CAPITAL

STRUCTURE
Prof (Dr) Hanuman Prasad
Director
Faculty of Management Studies
Mohanlal Sukhadia University,
Udaipur (Rajasthan) India
Cell: +91 9414343358
Email: profhanumanprasad@gmail.com
 Content
- Meaning of Capital Structure
- Factors influencing Capital Structure
- Essentials of a Sound Capital Structure
- Theories of Capital Structure
Meaning of Capital Structure
■ A firm can raise funds from
different sources of financing i.e.
equity share capital, retained
earnings, preference share capital
and long term external debts.
■ Capital Structure is the
combination of capitals from
different sources of finance.
■ Broadly these sources of financing
can be categorized in to Debt and
Equity,
■ Thus, Capital Structure refers to
the combination or mix of debt and
equity which a company uses to
finance its long term operations.
Optimum Capital Structure
■ The capital structure is designed considering following points
– Control: control of existing shareholders is not diluted
– Risk: financial risk of company does not increase beyond
tolerable limit.
– Cost: Overall cost of capital remains minimum
Practically it is not possible to achieve all three goals thus a
balance among these three objectives need to be done.
■ Primarily, objective of company is to maximize the value of
company while deciding optimal capital structure.
■ Thus optimum capital structure is that proportion of various
sources of financing at with overall cost of capital is minimum
and value of firm is maximum
Optimum Capital Structure

■ Value of firm
■ ={Cost of Debt ×Weight of Debt}+{Cost of Equity
×Weight of Equity}
■ =[{Kd × D/(D+S)}+{Ke × S/(D+S)}]
■ = Weighted average cost of capital
■ Kd =Cost of Debt
■ Ke = Cost of Equity
■ Capital Structure will decide the weight of Debt
and Equity, thereby Cost of Capital and Value of
Firm
Theories of Capital
Structure
■ Capital Structure ■ Capital Structure
Relevance Theory Irrelevance Theory
– Net Income – Net Operating
(NI) Approach Income (NOI)
– Traditional Approach
Approach – Modigliani-Miller
(MM) Approach
Basic Assumptions
■ The following assumptions are made to understand variety of
approaches.
– There are only two kinds of funds used by a firm i.e. debt
and equity
– The total assets (capital structure) of the firm are given.
The proportion can be changed by selling debt to purchase
shares or selling shares to retire debt. Which means no
additional financing.
– Taxes are not considered.
– Payout ratio is 100%
– The firm’s total financing remains constant.
– Business risk is constant overtime.
– The firm has perpetual life.
Net Income (NI) Approach
■ Capital Structure decisions are
relevant
■ This theory was propounded by
“David Durand”.
■ There is relationship between
capital structure and value of firm.
■ Assumptions:
– Cost of debt is constant.
– Cost of equity remains
constant. Increase in debt
does not affect risk perception
of investors.
– Cost of debt is less than cost
of equity. (Kd<Ke)
– Corporate income taxes do
not exist
Firm Value and Cost of Capital Under NI
approach
■ (Kd<Ke) = increase in debt in capital structure, the proportion of
cheaper source of financing increases, the weighted average of debt
and equity will decline i.e. overall cost of capital
■ Thus, increase in financial leverage will lead to decline in weighted
average cost of capital thereby firms value will increase.
■ =[{Kd × D/(D+S)}+{Ke × S/(D+S)}]

■ = Or V
■ Value of Firm (V) can be ascertained in NI approach =S+D
– V = Value of Firm
– S = Market Value of equity
– D = Market Value of Debt
■ Market Value of Equity
– NI = Earning Available to equity shareholders
– = Cost of Equity
The Crux of NI Approach
■ NI approach supports the view that capital structure decisions
are relevant.
■ With increase in leverage overall cost of capital reduces.
■ The value of firm will be maximum at a point where overall cost
of capital is minimum
■ Approach suggests total or maximum possible use of debt
financing for minimizing the cost of capital.
■ The value of can be maximized by decreasing overall cost of
capital/
■ The firm must employ as much debt as possible to maximize its
value.
 Example:
A firm has EBIT of Rs 5,00,000. Firm has 10%,
debentures of 20 Lakhs. The equity capitalization rate of
the firm is 16%. Calculate Ko, Market value of equity
and value of firm. (if Debt is increased to 30 Lakhs)

