CHAPTER 15

CAPITAL STRUCTURE THEORY AND POLICY

Q.1 Explain the assumptions and implications of the NI approach and the NOI
approach. Illustrate your answer with hypothetical examples.
A.1 Under the Net Income (NI) approach, the cost of debt and cost of equity are
assumed to be independent to the capital structure. The weighted average cost of
capital declines and the total value of the firm rises with increased use of
leverage.
Under the net operating income (NOI) approach, the cost of equity is assumed to
increase linearly with leverage. The weighted average cost of capital remains
constant and total value of firm also remains constant as leverage is changed.
Example:
Assume that EBIT (i.e., Net Operating Income) is Rs. 100,000. The amount of
debt employed by firm Rs. 700,000; the cost of debt 6%; and the rate of return
expected by equity shareholders 10%. ko = 8%.

NI Approach:
Rs.
NOI 100,000
Less: Interest costs 42,000
----------
Net income available to shareholders 58,000
----------
Market value of equity(S) 580,000 (58000/0.10)
Market Value of Debt (D) 700,000
-------------
Total value of firm (S+D) 1,280,000
-------------

NOI Approach:

Rs.
NOI 100,000
Market value of firm 1,250,000 (100,000/0.08)
Market value of Debt (D) 700,000
Market value of Share (S) 550,000

Now, assume that value of debt increases to Rs. 900,000

NI approach:
Rs.
NOI 100,000
Less: Interest cost 54,000 (900,000 x 6%)
---------

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 Equity Earnings 46,000
Market value of shares (S) 460,000 (46000/0.10)
Market value of debt (D) 900,000
-------------
Total value of firm 1,360,000
-------------
NOI approach:
Rs.
NOI 100,000
Market value of firm 1,250,000
Market value of debt (D) 900,000
Market value of share (S) 350,000

From the above, it is clear that as per NI approach the value of firm increases as
the use of debt increases, i.e., from Rs. 1,250,000 to Rs. 1,360,000. As per NOI
approach, the value of firm remains constant.

Q.2 Describe the traditional view on the optimum capital structure. Compare and
contrast this view with the NOI approach and the NI approach.
A.2 According to traditional approach, the cost of capital declines and the value of the
firm increases with leverage up to a prudent debt level and after reaching the
optimum level, leverage cause the cost of capital to increase and the value of the
firm to decline. The optimum capital structure occurs when the cost of capital is
minimum or the value of firm is maximum.
The NI approach indicates that the total value of firm rises with increased use of
leverage, and weighted average cost of capital declines.
The NOI approach assumes that the total value of firm remains constant as
leverage is changed, because the cost of equity increases linearly with leverage
and sets off the benefits of debt capital.
The NI approach is valid, if financing decisions have an important effect on the
value of firm. NOI approach is valid, if the financing decisions is not of great
concern, but overall cost of capital depends on business risk. Traditional approach
is based on the NI approach.

Q.3 Explain the position of M-M on the issue of an optimum capital structure,
ignoring the corporate income taxes. Use an illustration to show how home-made
leverage by an individual investor can replicate the same risk and return as
provided by the levered firm.
A.3 The Modigliani-Miller hypothesis is identical with the NOI approach. M-M
approach indicates that a firm’s market value and the cost of capital remain
invariant to the capital structure changes, i.e., any combination of debt and equity
is as good as any other. M-M hypothesis indicates that securities are traded in
perfect capital market situation, and firms can be grouped into homogeneous risk
classes. Further, it is also assumed that no corporate income taxes exist, and firms
distribute all net earnings to the shareholders.

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 If two identical firms, except for the degree of leverage, have different market
values, arbitrage will take place to enable investors to engage in personal or
home-made leverage as against the corporate leverage to restore equilibrium in
the market.
Example:
Assume that two firms, i.e., un-leveraged firm U and leveraged firm L – have
identical expected NOI of Rs. 10,000. The value of leveraged firm is Rs. 110,000
– the value of equity shares being Rs. 60,000 and the value of debt Rs. 50,000,
and the value of un-leveraged firm is Rs. 100,000. Firm L have borrowed at the
expected rate of return of 6%. Assume that an investor, Mr. X, holds 10% of
shares of leveraged firm. How arbitrage benefits him?

