CAPITAL STRUCTURE

THEORIES

BY:
SHWETA GOEL
 CAPITAL STRUCTURE 2

 Capital structure can be defined as the mix of owned capital

(Equity) and borrowed capital( Debt) used by a firm to finance its
overall operations and growth.
 Maximization of shareholders’ wealth is prime objective of a
financial manager.
 The aim of finance manager is to maximise the value of the firm
and minimizing the cost of capital by choosing optimum capital
structure.
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 VALUE OF FIRM 3

• The value of firm depends on the earnings of the firm and the
earnings depend on investment decision of firm.
• The earnings of firm are capitalized at a rate equal to cost of
capital to find out the value of the firm.
• So the value of firm depend on two factors
 Earnings of the firm
 Cost of Capital
 Capitalization refers to the total amount of long-term funds
employed by the firm.
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 COST OF CAPITAL AND WACC 4

• Cost of Capital is the rate of return the firm expects to earn from
its investment in order to increase the value of the firm in the
marketplace. In other words, it is the rate of return that the
suppliers of capital require as compensation for their contribution
of capital. Cost of Equity is denoted by Ke and Cost of Debt is
denoted by Kd
• Firm’s Weighted Average Cost of Capital (WACC) represents its
blended cost of capital across all sources, including common
shares, preferred shares, and debt. The cost of each type of
capital is weighted by its percentage of total capital and they are
added together.
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 5

• WACC
  =
where ,
E = Equity
D= Debt
Ke = Cost of Equity
Kd = Cost of Debt
V= Value of firm which is E+D
T = Tax rate
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 PATTERNS OF CAPITAL STRUCTURE 6

(A) WITH THE ISSUE (B) WITH THE ISSUE (C) WITH THE ISSUE (D) WITH THE ISSUE
OF EQUITY SHARE OF BOTH EQUITY OF EQUITY SHARES OF EQUITY SHARES,
ONLY. SHARE AND AND DEBENTURES, PREFERENCE
PREFERENCE A SHARES AND
SHARES. DEBENTURES.

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CAPITAL VS FINANCIAL STRUCTURE 7

BASIS FOR
CAPITAL STRUCTURE FINANCIAL STRUCTURE
COMPARISON

Meaning The combination of long term sources of funds, which The combination of long term and short term financing
are raised by the business is known as Capital represents the financial structure of the company.
Structure.

Appear on Balance Under the head Shareholders fund and Non-current The whole equities and liabilities side.
Sheet liabilities.

Includes Equity capital, preference capital, retained earnings, Equity capital, preference capital, retained earnings,
debentures, long term borrowings etc. debentures, long term borrowings, account payable,
short term borrowings etc.

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CAPITAL STRUCTURE THEORIES 8

There are Four theories of capital

structure:
• NET INCOME APPROACH
• NET OPERATING INCOME APPROACH
• TRADITIONAL APPROACH
• MODIGILANI MILLER APPROACH

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 ASSUMPTIONS 9

• 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.
• Operating profits of the firm are given and not expected to grow.
• Business risk complexion of firm is given and is not affected by the financing
mix.
• No corporate or personal taxation.
• Investors expect future profitability of the firm.
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 NET INCOME APROACH 10

 This theory was propounded by DURAND.

 This theory states that there is a relationship between capital structure and value of the
firm.
 Firm can affect value of the firm by increasing/ decreasing the debt proportion in the overall
capital structure.
 The cost of capital (WACC), and thus directly affects the value of the firm.
 NI approach assumptions –
o Both Kd and Ke are constant. NI approach assumes that increase in debt in capital structure does
not affect the risk perception of the investors.
o Cost of debt (Kd) is less than cost of equity (K e) [i.e. Kd < Ke ]
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o Total capital requirement of the firm is given and constant.
•The
  overall cost of capital (Ko) Or Weighted average cost of capital
is calculated under 11
Ko = EBIT/V
Cost of equity, Ke is given, Ko depends on D/E Ratio
The total market value of the firm (V) under the Net Income Approach is
ascertained by the following formula
V = E+D
E= Net profit
• V = Total market value of the firm
• E = Market value of equity
• D = Market value of debt
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NET INCOME
APROACH Cost
Cost

• As the proportion
of debt in capital ke,
ke, ko
ko ke
ke

structure increases,
the WACC (Ko) kd
kd
ko
ko
kd
kd
decreases and value
of the firm
increases. Debt
Debt

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 ILLUSTRATION 1 13

Ques: Four firms A, B, C, D belong to same risk class.

