CAPITAL STRUCTURE

THEORIES
CAPITAL STRUCTURE

Cost of
Capital
Cost of
Capital
ASSUMPTION OF THE RELATIONSHIP

 There are only two sources of fund: Equity and

Debt
 The total assets of the firm are given and there
will be no change in the investment decisions of
the firm.
 The firm has a policy of distributing the entire
amount of profits among the shareholders, i.e. no
retained earnings
 The EBIT is given and are not expected to grow
 The business risk complexion is given and
constant, not affected by the finance mix.
 No corporate or personal taxes
 VALUE OF FIRM

 The value of the firm depends on the earnings of

the firm
 Earnings of the firm depend upon the investment
of the firm
 The earnings are capitalized @equal to the cost
of capital to find the cost of capital
 Therefore, value of firm is based on two factors:
Earnings of the firm & Cost of Capital
EARNINGS = EBIT

Debt
holder
s

Gov
t

Share
holder
s

EBI
T
 The investment decisions determine the size of
EBIT pool
 Capital structure mix determines the way it is to be
sliced
 Value of the firm is the sum of its value to the Debt
holders & to its shareholders and is determined by
the amount of EBIT going to them respectively.
 For a given level of earnings, lower the level of
cost of capital, the higher would be the value of
firm.
THE THEORIES
 Net Income Approach
 Net Operating Income Approach
 Traditional Approach
 Modigliani- Miller Model
NET INCOME APPROACH

 Simplest approach suggested by Durand

 It states that there is a relationship between capital
structure and value of the firm therefore, the firm
can affect its value by decreasing or increasing the
debt proportion in the overall financing mix.
 A change in financing mix will lead to a change in
WACC, resulting in a change in the value of the
firm
THE NI APPROACH ASSUMES:
 The total capital requirement of the firm is given
and constant
 The cost of Debt is less than cost of equity
 Both cost of debt and equity remain constant and
increase in financial leverage, i.e. use of more
and more debt does not affect the risk perception
of the investor.
 As cost of debt is a cheaper source, increasing the
use of cheaper debt in the overall capital structure
will result in the magnified returns available to the
shareholders.
 The increased returns of the shareholders will
increase the total value of the equity and thus
increase the total value of the firm. (V=D+E)
 As the WACC decreases the value of the firm
increases.
PROBLEM
 The expected EBIT of a firm is Rs 2,00,000. it
has issued the equity share capital with K o @ 10%
and 6% debt of Rs 5,00,000. Find out the value of
the firm and the WACC.
SOLUTION:

EBIT 2,00,000
- Int 30,000
Net Profit 1,70,000
Ke 10%
Equity= 1,70,000/0.10 17,00,000
Debt 5,00,000
Value of firm 22,00,000
WACC (EBIT/ V) 9%
 If the firm has issued 6% debt of Rs 7,00,000
instead of Rs 5,00,000.
 WACC= 8.7%,
 Value of firm= Rs 22,80,000
 If the 6% debt is decreased to Rs 2,00,000
 Then WACC= 9.6%
 Value of firm= Rs 20,80,000
NET OPERATING INCOME APPROACH (NOI)

 NOI approach is opposite to the NI approach

 It is also known as independence hypothesis.
 The market value of the firm depends on EBIT
and WACC.
 Financing mix or capital structure is irrelevant
and does not affect the value of the firm.
IT ASSUMES:
 Value of firm is obtained by capitalizing the total earnings
of the firm
 The overall cost of capital is constant and depends upon
business risk which is further assumed to be unchanged.
 Cost of debt is constant
 Use of more and more debt in the capital structure increase
the risk of the shareholder and thus increases the cost of
equity. The increase in cost of equity is such as to
completely offset the benefit of employing cheaper debt.
 There is no tax
 Therefore, for a given value of EBIT, the value of
firm remains same irrespective of the capital
composition and instead depends on the overall
cost of capital.
 V= EBIT/ Ko
 E= V-D
 Ke = (EBIT- Int)/ V-D
PROBLEM
 A firm has an EBIT of Rs 2,00,000 and belongs
to a risk class of 10%. What is the value of cost
of equity capital it employees 6% debt to the
extent of 30%, 40% or 50% of the total capital
fund of Rs 10,00,000.
SOLUTION:
30% Debt

EBIT 2,00,000

Ko 10%

V 20,00,000

D 3,00,000

E= (V-D) 17,00,000

Net Profit 1,82,000

Ke (NP/E) 10.7%
 40% Debt
EBIT 2,00,000
Ko 10%
V 20,00,000
D 4,00,000
E= (V-D) 16,00,000
Net Profit 1,76,000
Ke (NP/E) 11%
TRADITIONAL APPROACH

