Capital Structure Theories

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Index
 Meaning of Capital Structure
 Optimum Capital Structure
 Capital Structure Theories
 NI approach
 NOI Approach
 Traditional Approach
 MM Approach

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Meaning of Capital Structure
 Capital Structure is also known as financial structure.
 It refers to the composition of long-term funds such as debentures, long term
borrowings, preference shares and equity shares including retained earnings.
 The essence of capital structure decision is to determine the relative
proportion of equity and debt.
 The capital structure decision is important as it affects the shareholder’s
return and risk and consequently the market value of shares.

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Optimum Capital Structure
 The capital structure is said to be optimum when the overall cost of capital is
minimum and the total market value of the firm is maximum.

 A sound or appropriate capital structure have the following features:

 Profitability
 Solvency
 Flexibility
 Conservatism
 Control

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Capital Structure Theories
 Capital Structure theories explain the theoretical relationship between cost
of capital and the value of the firm.
 The four important theories of capital structures:
 Net Income Approach
 Net Operating Income Approach
 Traditional Approach
 Modigliani and Miller Approach.

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Net Income Approach (NI)
 According to NI approach, a firm can change its value and the cost of capital
through a careful mix of debt and equity.
 This approach also says that WACC is not independent to its capital structure.
 According to NI approach, a firm can have optimum capital structure at which
WACC is lowest and Value of firm is highest through a careful mix of debt and
equity.
Effect on Effect of Increase in Effect of decrease in
Leverage Leverage

WACC (K0 ) Decreases Increases
Total Value of the Firm Increases Decreases
(V)

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Assumptions of NI approach
1. Kd is less than Ke
2. The use of debt content does not change the risk perception of investors. It
means Kd and Ke remains constant.
3. There are no corporate taxes.

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Steps in calculation of Value of firm and WACC
 Step-1: Market Value of Equity (S) = Net Income ÷ Ke

Where Net Income (EBT) = Net Operating Income (EBIT) – Interest

 Step-2: Market Value of Debt (D) = Interest ÷ Kd

 Step-3: Total Value of the Firm (V) = Market Value of Equity (S) + Market Value
of Debt (D)

 Step-4: WACC = NOI ÷ V

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Numerical using NI approach

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 Q.1 Determine the total value of the company and WACC using the following
information.
Expected Net Operating Income Rs.2,40,000
10 % Debt Rs. 7,20,000
Sol: NI Approach
Equity Capitalization Rate 20 %
(I) Market Value of Equity (S) = NI/Ke = 1,68,000
0.20
= Rs 8,40,000
Formulae:
 Market Value of Equity (S) = Net Income
÷ Ke Where
Where Net Income (EBT) = Net Operating Income (EBIT) – NI = NOI – Interest = 2,40,000- (10% * Rs7,20,000)
Interest
= Rs 1,68,000

 Market Value of Debt (D) = Interest ÷ Kd

(II) Market Value of Debt (D) = Interest = 72,000
Kd 0.10
 Total Value of the Firm (V) = Market Value
of Equity (S) + Market Value of Debt (D) = Rs 7,20,000
(III) Value of the firm (V) = S + D = 8,40,000 +7,20,000
 WACC = NOI ÷ V = Rs 15,60,000
(IV) WACC (Ko) = NOI/V = 2,40,000/15,60,000
11/10/2022 = 0.153 = 15.3 %
 Q.2 Determine the total value of the company and WACC using the following
information.
Expected Net Operating Income Rs.2,40,000
10 % Debt Rs. 11,00,000
Equity Capitalization Rate 20 %
Sol:
Ans: WACC = 13.71 %
Formulae:
 Market Value of Equity (S) = Net
Income ÷ Ke
Debt Ko Value
Where Net Income (EBT) = Net Operating Income (EBIT) – Interest

7,20,000 15.3 %
 Market Value of Debt (D) = Interest ÷ K d 15,60,000
11,00,000 13.71 %
 Total Value of the Firm (V) = Market
Value of Equity (S) + Market Value of 17,50,000
Debt (D)

 WACC = NOI ÷ V
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 Q.3 Determine the total value of the company and WACC using the following
information.
Expected Net Operating Income Rs.2,40,000
10 % Debt Rs. 3,40,000
Equity Capitalization Rate 20 % NI Approach
Debt Ko Value
Formulae:
3,40,000 17.51 % 13,70,000
 Market Value of Equity (S) = Net
Income ÷ Ke 7,20,000 15.3 % 15,60,000
Where Net Income (EBT) = Net Operating Income (EBIT) – 11,00,000 13.71 % 17,50,000
Interest

