Unit 2

Theory of Capital Structure

Capital Structure Theory
• Composition of long term fund - Debt capital and equity Capital
• Cost of Debt Kd
e.g. Interest = 50,000 and market value of interest the debt = 1,000,000
• Required Return on Equity (Ke)
Kd
e.g. Earning = Rs 300000 Market value of equity = 4,000,000
• Overall Capitalization Rate
Ko or
Net Income Approach( NIA)
• The theory was propounded by David Durand ( Fixed Ke Theory)
• According to this approach the value of the firm is increase and
decrease overall cost of capital by increasing the proportion of debt
financing in capital structure.
• It is due to the fact that debt is generally a cheaper source of finance
because :
• Interest rate is lower than the dividend rate
• Benefit of tax because interest is deductible expense
Assumptions of NI Approach
• There are no taxes
• The cost of debt is less than the cost of equity
• The uses of debt does not change the risk perception of the investor.
Use of more debt lowers the overall cost of capital High debt results into higher value of the firm
2.1 EBIT = 10 m 8
O/S Debt = 20 m at cost 7%

a. Cost of equity 12.5 %

EBIT 10m
Less interest (20m x 7% ) 1.4 m
--------
Earning to Common 8.6 m

Market value of equity (S) =

Market value of equity (S) 68.8m

Market value of Debt ( B) 20 m
--------
Total market value of the firm(V) 88.8

B. Additional 10 m debt
Net Operating Income ( NOI) Approach
• Capital Structure does not matter in determining the value of firm
• It suggest that the value of firm remains same and is not affected by the
change in debt composition of financing
• Increase in debt composition results in increased risk perception by
investors
• Thus firm appears to be more risky with more debt as capital which
result in higher required rate of return by investors
• The WACC and market value of firm remains same with increased cost of
equity
 • There are only two sources of financing –
Debt & Equity
• Value of equity is calculated by deducting the
value of debt from Total value of firm
• Value of firm is EBIT / Overall cost of capital
Assumptions • WACC remains constant and with an increase
in debt, the cost of equity increases
• Dividend payout ration is 1
• No taxes & no retained earning
 Numerical ( Case 1)
• Information Given
EBIT = 300,000 Debt = 500,000 cost debt = 5% WACC= 10%
Solution:
EBIT = 300,000 WACC= 10%
Market value of firm =3,000,000
Total debt = 500,000
Total equity = Market value of firm – Total debt = 3,000,000-500,000 = 2,500,000
Shareholder’s Earnings = EBIT- Interest on debt = 300,000- ( 5% of 500,000) =
275000
Cost of equity =
 Numerical ( Case 2)

Information Given
EBIT = 300,000 Debt = 800,000 cost debt = 5% WACC= 10%
Solution:
EBIT = 300,000 WACC= 10%
Market value of firm =3,000,000
Total debt = 800,000
Total equity = Market value of firm – Total debt = 3,000,000-800,000 = 2,200,000
Shareholder’s Earnings = EBIT- Interest on debt = 300,000- ( 5% of 800,000) =
260,000
Cost of equity =
Comparison

Case 1 Case 2
• EBIT = 300,000 • EBIT = 300,000
• WACC= 10% • WACC= 10%
• Market value of firm = • Market value of firm =
3000,000 3000,000
• Debt = 500,000 • Debt = 800,000
• Equity = 2500,000 • Equity = 2200,000
• Cost of Equity = 11% • Cost of Equity = 11.81%
The Modigliani- Miller’s (MM) Proposition
• Fanco Modigliani and Merton Miller
“ The cost of Capital, Corporation Finance and the Theory of
Investment” in 1958 American Economic Review
Argue – Firm’s market value and the cost of capital remain invariant to
the capital structure change in the absence of taxes
Discussed- Two Propositions in relation cost of capital , Capital
structure, value of the firm
Assumptions
• Capital market are perfect – Information is readily available to all
investors, there is no transaction cost, investors are rational.
• All investors have homogeneous expectation about future expected
operating income of the firm such that the expected value of the
probability distributions of expected operating income for all future
period are the same as present operating income.
• Firms can be categorized under equivalent return class all firms in the
same return class have same degree of business risk.
• No corporate income tax
Proposition I
• The market value of any firm is independent of its capital structure
and is given by capitalizing its expected return at the overall
capitalization rate appropriate to its risk class.
Two Firm X and Y in the same class. They have Rs 2000 in net operating income or EBIT. Firm X is an
Unlevered firm ( No debt use) and Firm Y has used Rs 5000 in debt on which it pays 10% annual interest.
According to the Traditional approach to capital structure The levered firm Y must have higher total value
Firm X ( Vu) Firm (VL)
EBIT Rs 2000 Rs 2000
Less : interest ( 5000 x 10%) Rs 500
EBT ( EBIT-I) Rs 2000 Rs 1500
Cost of equity ( Ke) 14% 15%
Market value of equity (S) Rs 14286 Rs 10000
Market value of Debt (B) Rs 5000
Total value of the firm(V) (B+S) Rs 14286 Rs 15000
Overall capitalization rate (Ko) 14% 13.33%

Person A cash Rs 1000

Share holder in Firm Y = 10% + Borrowing Rs 500 ( interest 10%)
Investment = 10 % x Rs 10000 = Rs 1000 Total Rs 1500
He sells his share in open market He require only Rs 1429 to buy 10% of the ownership in firm X
Eq= 929 debt 500 = 1429
What about the effect in your earning position?
Previously it was Rs 150 in firm Y ( 15% of 1000)
Earning is 200 in firm X ( 14% of 1429) – interest Rs 50 = Rs 150
 Proposition II
• The expected yield of a share of stock is equal to the appropriate
capitalization rate for a pure equity in the class plus a premium
related to financial risk equal to the debt to equity ratio times the
spread between pure equity capitalization rate and debt capitalization
rate.
• The expected return on equity is positively related to leverage
because the risk to common stockholder increase with leverage

= Cost of levered equity

𝐾 𝑒( 𝐿) = 𝐾 𝑒( 𝑈 ) + [ 𝐾 𝑒 ( 𝑈 ) − 𝐾 𝑑 ] ( )
𝐵
𝑆
• Risk premium required - stock holders of levered firm
• Observation of this equation
If cost of Unlevered equity exceeds the cost of debt
Cost of levered equity rises with increase in debt- equity ratio
The firm’s overall cost of capital cannot be reduced as debt is
substituted for equity
Prove – both the value of the firm and the overall cost of capital are
invariant to capital structure changes
Taxes and Capital structure
• e.g EBIT = Rs 2000 Firm X (U) firm Y (L)
• Debt = 5000 Interest =10% Tax =40%

Firm X Firm Y
EBIT 2000 2000
Less : Interest 500
EBT 2000 1500
Less tax ( 40%) 800 600
Earning Available to common stockholder 1200 900
Earning available to all security holders 1200 900+500=
1400
Overall Capitalization rate (Ko) 12% 13.33%
• Assuming that firm Y Perpetual debt :
The present value of debt tax shield=

Value of a levered firm = Value of unlevered + PV of debt tax shield

e.g.
Effects of Bankruptcy Cost
• There is an optimal capital structure that maximizes the value of the firm in
balancing the costs and benefits of an additional unit of debt
• Model of tradeoff
• Optimal level of leverage is achieved by balancing the benefits from interest
payment and costs of issuing debt.
• Benefit of debt
- Tax shield benefit – Interest expense are tax deductible but in equity div are not
- Added Discipline – Manager to think more about the investment decision more
carefully and reduce bad investment
- Firm value = firm cost
- Firm market value is not affected by capital structure