Capital Structure

Capital Structure
• Capital structure is the proportion of debt,
preference and equity shares on a firm’s
balance sheet.
 Optimal Capital Structure
• Optimum Capital Structure is the capital
structure at which the weighted average cost
of capital is minimum and thereby maximum
value of the firm.
 Assumptions of Capital Structure
• There are only two sources of funds used by a firm:
perpetual riskless debt and equity shares.
• Perpetual life of the firm
• Investment decision of the firm remain same.
• Maximisation of value of the firm is consistent with
maximisation of shareholders’ wealth
• Optimal capital structure is one that minimises WACC
• No retained earnings
 Theories of Capital Structure
• Net Income approach
• Net operating income approach
• Traditional approach
• Modigliani and Miller approach (MM
Approach)
 Net Income approach
• Capital structure decision is relevant to the
valuation of the firm.
• A change in the financial leverage will lead to a
corresponding change in the WACC as well as
total value of the firm.
• If degree of financial leverage increases, WACC
will decline, while the value of the firm will
increase.
 Assumptions of NI Approach
• No taxes
• Cost of debt is less than the cost of equity
• Use of debt does not change the risk
perception of investors.
Formula
• Total Value of firm = value of debt + Value of
equity
 Net Income Approach
  Scenario Scenario Scenario
A B C
Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance      
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate      
Equity, re 20% 20% 20%
Debt, rd 10% 10% 10%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

Chapter 16 Capital Structure – Theory 11

 Net Income Approach
Capitalization Rates
EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders
Market value of debt 100.00 500.00 900.00
(I/rd)
Market value of 2,450.00 2,250.00 2,050.00
equity
(EBIT – I - Taxes)/re
Total Value of the 2,550.00 2,750.00 2,950.00
firm
Overall capitalisation 19.61% 18.18% 16.95%
rate (r)

Chapter 16 Capital Structure – Theory 12

 Net Operating Income approach
• Capital structure of the firm is irrelevant.
• Any change in leverage will not lead to any
change in total value of the firm.
 Assumptions
• WACC is constant
• Total value of equity = Total value of firm –
Total value of debt
• Cost of equity increases with increased use of
debt capital or financial leverage.
• No optimum capital structure.
 Cost of equity

WACC
Cost of
Capital
Cost of debt

Degree of leverage
 Formula
• Total market value of firm = EBIT/WACC
• Total market value of equity = Total market
value of firm – Total market value of debt
 EXAMPLE
  Scenario Scenario Scenario
A B C
Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance      
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate      
Debt 10% 10% 10%
Overall 20% 20% 20%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

 SOLUTION
EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders (EAT)

Market value of debt 100.00 500.00 900.00

(I/rd)
Market value of firm 2,500.00 2,500.00 2,500.00
(EBIT/r)

Value of equity (E) 2,400.00 2,000.00 1,600.00

Equity capitalisation 20.42% 22.50% 25.63%

rate (EAT/E)
 Modigliani and Miller approach (MM Approach)

• Proposition I ( In the absence of taxes)

• Proposition II (In the presence of taxes)
 Assumptions
• The overall cost of capital and value of the firm
remain constant for all the degrees of leverage.
• With increased use of debt, cost of equity increases.
• No retained earnings
• No transaction cost
• Information is available free of cost to all the
investors.
• Substitution of personal leverage for corporate
leverage.
 Propositions I (Absence of taxes)
• Change in leverage will not lead to any change
in total value of the firm.
• The Proposition I is based on the concept of
arbitrage process.
• The term arbitrage refers to an act of buying a
security in one market at lower price and
selling it in another market at higher prices.
Continued…
• If two firms are similar in all respects except
leverage, the total value of both the firms can
not be different because of operation of
arbitrage.
• The investors of the firm whose value is higher
will sell their shares and instead will buy the
shares of the firm whose value is lower.
 Presence of taxes
• Based on the assumption of taxes
• Capital structure affects the value of the firm
• Value of levered firm = value of Unlevered firm
+ Present value of tax shield
• VL = VU + T x D
 Traditional Approach
• Traditional approach is a midway between the
NI approach and NOI approach.
• Through judicious use of debt-equity
proportions, a firm can reduces its overall cost
of capital and thereby increase its total value .
• Because debt is the cheaper source of funds.
Continued…
• If use of debt increases , WACC will decline, while the value of
the firm will increase.
• If use of debt is increased further, the cost of equity will
increase and advantage of using debt is more, therefor WACC
will still decrease.
• If debt is used after this level, the cost of equity will increase
more and advantage of using debt will be exactly offset with
increased cost of equity. Therefore WACC will remain constant.
• Beyond a certain level of debt, the cost of equity as well as cost
of debt will increase and therefore WACC will also start
increasing and value of the firm will decrease
 TRADITIONAL APPROACH - CAPITALISATION RATES

Rates of
Return c = optimal capital structure

re
r0

r
rd

D/E
0 c
 Factors Affecting Capital Structure
1. Tangible Fixed Assets ( If High – More debt)
2. Control (Desire to control – More debt)
3. Nature of Industry ( If sales fluctuate widely –
less debt)
4. Earning capacity of the firm ( If higher
earning firm – More debt)
5. Size of the firm ( Large – More debt)
6. Nature of the firm
 Continued…
7. Tax Planning
8. Timing of issue (good state of economy and
capital market– equity capital)
9. Flexibility