CAPITAL STRUCTURE

Terminology

• D is the market value of debt.

• E is the market value of equity
• V is the market value of firm
• kd (cost of debt) = (I/D)
• ke (cost of equity)= [EBIT – I]/E
• ko (overall cost or weighted average cost of capital)= EBIT/V
Net Income (NI) Approach
• According to NI approach
both the cost of debt and
the cost of equity are Cost
independent of the capital
structure; they remain
constant regardless of how
much debt the firm uses. As ke, ko ke
a result, the overall cost of
capital declines and the firm kd
ko
kd
value increases with debt.
This approach has no basis
in reality; the optimum
capital structure would be Debt

100 per cent debt financing

under NI approach.
Assumptions

• No Taxes
• EBIT is constant
• kd and ke remain constant irrespective of
the capital structure
• kd< ke
• The risk perception of investors remains
constant.
 Net Income Approach -illustrated
Scenario A Scenario B Scenario C

Project Cost 1000 1000 1000

Sources of finance
EQUITY (book value) 900 500 100
Debt (book value) 100 500 900
Capitalization rate
Equity, ke 20% 20% 20%
Debt, kd 10% 10% 10%

EBIT or NOI 500 500 500

INTEREST 10 50 90
EBT 490 450 410
Taxes no taxes no taxes no taxes
EATor NI (earnings
available to share holders) 490 450 410
Market value of debt (I/kd) 100 500 900
Market value of equity 2450 2250 2050
(NI/ke)
Total value of the firm 2550 2750 2950
(D+E)
ko= EBIT/V
19.61% 18.18% 16.95%
Net Operating Income (NOI)
Approach
• According to NOI approach
the value of the firm and
the weighted average cost
Cost
of capital are independent ke
of the firm’s capital
structure. In the absence
of taxes, an individual
holding all the debt and ko

equity securities will kd

receive the same cash

flows regardless of the
capital structure and Debt

therefore, value of the

company is the same.
Assumptions

• Cost of capital i.e. ko remains constant

regardless of the level of debt.
• EBIT is constant.
• Cost of debt remains constant.
 Net Operating Income Approach -illustrated
Scenario A Scenario B Scenario C

Project Cost 1000 1000 1000

Sources of finance
EQUITY (book value) 900 500 100
Debt (book value) 100 500 900
Capitalization rate
Overall, ko 20% 20% 20%
Debt, kd 10% 10% 10%

EBIT or NOI 500 500 500

INTEREST 10 50 90
EBT 490 450 410
Taxes no taxes no taxes no taxes
EAT or NI (earnings available to share
holders) 490 450 410
Market value of debt (I/kd) 100 500 900
Market value of firm (EBIT/ko) 2500 2500 2500
Value of Equity (E = V-D) 2400 2000 1600
ke= NI/E 20.42% 22.50% 25.63%