Debt incresed to
30 Lakhs
EBIT 500000 500000
Less: Interest on debentures (10% pm Rs
2000000) -200000 -300000

Earning avalilable to Equity Shareholders( NI) 300000 200000

Equity Capitalization rate Ke 16% 16%

Market Value of Equity (S)= NI/Ke= 800000/.16 1875000 1250000

Market value of Debt (D) 2000000 3000000
Total Value of firm V=D+S 3875000 4250000
Overall Cost of Capital =EBIT/V
=500000/3875000 12.90% 11.76%
 Net Operating Income Theory
■ This theory was propounded by “David
Durand” and is also known as “THEORY of
IRRELEVANCE”.
■ An increase in use of debt which is apparently
cheaper is offset by an increase in the equity
capitalization rate.
■ It is because equity investors seek higher
compensation as they are exposed to higher risk
due to the existence or increase in fixed return
securities (Leverages) in the capital structure
■ As a result, overall all cost of capital remains
constant.
■ The business risk at each level of debt-equity
mix remains constant. Therefore, overall cost of
capital also remains constant.
■ According to this theory, cost of debt is also
constant.
■ The corporate income tax does not exist.
■ Thus, the total market value of the firm (V) is not
affected by the change in the capital structure.
 Example:
A firm has EBIT of Rs 5,00,000. Firm has 10%, debentures of 20
Lakhs. The equity capitalization rate of the firm is 16%. Calculate
Ko, Market value of equity and value of firm. (if Debt is increased
to 30 Lakhs)
Debt
incresed to
30 Lakhs
EBIT 500000 500000
Less: Interest on debentures
(10% pm Rs 2000000) -200000 -300000
Earning avalilable to Equity
Shareholders( NI) 300000 200000
Equity Capitalization rate
Ke=NI/S 16% 22.85% Ke = EBIT – I X
100
Market Value of Equity (S)= S of
Market Value
NI/Ke= 800000/.16 1875000 875000
Equity: S = V – D
Market value of Debt (D) 2000000 3000000
Total Value of firm V=D+S 3875000 3875000
Overall Cost of Capital
=EBIT/V =500000/3875000 12.90% 12.90%
Traditional Theory
■ This theory was propounded by Ezra
Solomon.
■ According to this theory, a firm can reduce its
overall cost of capital or increase the total
value of the firm by increasing the debt
proportion to certain limit. Beyond this limit,
reverse trend emerges.
■ The implication of theory is that there is an
optimal capital structure which minimizes
overall cost of capital.
 Assumptions: Traditional Theory
■ The cost of debt remains constant up to certain degree of
leverages, thereafter it increases.
■ The cost of equity (expectations of equity shareholders )
remains more of less constant or gradually increases up to
certain degree of leverages, beyond this it increases
sharply/ speedily.
■ As a result of above behavior of cost of debt and cost of
equity, Weighted average cost of capital
– Decreases to certain level –I
– Remains constant for Certain level-II
– Increases thereafter-III
■ The level where it remain constant or lowest point of curve
is optimal capital structure.
Traditional Approach and Firm Value

■ Step I: Growing Firm Value

and Declining Overall Cost
of Capital
■ Step II: Constant Value (X)
Optimum Capital Structure:
Lowest Overall Cost of
Capital
■ Step III: Declining Firm
Value and Increasing Cost of
Capital
Firm should strive to reach on
judicious use of debt and equity
(optimum capital structure) to
attain maximum value.
Example: The behavior of Cost of equity and cost of debt is given in
first two columns as a response to change in Degree of Leverage (third
Column). The Weighted Average Cost of Capital is calculated by
Ko=Ke*We+Kd*Wd. Value of Firm is Calculated on EBIT level of
5,00,000 by EBIT/Ko