 Market Value of Debt (D) = Interest

÷ Kd

 Total Value of the Firm (V) =

Market Value of Equity (S) + Market
Value of Debt (D)
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 WACC = NOI ÷ V
Q.1 Determine the total value of the company and WACC using the following
information.
Expected Net Operating Income Rs.50,000
10 % Debt Rs. 2,00,000
Equity Capitalization Rate 12.5 %
Formulae:
 Market Value of Equity (S) = Net
Income ÷ Ke
Where Net Income (EBT) = Net Operating Income (EBIT) – Interest

 Market Value of Debt (D) = Interest ÷ Kd

 Total Value of the Firm (V) = Market

Value of Equity (S) + Market Value of
Debt (D)

 WACC = NOI ÷ V

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 Q.2 Determine the total value of the company and WACC using the following
information.
Expected Net Operating Income Rs.50,000
10 % Debt Rs. 2,00,000
Equity Capitalization Rate 12.5 %
In the above problem, calculate total value of the firm and WACC if company has
decided to raise debt by Rs.1,00,000 and use the proceed to buyback equity shares.

Formulae:
 Market Value of Equity (S) = Net
Income ÷ Ke
Where Net Income (EBT) = Net Operating Income (EBIT) – Interest

 Market Value of Debt (D) = Interest ÷ Kd

 Total Value of the Firm (V) = Market

Value of Equity (S) + Market Value of
Debt (D)

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 WACC = NOI ÷ V
Q.3 Determine the total value of the company and WACC using the
following information.
Expected Net Operating Income Rs.50,000
10 % Debt Rs. 2,00,000
Equity Capitalization Rate 12.5 %
In the above problem, calculate total value of the firm and WACC if
company has decided to issue equity shares by Rs.1,00,000 and use the
proceed to redeem the debt.

Formulae:
 Market Value of Equity (S) = Net
Income ÷ Ke
Where Net Income (EBT) = Net Operating Income (EBIT) – Interest

 Market Value of Debt (D) = Interest ÷ K d

 Total Value of the Firm (V) = Market

Value of Equity (S) + Market Value of
Debt (D)
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 WACC = NOI ÷ V
Net Operating Income Approach (NOI)
 According to NOI approach, WACC is independent of its capital structure. In
other words, a firm can not change its value and the cost of capital through a
judicious mix of debt and equity.

 According to NOI approach, there is nothing like an optimum capital

structure.

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Assumptions of NOI Approach
1) Kd is constant.
2) Ko is constant.
3) There are no corporate taxes.
4) Neutralisation: The increase in the proportion of debt in the capital structure
would lead to increase in the financial risk of equity shareholders. The
advantage associated with the use of relatively less expensive debt is
neutralized by the increase in cost of equity capital.

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Steps involved in calculation of Total Value of the firm and
Ke
Step-1: Calculate Total Value of Firm
Total Value of firm = NOI ÷ KO

Step-2: Calculate Market Value of Debt

Market Value of Debt (D) = Interest ÷ Kd

Step-3: Calculate Market Value of Equity (S)

Market Value of Equity (S) = Total Value of the firm (V) – Market Value of
Debt (D)

Step-4: Calculate Equity Capitalization Rate

Equity capitalization rate (Ke) = Net Income ÷ Market Value of Equity (S)

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Numerical using NOI approach

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 Q.1 Calculate Total Market Value of the Equity and Equity Capitalization Rate using the following information (NOI
Approach)
NOI : Rs.2,40,000
10 % Debt Rs.7,20,000
Ko :15 % Sol:
(I) Value of the firm (V) = NOI/Ko
= 2,40,000/0.15
= Rs 16,00,000
Total Value of firm = NOI ÷ KO
(II) Market Value of Debt (D) = Interest
Kd
Market Value of Debt (D) = Interest ÷ Kd = 10% * Rs 7,20,000 = Rs 7,20,000
10 %
Market Value of Equity (S) = Total (III) Value of Firm = S + D
Value of the firm (V) – Market Value of 16,00,000 = S + 7,20,000
Debt (D)
Value of Equity (S) = Rs 8,80,000
(IV) Ke = NI/S
Equity capitalization rate (Ke) = Net = (NOI-Interest)
Income ÷ Market Value of Equity (S)
S
Where, NOI-Interest = NI
= (2,40,000 – 72,000) = 0.190 = 19 %
8,80,000 11/10/2022
 Q.2 In Q1. the following information is given :
NOI : Rs.2,40,000
10 % Debt Rs.11,00,000
Ko :15 %
What will be the Total Value of the firm and K e.

