CAPITAL STRUCTURE

THEORIES
WHAT IS CAPITAL STRUCTURE
 CAPITAL STRUCTURE –
For raising long term
finances a company can issue three types of
securities viz. equity shares, preference shares
and debentures.
A decision about the proportion of these
three types of securities refers to the capital
structure of an enterprise..
IMPORTANCE OF CAPITAL
STRUCTURE -
Financing the firm's assets is a very crucial problem
in any business and as a general rule there
should be a proper mix of debt and equity mix in
financing the assets of any firm.

the use of long term fixed interest bearing debt and

preference share capital along with equity
shares is called financial leverage of trading on equity.

the capital structure can not affect the total

earnings of a firm but it can affect the share of
earnings available for equity shareholders..
FORMS OF CAPITAL STRUCTURE
THE CAPITAL STRUCTURE OF A COMPANY MAY CONSIST OF
ANY OF THE FOLLOWING FORMS –

EQUITY SHARES ONLY

EQITY AND PREFERENCE SHARES
EQITY SHARES AND DEBENTURES
EQUITY SHARES, PREFERENCE SHARES AND DEBENTURES
THEORIES OF CAPITAL STRUCTURE -

1. NET INCOME APPROACH

2. NET OPERATING INCOME
APPROACH
3. THE TRADITIONAL APPROACH
4. MODIGLIANI AND MILLER
APPROACH
NET INCOME APPROACH -
ACCORDING TO THIS THEORY A FIRM CAN
MINIMISE THE WEIGHTED AVERAGE COST OF
CAPITAL AND INCREASE THE VALUE OF THE FIRM AS
WELL AS MARKET PRICE OF EQUITY SHARES BY
USING DEBT FINANCING TO THE MAXIMUM POSSIBLE
EXTENT.

THIS
APPROACH
IS BASED ON CERTAIN ASSUMPTIONS......
ASSUMPTIONS OF NET INCOME
APPROACH -
1. THE COST OF DEBT IS LESS THAN THE COST OF EQUITY.
2. THER ARE NO TAXES.
3. THE RISK PERCEPTION OF INVESTORS IS NOT CHANGED
BY THE USE OF DEBT.

AS THE PROPORTION OF DEBT

FINANCING IN CAPITAL STRUCTURE INCREASE, THE
PROPORTION OF AN EXPENSIVE SOURCE OF FUNDS
INCREASES. THIS RESULTS
IN THE DECREASE IN OVERALL COST OF CAPITAL LEADING
TO AN INCREASE IN THE VALUE OF A FIRM.
THE REASON FOR ASSUMING COST OF DEBT TO BE LESS THAN THE
COST OF EQUITY ARE THAT INTEREST RATES ARE USUALLY LOWER
THAN DIVIDEND RATES DUE TO RISK AND THE BENEFIT OF TAX AS
THE
INTEREST IS A DEDUCTIBLE EXPENSE.
THE TOTAL MARKET VALUE OF A FIRM ON THE BASIS OF NET
INCOME
APPROACH CAN BE ASCERTAINED AS BELOW -

V= S+D

WHERE, V = TOTAL MARKET VALUE OF A FIRM

S = MARKET VALUE OF EQUITY SHARES
D = MARKET VALUE OF DEBT

AND OVERALL CAPITAL CAN BE CALCULATED AS -

FOR EXAMPLE -
A company expects a net income of Rs. 80,000. it
has Rs. 2,00,000, 8% debentures. the equity
capitalisation rate of the company is 10%
calculate the value of the firm and overall
capitalisation rate according to the net income
approach.
and if the debenture debt is increased to rs.
3,00,000 what shall be the value of the firm and
the overall capitalisation rate ?
CALCULATION OF THE VALUE OF THE FIRM

Net income 80,000

LESS : INTEREST ON 8% DEBENTURES OF Rs. 2,00,000 16,000
Earnings available to equity shareholders 64,000
Equity capitalisation rate 10%
Market value of equity (S) = 64,000* 100/10 6,40,000
Market value of debentures (D) 2,00,000
Value of firm (S+D) 8,40000