Example: Traditional Approach

Overall
Cost of Cost of Degree of Cost of Value of Firm on
equity Debt Leverage Capital 500000 EBIT
0.12 0.06 0.00 12 4166667
0.12 0.06 0.10 11.994 4168751
0.12 0.06 0.20 11.988 4170838
0.12 0.06 0.30 11.982 4172926
0.13 0.06 0.40 12.972 3854456
0.13 0.07 0.50 12.97 3855050
0.13 0.08 0.60 12.97 3855050
0.14 0.08 0.80 13.952 3583716
0.15 0.09 0.90 14.946 3345377
Modigliani-Miller Theory
■ The theory was propounded by Franco Modigliani
and Merton Miller.
■ NOI approach of irrelevance is conceptual and
lacks behavioral significance.
■ MM approach provides behavioral and operational
justification for constant overall cost of capital and
value of firm thereby irrelevance of capital
structure.
■ They have given two approaches :
– MM Without Taxes: 1958
– MM With Taxes: 1963
MM Approach: Without Taxes
■ The Value and Cost of Capital will remain unchanged Irrespective
of change in capital Structure:
■ Assumptions:
– Perfect Capital Market:
■ Information are freely available
■ Not transaction costs
– Investors are Rational
– Firms can be grouped in ‘equivalent risk classes’ on the basis
of their business risk.
– Risk in terms of expected EBIT should also be identical for
determination of market value of the shares
– Cent-Percent Distribution of earnings to the shareholders
– No Corporate Taxes: But later on in 1969 they removed this
assumption.
 MM Approach: Without Taxes
■ Based on assumptions following Three
propositions are drawn by them:
(1) Total Market Value of firm is equal to its
expected net operating income divided by the
discount rate appropriate to its risk class decided
by the market.
V
Value of Levered firm (VL) = Value of
Unlevered Firm(Vu)
(2) A firm having debt in the capital structure has
higher cost of equity than an unlevered firm. The
cost of equity will include risk premium for the
financial risk.

(3) The capital structure does not affect the overall

cost of capital. Cost of Capital is affected by
business risk. Ko is constant in diagram.
 MM Approach: Without Taxes:
Operational Justification
■ Operational Justification is explained by
– Functioning of Arbitrage Process
– Substitution of Corporate leverage by Personal leverage
■ Arbitrage: Buying an asset from market where price is lower and selling it in
another market at higher prices. As a result equilibrium in both the markets is
attained.
■ This is illustrated in theory by taking two identical firms out of which one has debt
in capital structure and another does not.
■ Investors of higher value firm will sell their shares and buy share of the firm whose
value is lower.
– Bought company shares Demand Value Will Increase
– Sold company shares Supply Value will decline
■ They will be able to earn same return at lower investment.
■ This buying and selling will continue until equilibrium in value of both firm is
attained.
 Unlevered Firm Levered Firm
EBIT 100000 100000
Less: Interest on debentures (16% pm Rs 500000 0 50000
Earning avalilable to Equity Shareholders( NI) 100000 50000
Equity Capitalization rate Ke 0.125 0.16
Market Value of Equity (S)= NI/Ke 800000 312500
Market value of Debt (D) 0 500000
Total Value of firm V=D+S 625000 812500
Overall Cost of Capital =EBIT/V 0.16 0.123076923

Investme
INVESTMENT IN LEVERED FIRM Equity Value Earning for equity nt Earning

Mr X has 10% Portion In Levered

Firm 0.1 312500 50000 31250 5000

FINANCIAL RISK OF 10% OF

500000 0.1 500000 50000 50000
BUY

Mr X Will buy 10% In Unlevered

Firm 0.1 625000 100000 62500 10000

TAKE PERSONAL LOAN TO

EQUALISE RISK 0.1 500000 50000 50000 5000

TOTAL INVESTMENT FOR CURRENT LEVEL OF

FUNDS EARNINGS
HE NOW HAS FUNDS 50000+31250 81250 62500
EXCESS FUNDS 18750 3000
THANK
YOU