Total Value of firm = NOI ÷ KO

Value of the firm (V) = Rs 16,00,000
Value of Debt (D)= Rs 11,00,000
Market Value of Debt (D) = Interest ÷ Value of Equity (S) = Rs 5,00,000
Kd
Ke = 26 %

Market Value of Equity (S) = Total

Value of the firm (V) – Market Value
of Debt (D)

Equity capitalization rate (Ke) = Net

Income ÷ Market Value of Equity (S)
Where, NOI-Interest = NI 11/10/2022
 Q.3 In Q1. the following information is given :
NOI : Rs.2,40,000
10 % Debt Rs.3,40,000
Ko :15 %
Calculate Total Value of the firm and Ke.

Total Value of firm = NOI ÷ KO NOI Approach

Market Value of Debt (D) = Interest ÷ Debt(10%) Value Ke

Kd
3,40,000 16,00,000 16.3%
7,40,000 16,00,000 19%
Market Value of Equity (S) = Total
Value of the firm (V) – Market Value 11,00,000 16,00,000 26%
of Debt (D)

Equity capitalization rate (Ke) = Net

Income ÷ Market Value of Equity (S)
Where, NOI-Interest = NI
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  Traditional approach is an intermediate approach.
 It takes a midway between NI approach and NOI approach.
 According to this approach, companies should use the debt
(leverage) but up to certain limit.
 Upto the reasonable limit of Debt (leverage), the cost of debt
plus increased cost of equity will be less than the cost of
equity. As a result, the overall cost of capital (Ko) decreased
and the value of the firm increases (V). At this limit, capital
structure will be optimum.
Traditional  Beyond the reasonable limit of Debt (leverage), the cost of
debt plus increased cost of equity will be more than cost of
Approach equity. As a result the overall cost of capital increases and the
value of the firm decreases.
 According to traditional approach, at a reasonable limit of
leverage, the capital structure is optimum since the overall
cost of capital is the least and the value of the firm is
maximum.

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Steps involved in the calculation of WACC

 Step-1: Calculate Market Value of equity (S) as follows:

Market Value of Equity (S) = Net Income ÷ Ke

Where Net Income = NOI – Interest

 Step -2: Calculate Market Value of Debt (D) as follows

Market Value of Debt (D) = Interest ÷ Kd

 Step-3: Calculate Total Value of the Firm (V) as follows:

Total Value of the firm (V) = S + D

 Step-4: Calculate WACC (Ko)

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WACC = NOI/V
Numerical as per traditional approach

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 Q.1 Calculate Total Market Value of the company and WACC using the
following information (Traditional Approach)
NOI : Rs.2,40,000
10 % Debt Rs.7,20,000
Ke :20 % Sol: Market value of Equity = NI/Ke
= (NOI –Interest)/Ke
 Market Value of Equity (S) = NI ÷ Ke
= (2,40,000-72,000)/0.20
Where Net Income = NOI – Interest
= Rs 8,40,000

 Market Value of Debt (D) = I ÷ Kd

 Total Value of the firm (V) = S + D
 WACC = NOI/V
(II) Market Value of Debt (D) = I/Kd
= 72,000/0.10 = Rs 7,20,000
(III) Total Value of the firm (V) = S+D
= 8,40,000 + 7,20,000 = Rs 15,60,000
(IV) WACC (Ko) = NOI/V = 2,40,000/15,60,000 =
0.153 = 15.3 %
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 Q.2 In Q.1 the following information is given (Traditional Approach)
NOI : Rs.2,40,000
10 % Debt Rs.7,20,000
Ke :20 %

Calculate the total value of the firm and WACC if company has decided to
raise the debt by Rs. 1,60,000 and use the proceeds to buyback equity
shares. Due to increased financial risk Kd would rise to 11 % and Ke would rise
to 21 %.
Sol:
 Market Value of Equity (S) = NI Step
÷ Ke (I)

Where Net Income = NOI – Interest

New Debt = 7,20,000 + 1,60,000 = Rs 8,80,000
Interest = 11% * Rs 8,80,000 = Rs 96,800
Market Value of Equity (S) = NI/Ke = (2,40,000 -96,800)/0.21
 Market Value of Debt (D) = I ÷ Kd
= Rs 6,81,904.76
Step (II) Market Value of Debt (D) = Interest/Kd
 Total Value of the firm (V) = S + D= 96,800/0.11 = Rs 8,80,000
Step (III) Value of the firm (V) = S+D
= 6,81,904.76 + 8,80,000 = Rs 15,61,904.76
 WACC = NOI/V Step (IV) WACC (Ko)= NOI/V = 2,40,000/15,61,904.76
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= 15.36 %
 Q.3 In Q.1 the following information is given (Traditional Approach)
NOI : Rs.2,40,000
10 % Debt Rs.7,20,000
Ke :20 %