Calculation of overall capitalisation rate

Overall cost of capital(k0) = EBIT/V

= 80,000/8,40,000*(100) = 9.52%
CALCULATION OF VALUE OF THE FIRM IF DEBENTURES IS
RAISED TO Rs. 3,00,000

Net income 80,000

LESS : INTERST ON 8% DEBENTURES OF rs. 3,00,000 24,000
Earnings available to equity shareholders 56,000
Equity capitalisation rate 10% 10%
Market value of equity = 56,000 *100/10 5,60,000
Market value of debentures 3,00,000
Value of the firm 8,60,000
Overall capitalisation rate = 80,000/8,60,000 * 100 9.30%
NET OPERATING INCOME APPROACH -
This theory is diametrically opposite to the
net income approach. according to this
change in the capital structure of a
company does not affect the market value of
the firm and the overall cost of capital
remains constant irrespective of the method of
financing. it implies that the overall cost of
capital remains the same whether the debt-equity
mix is 50:50 or 20:80 or 0:100.
Thus there is
nothing as an optimal capital structure and
every structure is the optimum capital
structure.
THIS THEORY PRESUMES THAT -
 1. THE MARKET CAPITALISES THE VALUE OF
THE FIRM AS A WHOLE.

2. THE BUSINESS RISK REMAINS CONSTANT AT

EVERY LEVEL OF DEBT EQUITY MIX.

3. THERE ARE NO CORPORATE TAXES.

The reasons propounded for such assumption
are that the increased use of debt increases
the financial risk of the equity shareholders
and hence the cost of equity increases. on the
other hand. the cost of debt remains constant
with the increasing proportion of debt as the
financial risk of the lenders is not affected.

Thus, the advantage of using the cheaper

source of funds., ie., debt is exactly offset by
the increased by the increased cost of equity.
THE VALUE OF A FIRM ON THE BASIS OF NET
OPERATING INCOME APPROACH CAN BE
DETERMINED AS BELOW :

V = EBIT/ K0

WHERE,
V= VALUE OF THE FIRM
EBIT = NET OPERATING INCOME OR
EARNINGS BEFORE INTEREST AND TAX
K0 = OVERALL COST OF CAPITAL
 The market value of equity , according to this
approach is the residual value which is
determined by deducting the market value of
debentures from the total market value of the
firm.

S= V-D
WHERE,
S = MARKET VALUE OF EQUITY SHARES
V= TOTAL MARKET VALUE OF A FIRM
D= MARKET OF DEBT
FOR EXAMPLE -
A company expects a net operating income of rs.
1,00,000 it has Rs. 5,00,000, 6% debentures. the
overall rate is 10%. calculate the value of the firm
and the equity capitalisation rate (cost of equity)
according to the net operating income approach

and if the debenture debt is increased to Rs.

7,50,000. what will be the effect on the value of the
firm and the equity capitalisation rate ?
A. NET OPERATING INCOME = Rs. 1,00,000
OVERALL COST OF CAPITAL = 10%

MARKET VALUE OF THE FIRM (V) = EBIT/K0

= 1,00,000*100/10
= 10,00,000
LESS : MARKET VALUE OF DEBENTURES 5,00,000
TOTAL MARKET VALUE OF EQUITY = 5,00,000

EQUITY CAPITALISATION RATE OR COST OF EQUITY (Ke)

= EARNINGS AVAILABLE TO EQUITY

SHAREHOLDERS/TOTAL MARKET VALUE OF EQUITY SHARES

OR EBIT-I/V-D = 1,00,000-30,000/10,00,000-
5,00,000*(100) = 70,000/5,00,000*100 = 14%

B. IF THE DEBENTURES DEBT INCREASED TO Rs. 7,50,000, THE VALUE OF

THE FIRM SHALL REMAIN UNCHANGED AT Rs. 10,00,000
THE EQUITY CAPITALISATION RATE WILL INCREASE AS FOLLOWS
EQUITY CAPITALISATION RATE (Ke) = EBIT-I/V-D
= 1,00,000-45,000/10,00,000-7,50,000 *100
= 55,000/2,50,000 * 100 = 22%
THE TRADITIONAL APPROACH -
The traditional approach also known as the
intermediate approach is a compromise between the
two extremes of the above mentioned 2 approaches.

