According to this approach, more debt finance should be used in the capital structure to reduce
the overall cost of capital and to increase the value of firm.

Assumptions of Net Income Approach(NI Approach)

The net income approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources of
finance like Preference Share Capital and Retained Earnings.
 Dividend payout ratio is 100 percent
 There is no flotation cost, no transaction cost, and corporate dividend tax.
 The capital market is perfect; it means information about all companies is available
to all investors, and there are no chances of overpricing or underpricing of security.
 All investors are rational. So, all investors want to maximize their return by
minimizing risk.
 All sources of finance are for infinity. There are no redeemable sources of finance.
Determination of valuation of firm (V) and Overall cost of Capital/Weighted Average of
capital/Composite cost of capital (Ko) under Net Income Approach

Books of ---------

Statement of Valuation of Firm (V) and Overall Cost of Capital/Weighted Average Of

Capital/Composite Cost Of Capital (Ko)

Particulars Amount(Rs)
EBIT/Operating Profit/Net Income xxx
Less interest on Debentures(Debt Amount x Interest xxx
Rate/Cost of Debt)
EBT(if tax rate is given) Otherwise Earnings Available xxx
to Equity Shareholders
Less Tax (If tax rate is given) xxx
Earnings Available to Equity Shareholders xxx
Equity Capitalisation rate xxx
Market Value of Equity(S) xxx
(Earnings Available to the Equity Shareholders/
Equity Capitalisation rate)
Add Market Value of Debentures xxx
Total Market Value of Firm(V) xxx
Ko= (EBIT/V) X 100 xxx in Percentage

Net Operating Income (NOI) Approach (5Marks)

This is another modern theory of capital structure, suggested by Durand. This is just the
opposite of the Net Income approach.

According to this approach, Capital Structure decision is irrelevant to the valuation of the firm.
The market value of the firm is not at all affected by the capital structure changes.

According to this approach, the change in capital structure will not lead to any change in the
total value of the firm and market price of shares as well as the overall cost of capital.

As per this approach, the WACC/Overall Cost of capital and the total value of a company
are independent of the company’s capital structure decision or financial 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 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, a
change in the debt to equity ratio cannot change the firm’s value.

It further says that with the increase in the debt component of a company, the company is
faced with higher risk. To compensate for that, the equity shareholders expect more
returns. Thus, with an increase in financial leverage, the cost of equity increases.
Assumptions;
NOI approach is based on the following important assumptions;
1. The overall cost of capital remains constant,
2. There are no corporate taxes
3.Value of equity is residual i.e., the difference between total firm value and less value of
debt, i.e., Value of Equity = Total Value of the Firm – Value of Debt.

4. The business consists of the same level of business risk.

5. The segregation of debt and equity is not important here and the market capitalises the
value of the firm as a whole.

Determination of valuation of firm (V) and Cost of Equity Capital/Equity Capitalisation

Rate (Ke) under Net Operating Income Approach

1. Valuation of Firm= (EBIT/Ko) =Rs. ----------- Where EBIT stands for ‘ Earnings before
interest and taxes and ‘Ke’ stands for Overall cost of Capital

2. Market Value of Equity(S)=V –D Where ‘V’ stands for Valuation of Firm and ‘D ‘
stands for Market Value of Debentures

3. Equity Capitalisation Rate =(EBIT-Interest)/ Market Value of Equity(S) x 100

Determination of valuation of firms (V) under Net Operating Income Approach when two
identical firms are given

1.Value of Unlevered firm(Vu) when tax rate is not given

Vu=EBIT/Ko

2.Value of Levered firm(VL)

VL= Vu +t x D Where stands for Value of Unlevered firm, ‘t’ for tax
rate and ‘D’ for Market Value of Debentures

1.Value of Unlevered firm(Vu) when tax rate is given

Vu=EBIT(1-t)/Ko where EBIT stands for ‘Earning before Interest

Taxes’ ‘t’ for tax and Ko for overall Capitalisation rate

2.Value of Levered firm(VL)

VL= Vu +t x D Where stands for Value of Unlevered firm, ‘t’ for tax
rate and ‘D’ for Market Value of Debentures

Net Income Vs Net operatin Income Approach/ Differences between Net Income Vs Net
operatin Income Approach

Basis Net Income Net operatin Income Approach

Role of There is relevance of capital There is no relevance of capital structure

Capital structure in the value of firm in the value of firm
Structure
Degree of Assumes change in the degree of Assumes degree of leverage irrelevant to
leverage and leverage will alter overall cost of the cost of capital
cost of capital capital
Assumptions There are no corporate taxes Cost of capital is always constant
Cost of debt is cheaper than the cost Value of equity is residual
of equity
Debt does not change the perception Increase in debt increases the
of investors expectations of shareholders