Their Ke and Kd are same at 20% and 12% resp. and
earn same amount of EBIT of ₹6,00,000 p.a. However,
these firms differ with respect to amount of debt
financing. Firm A is an unlevered firm, other firms have
12% debt of ₹5,00,000, ₹10,00,000 and ₹15,00,000
resp. Find out their values and WACC under NI approach
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 SOLUTION 14

Particulars A B C D
Debt ----- 5,00,000 10,00,000 15,00,000
Kd ----- 12% 12% 12%
EBIT 600000 600000 600000 600000

Less: Interest 0 60000 120000 180000

Profit before/ After tax 600000 540000 480000 420000
Ke 20% 20% 20% 20%
Value of Equity (E) 3000000 2700000 2400000 2100000
(NP/Ke )
Value of Debt 0 500000 1000000 1500000
Value of firm 3000000 3200000 3400000 3600000 07/01/2021
Ko ( EBIT/ V) 0.2=20% 0.1875= 18.75% .176= 17.6% 0.17=17%
NET OPERATING INCOME APPROACH 15

 Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach.
 It is also given by DURAND.
 As per NOI approach, value of a firm is not dependent upon its capital structure.
 For a given level of EBIT, the value of the firm remain same irrespective of the capital composition and instead
depends on overall cost of capital and operating profits.
 Assumptions –
o Investor see the firm as a whole and thus capitalizes the total earnings of the firm to find out the value of the firm as a whole
o WACC is always constant, and it depends on the business risk which is also assumed to be constant.
o Value of the firm is calculated using the overall cost of capital i.e. the WACC only.
o The cost of debt (Kd) is constant.
o The use of more and more debt increases the risk of shareholders and thus increases the cost of equity i.e., K e . The increase
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in Ke that completely offset the benefits of cheaper debt.
o Corporate taxes do not exist
NET OPERATING
INCOME APPROACH Cost
Cost
ke
ke

 Cost of capital (Ko) is

constant.
ko
ko
 As the proportion of debt
increases, (Ke) increases. kd
kd
 No effect on total cost of
capital (WACC)
Debt
Debt

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 ILLUSTRATION 2 17

Particulars 30% Debt 40% Debt 50% Debt

Ques. A firm has an EBIT
EBIT 200000 200000 200000
of ₹2,00,000 and belongs
to risk class of 10%. What Less: Interest 18000 24000 30000

is the value of cost of Net profit 182000 176000 170000

equity if it employs 6% Ko 0.10 0.10 0.10
debt to the extent of 30%, Value of firm(V) 2000000 2000000 2000000
40%, 50% of the total (EBIT/ko)
capital fund of ₹
Value of Debt(D) 300000 400000 500000
10,00,000?
SOLUTION: Value of Equity(E) 1700000 1600000 1500000
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Ke ( NP/E) 0.107 0.11 0.113

 TRADITIONAL APPROACH 18

 The NI approach and NOI approach hold extreme views on the relationship between
capital structure, cost of capital and the value of a firm.
 Traditional approach (‘intermediate approach’) is a compromise between these two
extreme approaches.
 Traditional approach confirms the existence of an optimal capital structure; where WACC
is minimum and value is the firm is maximum.
 As per this approach, a best possible mix of debt and equity will maximize the value of the
firm.
 As per this approach, a firm should make judicious use of both the debt and equity to
achieve the capital structure which is the optimum capital structure. 07/01/2021
TRADITIONAL APPROACH 19

The approach works in 3 stages –

1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will not
affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk(financial risk) and hence Ke increases. Kd also rises due to
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higher debt, WACC increases & value of firm decreases.
TRADITIONAL Cost
Cost

APPROACH ke
ke

 Cost of capital (Ko) is ko

ko
reduces initially.
 After that point, it stables.
kd
kd
 But after this point, (Ko)
increases with increase in
further debt due to
Debt
Debt
increase in the cost of
equity. (Ke)

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 21

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 ILLUSTRATION 22

Particulars 0% Debt 30% Debt 50% Debt

Debt --- 300000 500000
Kd --- 10% 12%
EBIT 150000 150000 150000

- Interest 0 30000 60000

Profit before tax 150000 120000 90000
Ke .16 .17 .20
Value of equity(E) 937500 705882 450000
Value of Debt(D) ----- 300000 500000
Total value 937500 1005882 950000 07/01/2021

Ko or WACC 0.16 0.149 0.157

MODIGLIANI- MILLER (MM) APPROACH 23

 MM approach restated the NOI approach, i.e.the capital structure (debt-

equity mix) has no effect on value of a firm and added behavioural
justification for their model.
 There is no optimum capital structure.
• MODIGLIANI- MILLER explain the relationship between capital
structure, cost of capital and value of the firm under two conditions:
1. With taxes
2. Without taxes
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MODIGLIANI- MILLER (MM) APPROACH 24