according to this theory, the value of the firm can be

increased initially or the cost of capital can be
decreased by using more debt as the debt is a cheaper
source of funds than equity. thus, optimum capital
structure can be reached by a proper debt-equity mix.

beyond a particular point, the cost of equity increases

because increased debt increases the financial risk of the
equity share holders. the advantage of cheaper debt at this
point of capital structure is offset by increased cost of
equity.
After this there comes a stage , when the increased
cost of equity cannot be offset by the advantage
of low - cost debt.

thus, overall cost of capital, according to this theory,

decreases upto a certain point, remains more or
less unchanged for moderate increase in debt
thereafter ; and increases or rises beyond a certain
point. even the cost of debt may increase at this
stage due to increased financial risk.
FOR EXAMPLE -
COMPUTE THE MARKET VALUE OF THE FIRM, VALUE OF SHARES AND THE
AVERAGE COST OF CAPITAL FROM THE FOLLOWING INFORMATION :

NET OPERATING INCOME RS. 2,00,000

TOTAL INVESTMENT RS. 10,00,000

EQUITY CAPITALISATION RATE :
(a) IF THE FIRM USES NO DEBT 10%
(b) IF THE FIRM USES RS. 4,00,000 DEBENTURES 11%
(c) IF THE FIRM USES RS. 6,00,000 DEBENTURES 13%

ASSUME THAT RS. 4,00,000 DEBENTURES CAN BE RAISED AT 5% RATE OF

INTEREST WHEREAS RS. 6,00,000 DEBENTURES CAN BE RAISED AT 6% RATE OF
INTEREST.
COMPUTATION OF THE MARET VALUE OF THE FIRM, VALUE OF SHARES
& THE AVERAGE COST OF CAPITAL
A. NO B.Rs.4,00,00 c. Rs. 6,00,000
DEBT 0 6% debentures
5%
Debentures
NET OPERATING INCOME Rs2,00,000 Rs.2,00,000 Rs. 2,00,000
Less : interest ie. Cost of debt 20,000 36,000
Earnings available to equity 2,00,000 1,80,000 1,64,000
shareholders
Equity capitalisation rate 10% 11% 13%
Market value of (shares) 20,00,000 16,36,363 12,61,538
Market value of debt
(debentures) 4,00,000 6,00,000
Market value of firm 20,00,000 20,36,363 18,61,538
Average cost of capital 2,00,000/ 2,00,000/ 2,00,000/
EBIT/V 2,0,00,000 20,36,363 18,61,538 *100
*100 = 10% *100 = 9.8% 10.7%
It is clear from the above that if debt of
Rs. 4,00,000 is used the value of the firm
increases and the overall cost of capital
decreases. But, if more debt is used to
finance in place of equity, ie. Rs.
6,00,000 debentures the value of the
firm decreases and the overall cost of
capital increases.
MODIGLIANI AND MILLER
APPROACH -
This approach is identical with the net
operating income approach if taxes are
ignored. however, when corporate taxes
are assumed to exist, their hypothesis is
similar to net income approach.
(A) IN THE ABSENCE OF TAXES -
This theory proves that the cost of capital is
not affected by changes in the capital structure
or say that the debt-equity mix is irrelevant in
the determination of the total value of a firm.

The reason argued is that

though debt is cheaper to equity, with increase
use of debt as a source of finance, the cost of
equity increases . This increase in cost of equity
offsets the advantage of the low cost of debt.
Thus , although the financial leverage affects the cost
of equity , the overall cost of capital remains constant.
the theory further propounds that beyond a certain
limit of debt, the cost of debt increases( due to
increase in financial risk) but the cost of equity falls
thereby again balancing the two costs.
according to Modigliani and Miller two identical firms
in all respects except their capital structure cannot
have different market values due to arbitrage process.