50% Debt
EBIT 2,00,000
Ko 10%
V 20,00,000
D 5,00,000
E= (V-D) 15,00,000
Net Profit 1,70,000
Ke (NP/E) 11.33%
WACC AT DIFFERENT DEBT LEVELS
 At 30%, Ko= [ D/ (D=E)] Kd + [E/ (E+D)] Ke
 = 10%

 At 40%, Ko= [ D/ (D=E)] Kd + [E/ (E+D)] Ke

 = 10%

 At 50%, = [ D/ (D=E)] Kd + [E/ (E+D)] Ke

= 10%

 NOI approach considers Ko to be constant and therefore there is

no optimal capital structure rather every capital structure is good
and optimal as others.
TRADITIONAL APPROACH
 The NI and NOI approach hold extreme views
and seems to be a little unrealistic.
 The traditional approach takes a compromising
view and incorporates the basic philosophy of
both.
 NI says V increases with the increase in leverage
& the NOI says that V is constant irrespective of
the degree of leverage.
 Traditional approach talks about making a
judicious use of both debt and equity to achieve a
capital structure.
 At this capital structure the WACC, will be
minimum and the value of firm will be maximum.
 The V increases with the increase in financial
leverage but up to a certain limit only. Beyond this
limit, the increase in financial leverage will
increase its WACC also the V will decline.
 Increase in leverage beyond a limit, increases the
risk of equity investors as also the K e
 In any firm, there is a level of financial leverage
upto which it favourably affects the V, but
thereafter if the leverage is increased further, then
the effect may be adverse and V can decrease.
 The Ko is the function of financial leverage, V
can be affected by judicious use of debt and
equity.
PROBLEM
 ABC ltd having an EBIT of Rs 1,50,000.
presently it is a 100% equity firm with K e of
16%. The firm wants to introduce debt up to
3,00,000, i.e. 30% of the total funds or up to Rs
5,00,000 i.e. 50% of the total fund. For debt up to
30% int will be 10% and Ke will increase to 17%.
In case of 50% debt the int will be 12% and K e
will increase to 20%. Find out the WACC and V.
SOLUTION
0% Debt 30% Debt 50% Debt
Total Debt - 3,00,000 5,00,000
Rate of Int - 10 12
EBIT 1,50,000 1,50,000 1,50,000
- Int - 30,000 60,000
PAT 1,50,000 1,20,000 90,000
Ke .16 .17 .20
E 9,37,500 7,05,882 4,50,000
D - 3,00,000 5,00,000
V 9,37,500 10,05,882 9,50,000
Ko .16 .149 .158
MODIGLIANI- MILLER MODEL

 MM model shows that the financial leverage does

not matter and the cost of capital and value of
firm are independent of the capital structure.
 The model assumes :
 Capital markets are perfect, complete information is
available
 Investors are rational and well informed about the
risk and return.
 Investors have the same probability of expected
future earnings
 No corporate income tax
 Personal leverage and corporate leverage are perfect
substitute.
MM MODEL DERIVES:
 The total value of the firm is equal to the
capitalized value of the operating earnings.
 Total value of firm is independent of financial
leverage
 Cut off rate for the investment decisions of the
firm depends upon the risk class to which the
firm belongs
MM MODEL PROPOSITION I
 Says that it is completely irrelevant how a firm arranges
its capital funds.
 Two firms are alike in all respect, differ in financing
pattern and their market value.
 Investors have the tendency to sell the shares of
overvalued firm and buy of the undervalued.
 This buying and selling continues till market price
comes at the same level.
 This also referred as arbitrage process.
 Concluding that Ko is independent of financial leverage.
 MM MODEL PROPOSITION II
 Cost of equity depends on three factors
 Overall cost of capital, cost of debt and debt
equity ratio.
 Ke = Ko + (Ko - Kd)(D/E)
PROBLEM
 ABC & Co. has raised equity capital of Rs
30,00,000 and 10% debt of Rs 20,00,000. it
belongs to a risk class having overall cost of
capital, Ko of 18%. Find the cost of equity
capital.
 Ke = Ko + (Ko - Kd)(D/E)
= .18 + (0.18 - 0.10) (2/3) = .233 or 23.3%
 If the company issues additional debt of Rs
10,00,000 the debt equity ratio will be 1:1 and the
Ke will be ?
 Ke = Ko + (Ko - Kd)(D/E)
= .18 + ( 0.18 – 0.10) (1/1)= .26 or 26%
 The overall cost of capital remains same but with
the increase in financial leverage the risk
premium of equity shareholders has increased.
 If the debt equity ratio is 2:3
 Ko = [D/ (D+E)] Kd + [E/ (E+D)] Ke
= [2/ (2+3)] 0.10 + [3/ (2+3)] 0.233= 18%
 When the debt equity ratio is 1:1
 Ko = [D/ (D+E)] Kd + [E/ (E+D)] Ke
= [1/ (1+1)] 0.10 + [1/ (1+1)] 0.26= 18%
 Thus, as per MM model, the will not rise even if
the degree of financial leverage is increased.