Mr. X’s value of investment in firm L = Rs. 6,000 (60,000 x 10%)

Mr. X’s return from firm L
= 10% of (EBIT – INT)
= 10% (10,000 – 3,000)
= Rs. 700.
Now, Mr. X will sell his shares of firm L for Rs. 6,000, and will borrow Rs. 5,000
(Rs. 50000 × 10%) at 6% interest rate on his personal account. He will invest Rs.
11,000 to purchase shares of firm U (Rs 110,000 × 10%).
Mr. X’s return from firm U Rs.
= 10% x 11,000 = 1100
Less: Interest on personal borrowing
= 6% x 5,000 = 300
-----
Rs. 800
-----
This strategy pays to Mr. X more return at same investment. As a result of this
switching, i.e., arbitrage process, the market value of leveraged firm’s share will
decrease and that of un-leveraged firm will increase. So, equilibrium takes place
when values of both firms, i.e., U and L are identical.

Q.4 Assuming the existence of the corporate income taxes, describe M-M’s
proposition on the issue of optimum capital structure.
A.4 When the corporate taxes are assumed, firms can increase earnings of investors
through borrowing which results in interest tax shield. Under the assumption of
infinite stream of constant tax shield, the value of interest tax shield (PVINTS) is
equal to tax rate multiplied by debt (TD).
T ( k d D)
PVINTS = = TD
kd
where T is the corporate tax rate, kd is the cost of debt and D is the amount of
debt. Thus the market value of levered firm is equal to market value of un-levered
firm plus the present value of interest tax shield.

Q.5 ‘The M-M thesis is based on unrealistic assumptions.” Evaluate the reality of the
assumptions made by M-M.

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A.5 The M-M thesis is based on the assumption of perfect capital market in which
arbitrage is expected to work. The assumption that firms and individuals can
borrow and lend at the same rate of interest may not hold in practice. In reality,
firms are able to borrow at lower rates of interest than individuals. The existence
of limited liability of firms in contrast with unlimited liability of individuals
makes it incorrect to assume that ‘personal leverage’ is a perfect substitute of
‘corporate leverage’. The existence of transaction costs also interferes with the
working of arbitrage. The existence of number of institutional investors would
make it unfeasible to substitute personal leverage for corporate leverage. The
existence of corporate income tax provide the interest tax shield benefits to firm,
which results in lower cost of borrowed funds than the contractual rate of interest.

Q.6 How does the cost of equity behave with leverage under the traditional view and
the M-M position?
A.6 According to the traditional view, the rate at which shareholders’ capitalize their
net income, i.e., the cost of equity, ke remains constant up to certain level of debt,
(i.e., a certain degree of leverage). Later on, further increase in the leverage
increases the cost of equity due to the added risk (i.e., financial) and offsets the
advantage of low cost of debt, after the acceptable limit of leverage.
On the other hand, according to M-M view, the cost of equity increases with debt;
, ke, is equal to the constant average cost of capital, ko, plus a premium for the
financial risk, which is equal to debt-equity ratio times the spread between the
constant average cost of capital and the cost of debt, (ko – kd) D/E. The ke is a
linear function of leverage, measured by the market value of debt to equity, D/E.

Q.7 Consider two firms, L and U, that are identical except that L is levered where as U
is un-levered. Let Vl and Vu stand respectively, for the market value of L and U.
In a perfect market, would one expect Vu to be less or greater than or equal to Vl?
Explain.
A.7 In a perfect market Vu will be equal to Vl. If Vu is less than Vj then arbitrage
process (as suggested by M-M) will take place and value of both firms will
become equal. The arbitrage process is explained above in answer A. 3.

Q.8 “When the corporate income taxes are assumed to exist, Modigliani and Miller
and the traditional theorist agree that capital structure does affect value, so the
basic point of dispute disappears.” Do you agree? Why or Why not?
A.8 Two theories are based on different premises. Taxes or no taxes, traditional theory
is based on the assumption that leverage has three-stage effect on value of the
firm (or the firm’s cost of capital). First, there is a favourable effect on value.
Second, there is no effect. Third, as the use of leverage goes beyond certain level
(undefined level) , there is unfavourable effect. The MM theory, on the other
hand, is based on the assumption that there is a linear relationship between
leverage and financial risk. Since the advantage of leverage taken off by the
financial risk, there is no effect on value. When corporate taxes are considered,
there is a net advantage of leverage because of interest tax shield.