• ASSUMPTIONS
1. The capital markets are perfect and information is available to
all investors free of cost.
2. No Transaction cost
3. Securities are infinitely divisible.
4. Homogenous Risk Class.
5. Personal leverage and corporate leverage are perfect
substitutes
6. 100% dividend payout. 07/01/2021
MODIGLIANI- MILLER (MM) APPROACH PROP
I 25
••  Value
of a firm is independent of the capital structure.
• Value of firm is equal to the capitalized value of operating
income (i.e.EBIT) by the appropriate rate (i.e.WACC).
• Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
•=

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MODIGLIANI- MILLER (MM) APPROACH PROP
I 26

As per MM, identical firms (except capital structure) will have
the same level of earnings.
 As per MM approach, if market values of identical firms are
different, ‘arbitrage process’ will take place.
In this process, investors will switch their securities between
identical firms (from levered firms to un-levered firms) and
receive the same returns from both firms

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 ARBITRAGE PROCESS 27

Particulars Levered firm Unlevered firm Levered Firm

EBIT 10,00,000 10,00,000 10% Debt = 30,00,000
- Interest 300000 ---- Kd = 10 %, Ke = 20%
Net profit 700000 100000
EBIT = Rs. 10,00,000
Ke 0.20 0.20
Investor holds 10 % share capital
Value of equity(E) 35,00,000 50,00,000 Un-Levered Firm
Value of debt(D) 30,00,000 EBIT = Rs. 10,00,000 , Ke = 20%
Total value of firm(E+D) 6500000 5000000
WACC = EBIT/V 0.153 0.20

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 ARBITRAGE PROCESS 28

Levered firm
Value of ownership = 3,50,000 (10% of 3500000)
Investor’s share in profit= 70,000 (10% of 7,00,000)
Now he convert his holding from levered to unlevered firm
Sell shares of lev. Firm= 350000
Funds required to buy 10% stake in Unlev. Firm= 500000 (10% of 50,00,000)
Loan taken = 300000 (10% 0f debt of lev. Firm)
Total funds now with investor= 650000 (350000+300000)
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 ARBITRAGE PROCESS 29

RETURN FROM UNLEVERED FIRM

Profit from Unlev. Firm = 1,00,000 (10% of EBIT)
- Interest on loan = 30,000 (300000*10%)
Net Return = 70,000

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 PROPOSITION II 30

•Cost
  of equity increases proportionately with increase in proportion
of debt so as to nullify the benefit of cheaper debt
Cost of Equity depends on three factors:
 Overall cost of capital
 Cost of Debt
 Debt- Equity Ratio
Ke = Ko+ (ko- kd)

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 ILLUSTRATION 31

Ques: Equity= Rs 30,00,000

10% Debt = 20,00,000, Ko=18%
Calculate cost of equity. Also calculate the cost of equity if
Additional Debt of Rs 10,00,000 is raised.
SOLUTION: 0.233 or 23.3%
0.26 or 26%

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 LIMITATIONS OF MM APPROACH 32

• Non- substitutability of personal and corporate leverage

• Transaction Cost
• Institutional Investor
• Availability of Complete information
• Corporate Taxes

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 MM APPROACH WITH TAXES 33

•Interest
  is tax deductible which allows less tax to be paid by levered firm.
Therefore, earnings available for equity shareholders will increase and less
earnings are taxed when leverage is used.
In other words, the debt “shields” some of the firm’s Cashflow from taxes
VL = VU + Debt
VL= VU + PV of interest tax-shield
Pv of interest tax-shield =
= D(t)

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 MM APPROACH WITH TAXES 34

Under MM with corporate taxes, the firm’s value 07/01/2021

increases continuously as more and more debt is used

 EXAMPLE 35

U ltd L Ltd
EBIT 10,00,000 10,00,000
Ke 10% 10%
Total assets 50,00,000 50,00,000
5% Debt 20,00,000
Corporate tax 40% 40%

Calculate the value of both the firms

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 36

•  VU = =
= 60,00,000
VL = VU + Debt
= 6000000 + 2000000 0.40 = 6800000
For L ltd Value of equity = 6800000- 2000000= 4800000
Ke= = = =11.25%
Ko = = = 8.82%

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FACTORS AFFECTING CAPITAL STRUCTURE 37

• Profitability
• Cashflows
• Growth opportunities
• Issue cost and floatation cost
• Control
• Stability of sales
• Capital market conditions

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 38

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