Calculate the total value of the firm and WACC if company has decided to
raise the debt by Rs. 1,70,000 and use the proceeds to buyback equity
shares. Due to increased financial risk Kd would rise to 12 % and Ke would rise
to 22 %.
Sol:
 Market Value of Equity (S) = NI ÷ Ke New Debt = 7,20,000 + 1,70,000 = Rs 8,90,000
Interest = 8,90,000 * 12 % = Rs 106,800
Where Net Income = NOI – Interest

Step (I) S = NI/Ke = (2,40,000 – 106,800)/0.22

 Market Value of Debt (D) = I ÷ Kd

= Rs 605,454.55
Step (II) D = I/Kd = 106,800/0.12 = Rs 8,90,000
Step (III) V = S +D = 605,454.55 + 8,90,000
 Total Value of the firm (V) = S + D
= Rs 14,95,454.55
Step (IV) WACC (Ko)= NOI/V = Rs 2,40,000/14,95,454.55
 WACC = NOI/V = 16.04 % 11/10/2022
Modigliani Miller Approach (MM
Approach)
 According to MM Approach, weighted average cost of capital of a firm is
independent of its capital structure.

 In other words, a firm can not change its value and the cost of capital through
a judicious mix of debt and equity.

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Assumptions

1. Existence of Perfect Capital Market It includes:

a) There is no transaction cost;
b) Flotation costs are neglected;
c) No investor can affect the market price of shares;
d) Information is available to all without cost;
e) Investors are free to purchase and sale securities.
2. Homogeneous Risk Class/Equivalent Risk Class: It means that the expected
yield/return have the identical risk factor i.e., business risk is equal among all
firms having equivalent operational condition.
3. Homogeneous Expectation: All the investors should have identical estimate about
the future rate of earnings of each firm.
4. The Dividend pay-out Ratio is 100%: It means that the firm must distribute all its
earnings in the form of dividend among the shareholders/investors, and
5. Taxes do not exist: That is, there will be no corporate tax effect (although this
was removed at a subsequent date).
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 Calculations of Market Value and Ko

When no corporate taxes exist When corporate taxes exist

(A) Unlevered firm (No Debt) A) Unlevered firm (No Debt)

(1) Total Market value of unlevered firm Vu = NOI ÷ Ke (1) Total Market value of unlevered firm (V u)
(Since Ko=Ke) Vu = NOI (1-t) ÷ Ke (Since Ko=Ke)
(2) WACC (Ko) = Ke
(2) WACC (Ko) = Ke
(B) Levered firm (Debt)
(B) Levered firm (Debt)
(3) Total Market value of levered firm (Vl) Vl =
Vu (2) Total Market value of levered firm (Vl) = Vu +Dt

(4) Market Value of Debt (D) = I ÷ Kd Where, D= Market Value of Debt

(5) Market Value of Equity (S) = Market value of levered t = tax rate
Firm (Vl) – Market Value of Debt (D) (3) Market Value of Debt (D) = I ÷ Kd
(6) Ke = (NOI-Interest) ÷ S (4) Market Value of Equity (S) = Market value of levered Firm
(Vl) – Market Value of Debt (D)
(5) WACC (K0 ) = NOI ÷ Vl (5) Ke = (NOI-Interest-Tax) ÷ S
where S = Market Value of Equity
(5) WACC (K0) = {(NOI-I) (1-t) +I} ÷ V
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Numerical using MM Approach

