Chapter 4 Capital Structure Theory 3-1

Chapter 4: Capital Structure Theory

B Market value of debt K
o
Overall cost of capital
EBIT Earnings Before Interest & Tax NI Net Income = EBITI
EPS Earnings Per Share NS No. of Shares
I Total Interest S Market value of equity
K
d
Cost of debt V Value of the firm = S + B
K
c
Cost of equity VPS Market Value Per Share

Formulas Main Assumptions
N
I


A
p
p
r
o
a
c
h


a. There are no corporate taxes;
b. Cost of debt (K
d
) is less than cost of
equity (K
e
);
c. K
d
and K
e
will remain constant.
d. Total value of the firm may be enhanced by
lowering its cost of capital by the use of
debt capital.
S =
LBI1-I
K
c


I = S +B I =
LBI1-I
K
c

+B
K
0
=
EBII
I

K
0
= K
d
_
B
I
] +K
c
_
S
I
]
IPS =
S
NS

EPS =
S
NS


N
O
I


A
p
p
r
o
a
c
h

I =
EBII
K
0

a. There are no corporate taxes;
b. K
O
and K
d
will remain constant.
c. If degree of leverage increases, cost of
equity (K
e
) will also increase.
d. The value of the firm depends on its net
operating income and business risk.

S = I B
K
c
=
EBII I
S

K
c
= K
0
+(K
0
K
d
)
B
S


T
r
a
d
i
t
i
o
n
a
l


A
p
p
r
o
a
c
h

S =
EBII I
K
c

a. K
d
remains constant up to a certain degree
of leverage and thereafter rises;
b. K
e
remains constant or rise gradually up to a
certain degree of leverage and thereafter
increases rapidly;
c. There is an optimal capital structure which
minimises the overall cost of capital.
B =
I
K
d

I = S +B
K
0
= K
d
_
B
I
] +K
c
_
S
I
]

M
-
M

H
y
p
o
t
h
e
s
i
s

(
n
o

T
a
x
)

I =
EBII
K
0

a. K
O
will remain constant.
b. 100% dividend payout ratio
c. In unlevered situation, K
0
= K
c

d. Total market value of the firm and the cost
of capital are independent of the capital
structure.
S = I B
K
c
=
EBII I
S

K
c
= K
0
+(K
0
K
d
)
B
S


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