In case 2 identical firms except for their capital

structure have different market values or cost of
capital, arbitrage will take place and the investors will
engage in 'personal leverage' (ie. they will buy the
equity of the company having more value) as against
the corporate leverage and this will again render the
two firms have the same total value.
 ASSUMPTIONS -
1. There are no corporate taxes
2. There is a perfect market
3. Investors act rationally
4. The expected earnings of all the firms have identical
risk characteristics
5. The cut off point of investment in a firm is
capitalisation rate
6. Risk to investors depends upon the random
fluctuations of expected earnings and the possibility
that the actual value of the variables may turn out to
be different from their best estimates.
7. All earnings are distributed to the shareholders
 FOR EXAMPLE -
1. The following information are available about the mid air
Enterprises
1. Mid air currently is an all equity company
2. Expected EBIT = 24 lakhs
3. No taxes, so T = 0 percent
4.Mid air pays all its income as dividends
5. If mid air begins to use debt it can borrow at the rate Kd = 8
percent this
borrowing rate is constant and it is independent of the amount of
debt.
Any
Money raised by selling debt would be used to retire common stock.
So mid
Air's assets would remain constant ;
6.The risk of mid air's assets, and thus its EBIT, is such that its share
holders
USING MM MODEL YOU ARE REQUIRED TO

(A) DETERMINE THE FIRM'S TOTAL MARKET VALUE

(B) DETERMINE THE FIRM'S VALUE OF EQITY

(C) DETERMINE THE FIRM'S LEVERAGE COST OF

EQUITY.
A. FIRM’S TOTAL MARKET VALUE :
V = EBIT / Ke
= 24,00,000/0.12 = Rs. 2 crore

B. FIRM MARKET VALUE OF EQUITY :

S= V-D
= 2-1 = Rs. 1 crore

C. FIRM’S LEVERAGE COST OF EQUITY :

= COST OF EQUITY + (COST OF
EQUITY – COST OF DEBT)
= 12% +(12%-8%)
= 16%
 2. WHEN THE CORPORATE TAXES ARE
ASSUMED TO EXIST-
According to Modigliani and Miller the value of the firm
will increase or the cost of capital will decrease with
the use of debt on account of deductibility of interest
charges for tax purpose. Thus the optimum capital
structure can be achieved by maximising the debt
equity mix in the equity of the firm.

According to the M & M approach, the value of

a firm unlevered can be calculated as
VALUE OF UNLEVERED FIRM (Vu) = EARNINGS BEFORE
INTEREST & TAX / OVERALL COST OF CAPITAL ie.
EBIT/K0(1-t)

AND THE VALUE OF UNLEVERED FIRM IS

VL = Vu + tD
WHERE , Vu IS VALUE OF UNLEVERD FIRM
AND, tD IS THE DISCOUNTED PRESENT VALUE OF THE
TAX SAVINGS RESULTING FROM THE TAX
DEDUCTIBILITY OF THE INTEREST CHARGES, t IS THE
RATE OF TAX AND D THE QUANTUM OF DEBT USED IN
THE MIX.
FOR EXAMPLE -
A company has earnings before
interest and taxes of Rs. 1,00,000. It
expects a return on its investment
at a rate of 12.5%. You are required
to find out the total value of the
firm according to the Miller -
Modigliani theory.
ACCORDING TO M & M THEORY , TOTAL VALUE OF THE FIRM REMAINS
CONSTANT. IT DOES NOT CHANGE WITH THE CHANGE IN CAPITAL
STRUCTURE

TOTAL VALUE OF FIRM = EARNINGS BEFORE INTEREST AND

TAX/ OVERALL COST OF CAPITAL

OR V = EBIT/ K0

= 1,00,000/12.5/100

= 1,00,000 * 100/12.5 = Rs. 8,00,000

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