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 Particulars X ltd Y Ltd
Q.1 The following data relate to two
companies belonging to the same risk Expected NOI Rs.2,40,000 Rs.2,40,000
class. Determine the Value of the firm,
10 % Debt Rs.7,20,000 -
Ke, WACC for each company assuming no
taxes (using MM approach). Equity 15 %
Capitalization
Rate
(A) Unlevered firm (Y Ltd) (No Debt)
(1) Total Market value of unlevered firm V u = NOI ÷ Ke = 2,40,000/0.15
= Rs 16,00,000
(Since Ko=Ke)
(2) WACC (Ko) = Ke = 15 %
(B) Levered firm (X Ltd) (Debt)
(1) Total Market value of levered firm (V l) Vl = Vu = Rs 16,00,000
(2) Market Value of Debt (D) = I ÷ Kd = 72,000/0.10 = Rs 7,20,000
(3) Market Value of Equity (S) = Market value of levered Firm (V l) – Market Value of Debt (D)
= 16,00,000 – 7,20,000 = Rs 8,80,000
(4) Ke = (NOI-Interest) ÷ S = (2,40,000-72,000)/8,80,000 = 19.09 %
(5) WACC (K0 ) = NOI ÷ Vl = 2,40,000/16,00,000 = 15 %
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 Q.2 The following data relate to two Particulars X ltd Y Ltd
companies belonging to the same risk Expected NOI Rs.2,40,000 Rs.2,40,000
class. Determine the Value of the firm, (EBIT)
Ke, WACC for each company assume that 10 % Debt Rs.7,20,000 -
there is 40 % taxes (using MM approach).
Equity 15 %
Capitalization
Rate
Sol: A) Unlevered firm (No Debt)
(1) Total Market value of unlevered firm (Vu)

Vu = NOI (1-t) ÷ Ke (Since Ko=Ke)

(2) WACC (Ko) = Ke

(B) Levered firm (Debt)

(1)Total Market value of levered firm (Vl) = Vu +Dt

Where, D= Market Value of Debt

t = tax rate
(2)Market Value of Debt (D) = I ÷ Kd

(3)Market Value of Equity (S) = Market value of levered Firm (Vl) – Market Value of Debt (D)

(4)Ke = (NOI-Interest-Tax) ÷ S

where S = Market Value of Equity

(5)WACC (K0) = {(NOI-I) (1-t) +I} ÷ V 11/10/2022
Pecking order theory
 Pecking Order Theory or pecking order model postulates that the cost of financing
increases with asymmetric information.
 Financing comes from three sources, internal funds, debt and new equity.
Companies prioritize their sources of financing, first preferring internal financing, and
then debt, lastly raising equity as a "last resort". Hence: internal financing is used
first; when that is depleted, then debt is issued; and when it is no longer sensible to
issue any more debt, equity is issued. This theory maintains that businesses adhere
to a hierarchy of financing sources and prefer internal financing when available, and
debt is preferred over equity if external financing is required (equity would mean
issuing shares which meant 'bringing external ownership' into the company). Thus,
the form of debt a firm chooses can act as a signal of its need for external finance.
 The pecking order theory is popularized by Myers and Majluf (1984)[1] where they
argue that equity is a less preferred means to raise capital because when managers
(who are assumed to know better about true condition of the firm than investors)
issue new equity, investors believe that managers think that the firm is overvalued
and managers are taking advantage of this over-valuation. As a result, investors will
place a lower value to the new equity issuance.

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 Pecking Order Theory starts with asymmetric information as managers know
more about their company's prospects, risks and value than outside investors.
Asymmetric information affects the choice between internal and external
financing and between the issue of debt or equity. Therefore, there exists a
pecking order for the financing of new projects.
 Asymmetric information favours the issue of debt over equity as the issue of
debt signals the board's confidence that an investment is profitable and that the
current stock price is undervalued (were stock price over-valued, the issue of
equity would be favoured). The issue of equity would signal a lack of confidence
in the board and that they feel the share price is over-valued. An issue of equity
would therefore lead to a drop in share price. This does not however apply to
high-tech industries where the issue of equity is preferable due to the high cost
of debt issue as assets are intangible

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Trade Off Theory of Capital Structure
 The trade-off theory of capital structure is the idea that a company chooses how
much debt finance and how much equity finance to use by balancing the costs and
benefits.
 The classical version of the hypothesis goes back to Kraus and Litzenberger who
considered a balance between the dead-weight costs of bankruptcy and the tax saving
benefits of debt.
 Often agency costs are also included in the balance. This theory is often set up as a
competitor theory to the pecking order theory of capital structure.
 A review of the trade-off theory and its supporting evidence is provided by Ai, Frank,
and Sanati.
 An important purpose of the theory is to explain the fact that corporations usually are
financed partly with debt and partly with equity. It states that there is an advantage to
financing with debt, the tax benefits of debt and there is a cost of financing with debt,
the costs of financial distress including bankruptcy costs of debt and non-bankruptcy
costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms,
bondholder/stockholder infighting, etc.). The marginal benefit of further increases in
debt declines as debt increases, while the marginal cost increases, so that a firm that
is optimizing its overall value will focus on this trade-off when choosing
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how much debt
and equity to use for financing.