CAPITAL STRUCTURE

Capital Structure
The optimum capital structure may
be defined as the capital structure or
combination of debt and equity that
leads to the maximum value of the
firm.

Major capital structure

theories

1)Net Income Approach

2)Net Operating Income Approach
3)Modigliani-Miller(MM)approach
4)Traditional Approach

Assumptions
1)There are only two source of funds
2)There are no corporate taxes
3)The dividend-payout ratio is 100
4)The total assets remain constant
5)Firms total financing remain
constant.

Assumptions
6)Risk perception of the investor
remains constant
7)The operating profit(EBIT)are not
expeted to grow
8)Perpectual life of the firm
9)Return on Investment remains
constant
10)Investors profits remains constant

Definitions and symbols

S=total market value of equity
B=total market value of debt
I=total interest payments
V=total market value of the
firm(V=S+B)
NI=net income available to equity
holders

Definitions and symbols

Cost of debt(kd)=I/B
Value of debt(B)=I/Kd
Cost of equity capital (Ke)=D1/S
Value of equity(S)=D1/Ke
Value of firm(V)=B+S
Weighted average cost of debt(Wd)=B/V
Weighted average cost of equity(We)=S/V
Ko=Wd.Kd+We.Ke
Ko=B/V*Kd+S/V*Ke

Net operating Income

Approach
Any change in leverage will not lead
to any change in the total value of
the firm and the market price of
shares as well as the overall cost of
capital is independent of the degree
of leverage.

Propositions/Assumptions of
NOI Approach
1)Overall cost of capital/capitalisation Rate
is constant
2)Residual Value of equity
S=V-B
3)Changes in cost of equity capital
4)Cost of Debt
Explicit cost
Implicit cost
5)Optimum capital structure

Net Income approach

According to the Net Income
approach, suggested by the Durand,
the Cpital structure decision is
relevant to the valuation of the
firm.In other words, a change in the
financial leverage will lead to a
corresponding change in the overall
cost of capital as well as the total
value of the firm.

Assumptions
The IN approach to valuation is based on three
assumptions:
1)There are no taxes
2)The cost of debt is less than the cost of equity
3)That the use of debt does not change the risk
perception of investors.
Thus, with the cost of debt and cot of equity
being constant, the increased use of debt, will
magnify the shareholders earnings and, thereby,
the market value of the ordinary shares.

Modigliani-Miller approach
The Modigliani-miller Thesis relating to the
relationship between the capital structure,cost
of capital and valuation is akin to the NOI
Approach.The MM proposition supports the;
NOI approach relating to the independence of
the cost of capital of the degree of leverage at
any level of debt-equity ratio.The significance
of their theory hypothesis lies in the fact that
it provides behavioural justification for
constant overall cost of capital, and
,therefore,total value of the firm.

Basic Propositions
There are three basic propositions of the MM
Approach:
1) overall cost of capital(Ko) and the value of the
firm(V) are independent of its capital structure
2) Ke=Ko of pure equity firm plus a premium for
financial risk
that is,Ke increases in a manner to offset
exactly the use of a less expensive source of
funds represented by debt.
3)The Cut-off rate for investment purposes is
independent of capital structure.

Assumptions
1)Perfect capital market
Investors are free to buy/sell securities
Investors can borrow without restrictions
on the same terms and conditions as
firms can
There are no transaction costs
Information is perfect
Investors are rational and behave
accordingly

Assumptions
2)Investors have the same
expectations of firms EBIT
3)Business risk is equal among all
firms with similar operating
environment
4)The dividend payout ratio is 100%
5)There are no taxes.this assumption
is removed later.

Proposition-1
The total value of a firm must be constant
irrespective of the degree of leverage.
Similarly, the cost of capital as well as the
market price of shares must be the same
regardless of the financing-mix.
Operational justification:
Arbitrage process
Equilibrium is restored in the market price
of a security in different markets.

Proposition-1
Operational justification:
Two firm which are exactly similar in
all respects except leverage
The total value of the homogeneous
firms which differ only in respect of
leverage cannot be different because
of the operation of arbitrage.
Home trade leverage/personal
leverage

Arbitrage process
Switching from levered firm to
unlevered firm
Switching from unlevered firm to
levered firm

Corporate taxes and MM

approach
MM agree that the value of the firm will
increase and cost of capital will decline
with leverage, if corporate taxes exists:
Interest on debt is tax deductable
Actual cost of borrowing is
comparatively low
The levered firm would have greater
market value than an unlevered firm.

Corporate taxes and MM

approach
MM state that the value of the levered
firm would exceed that of the unlevered
firm by an amount equal to the levered
firms debt multiplied by the tax rate.
Vt=Vu+Bt
Vt=value of levered firm
Vu=value of unlevered firm
B=value of debt
T=Tax rate

Limitations of MM Approach
The risk perception of personal and
corporate leverage are different
Higher risk exposure, the investors
would find the personal leverage
inconvenient
Constraint on the perfect
substitutability of personal and
corporate leverage is cost
Institutional restrictions stand in the
way of a smooth operation of the

Limitations of MM Approach
The arbitrage process may not
actually work because of double
leverage {An investor would have
leverage both in personal portfolio as
well as in the firms portfolio}
Transaction costs would affect the
arbitrage process

Limitations of MM Approach
Personal leverage and corporate
leverage are, therefore not perfect
substitutes.This implies that the
arbitrage process will be hampered
and will not be effective.
If corporate taxes are taken into
account the MM approach will fail to
explain the relationship between
financing decision and value of the
firm.

TRADITIONAL APPROACH
The Traditional approach is midway between
the NI and NOI approaches.It parttakes of some
features of both these approach.
It resembles the NI approach in arguing that
cost of capital and total value of the firm are
not independent of the capital structure.
But it does not subscribe to the view(of NI
approach) that value of a firm will necessarily
increase for all degrees of leverage.

TRADITIONAL APPROACH
In one respect it shares a feature
with the NOI approach that beyond a
certain degree of leverage, the
overall cost increases leading to a
decrease in the total value of the
firm. But it differs from the NOI
approach in that it does not argue
that the weighted average cost of
capital is constant for all degree of
leverage.

TRADITIONAL APPROACH
If however, the amount of debt is
increased further, two things are
likely to happen:
1)owing to increased financial risk,Ke
will record a substantial rise
2)The firm would become very risky
to the creditors who also would like
to be compensated by a higher
return such that Ki will rise.

TRADITIONAL APPROACH
The crux of the traditional view relating to
leverage and valuation is that through
judicious use of debt-equity proportions, a
firm can increase its total value and
thereby reduce its overall cost of capital.
The advantages arising out of the use of
debt is so large that, even after allowing
for higher Ke, the benefit of the use of the
cheaper source fo funds is still available.

TRADITIONAL APPROACH
There are, of course, variations to the
traditional approach. According to one of
these, the equity capitalisation
rate(Ke)rises only after a certain degree of
leverage and not before,so that the use of
debt does not necessarily increase the
Ke.this happens only after a certain degree
of leverage.The implication is that a firm
can reduce its cost of capital significantly
with the initial use of leverage.

TRADITIONAL APPROACH
Another variant of the traditional
approach suggests that there is no
one single capital structure,but,there
is a range of capital structures in
which the cost of capital(Ko) is the
minimum and the value of the firm is
the maximum.In this range,changes
in leverage have very little effect on
the value of the firm.

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