Capital Structure

Theories

In this chapter

Net income and net operating income

approaches
Optimal capital structure
Factors affecting capital structure
EBIT/EPS and ROI & ROCE Analysis
Capital Structure Policies in practice

Capital Structure

Capital structure includes only long term

debt and total stockholder investment.
Capital Structure = Long Term Debt +
Preferred Stock + Net Worth
OR
Capital Structure = Total Assets Current
Liabilities.

Optimal Capital Structure

It is that capital structure at that level of debt

equity proportion where the market value per
share is maximum and the cost of capital is
minimum.
Features:

Profitability
solvency
Flexibility
Conservation
control

Determinants / Factors affecting

Capital Structure

The benefit of debt.

Control
Seasonal variations
Industry life cycle.
Company characteristics
Requirement of investors
Purpose of finance

Flexibility
Industry leverage ratios
Degree of competition
Agency cost
Timing of public issue
Period of finance
Legal requirements.

Patterns of Capital Structure

1.
2.
3.
4.

Complete equity share capital;

Different proportions of equity and preference
share capital;
Different proportions of equity and debenture
(debt) capital an
Different proportions of equity, preference and
debenture (debt) capital.

EBIT EPS Approach

In this approach, it is analyzed that how

sensitive is EPS to the changes in EBIT
under different capital structure.

ROI ROE Approach

This approach analyses the relationship

between the ROI and ROE for different
levels of financial leverage.

Theories of Capital Structure

Net Income Approach

Net Operating Income Approach
Modigliani and Miller Approach [MM
Hypothesis]
Traditional Approach.

Assumptions of Capital Structure

Theories
Firm uses only two sources of funds: perceptual riskless debt and equity;
There are no corporate or income: or personal tax;
The dividend payout ratio is 100% [There are no retained earnings];
The firms total assets are given and do not change [Investment decision
is assumed to be constant].
The firms total financing remains constant. [Total capital is same, but
proportion of debt and equity may be changed];
The firms operating profits (EBIT) are not expected to grow;
The business risk is remained constant and is independent of capital
structure and financial risk;
All investors have the same subject probability distribution of the
expected EBIT for a given firm; and
The firm has perpetual life;

Definitions used in Capital Structure

E = Total Market Value of Equity.

D = Total Market Value of Debt.
V = Total Market Value of the Firm.
I = Annual Interest payment.
NI = Net Income.
NOI = Net Operating Income.
Ee = Earning Available to Equity Shareholder.

Net Income Approach

A change in the proportion in capital structure will lead

to a corresponding change in Ko and V.
Assumptions:
(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(iii) Use of debt in capital structure does not change the
perception of investors.
(iv) Cost of debt and cost of equity remains constant;

risk

Net Income Approach

Formula used for NI Approach

Net Income [NI] = EBIT Debenture

Interest.
Value of the Firm [V] = Market Value of
Equity [E] + Market Value of Debt [D]
Market Value of Equity [E] = Net Income
[NI] / Cost of Equity [Ke]
Cost of Capital [Ko] = EBIT / V * 100

Net Operating Income Approach

There is no relation between capital structure and Ko and V.

Assumptions:
(i)

Overall Cast of Capital (Ko) remains unchanged for all degrees of

leverage.
(ii) The market capitalises the total value of the firm as a whole and no
importance is given for split of value of firm between debt and equity;
(iii) The market value of equity is residue [i.e., Total value of the firm minus market
value of debt)
(iv) The use of debt funds increases the received risk of equity investors, there by ke
increases
(v) The debt advantage is set off exactly by increase in cost of equity.
(vi) Cost of debt (Ki) remains constant
(vii) There are no corporate taxes.

Net Operating Income Approach

Formula used for NOI Approach

Value of the Firm [V] = EBIT / Ko

Market Value of Equity [E] = V D
Cost of Equity/ Equity Capitalization Rate
[Ke] = Ee / E or EBIT I / V - D

MM Hypothesis

This approach was developed by Prof.

Franco Modigliani and Mertan Miller.
According to this approach, total value of
the firm is independent of its capital
structure.

Assumptions
a.
b.
c.
d.
e.
f.
g.
h.
i.

Information is available at free of cost

The same information is available for all investors
Securities are infinitely divisible
Investors are free to buy or sell securities
There is no transaction cost
There are no bankruptcy costs
Investors can borrow without restrictions as the same
terms on which a firm can borrow
Dividend payout ratio is 100 percent
EBIT is not affected by the use of debt

Propositions:
I. Ko and V are independent of capital structure
II.Ke = to capitalisation rate of the pure equity plus a
premium for financial risk.
Ke increases with the use of more debt. Increased Ke
off set exactly the use of a less expensive source of
funds (debt)
III.The cut of rate for investment purposes is completely
independent of the way in which an investment is
financed.

MM Approach [Proposition I]
arbitrage Progress:

Refers to an act of buying an asset or security in one market at lower

price and selling it is an other market at higher price.
Steps in working out Arbitrage Process:
Step 1: Investors Current Position: In this step there is a need to find
out the current investment and income (return).
Step 2: Calculation of Savings in Investment by moving from levered
firm to unlevered firm. Savings in investment is equals to total
funds [Funds raise by sale of shares plus funds raised by
personnel borrowing] minus same percentage of investment.
Here the income will be same which was earning in previous
firm.
Step 3: Calculation of Increased Income, by investing total funds
available.

Limitations of MM Approach

Investors cannot borrow on the same terms and

conditions of a firm
Personal leverage is not substitute for corporate
leverage
Existence of transaction cost
Institutional restriction on personal leverage
Asymmetric information
Existence of corporate tax

Traditional Approach

This approach was given by Soloman.

This approach is the midway between NI
Approach and NOI Approach.
Traditional approach says judicious use of debt
helps increase value of firm and reduce cost of
capital

Main Prepositions
1. The pretax cost of debt (Ki) remains more or less constant up to a certain
degree of leverage and /but rises thereafter of an increasing rate
2. The cost of equity capital (Ke) remains more or less constant rises slightly
up to a certain degree of leverage and rises sharper there after, due to
increased perceived risk.
3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of
debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a)Decreases up to a certain point level of degree of leverage [stage I increasing
firm value];
(b) Remains more or less unchanged for moderate increase in leverage
thereafter [stage II optimum value of firm], and

(c) Rises sharply beyond certain degree of leverage [stage III decline in firm
value].