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Q.9 Explain the effect of capital structure on the value of the firm when both corporate
and personal income taxes are considered?
A.9 Investors are required to pay personal taxes on the income earned by them.
Hence, from investor’s view point, taxes will include both corporate and personal
taxes. So, firms have to aim at minimizing the total taxes while deciding about
capital structure.
The advantage of interest tax shield is offset by the personal taxes paid by debt
holders on interest income. Income on account of interest is tax-exempt at
corporate level while dividend income is not. Interest income is taxed at personal
level while dividend income may largely escape personal taxes. Thus, companies
can induce tax paying investors to buy debt securities if they are offered high rate
of interest. But after a stage it will not be possible to attract investors in the high
tax brackets. This point establishes the optimum debt ratio in the economy.
Thus, the value of leveraged firm will be equal to value of un-leveraged firm plus
present value of interest tax shield benefits. The present value of interest tax
shield (PVINTS) is:
é 1 - T )(1 - Tpe) ù
PVINTS = ê1 -
(1 - Tpb) úû
D
ë
where T is corporate tax rate; Tpe is personal tax rate on equity income; Tpb is
personal tax rate on dividend income; and D is the amount of debt.

Vl = Vu + PVINTS

where Vl value of leveraged firm and Vu is value of un-leveraged firm.

Q.10 What is financial distress? How does it affect the value of firm?
A.10 The offsetting advantage of debt is grouped under the term financial distress.
Financial distress occurs when the firm finds it difficult to honour the obligations
of creditors, which may lead to insolvency also. The financial distress also
introduces inflexibility of raising funds by firm when needed. The financial
distress reduces the value of the firm, on account of insolvency costs like legal
costs, arranging the funds at higher cost of capital, etc. Hence:
Value of leveraged firm = Value of un-leveraged firm + PV of tax shield benefit –
PV of financial distress.
The costs of financial distress increases as more and more debt is introduced in
the capital structure of the firm.

Q.11 Define the capital structure. What are the elements of a capital structure? What
do you mean by an appropriate capital structure? What are the features of an
appropriate capital structure?
A.11 Capital structure refers to the mix of long term sources of funds, such as
debentures, long term debt, preference share capital and equity share capital
including reserves and surpluses.
The appropriate capital structure maximizes the long term market price per share,
also keeping in view the financial requirements of a company.
A sound or appropriate capital structure should have the following features:

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 1. It should generate maximum returns to the shareholders.
2. There should not be the use of excessive debt to maintain long term solvency.
3. The capital structure should be flexible, to provide funds to finance its
profitable activities in future.
4. The capital structure should involve minimum risk of loss of control of the
company.

Q 12 Briefly explain the factors that influence the planning of the capital structure in
practice.
A 12 In addition to the concerns about EPS, value of firm and cash flow; the other
important considerations are as follows:
The desire to continue control over the company. For example, closely held
companies do not make issues of new shares, while widely-held companies may
make issue of new equity shares.
The firm’s willingness to venture into new profitable activities as and when
needed, then they may like to have present target debt ratio at lower end.
Restrictive covenants in loan agreements already executed.
Readiness of the investors to purchase a security in a given period of time and to
demand reasonable return.
Also, study the market conditions, and internal conditions of a company from the
view point of marketability of securities, etc.

Q 13 Explain the features and limitations of three approaches of determining a firm’s

capital structure: (a) EBIT- EPS approach, (b) valuation approach, and (c) cash
flow approach.
A 13 The EBIT-EPS approach analyzes the impact of debt on EPS. The use of fixed
cost sources of finance, such as debt and preference share capital to finance the
assets of the company, is known as financial leverage. If the assets financed with
the use of debt yield a return greater than the cost of debt, the earnings per share
also increases without an increase in the owners’ interest. The firm with high level
of the EBIT can make profitable use of the high degree of leverage to increase
return on the shareholders’ equity. The EBIT-EPS analysis does not reflect the
debt-servicing ability of the firm. This approach does not consider operating and
business risk also.
In the valuation approach, the capital structure is evaluated in terms of its effect
on the value of the firm. According to MM theory, capital structure will have
favourable effect on the value of the firm only because of the interest tax shield.
This advantage reduces because of personal taxes and financial distress caused by
leverage.
In the cash flow approach, a firm is considered prudently financed if it is able to
service its fixed charges, i.e., pay interest and principal, under any reasonably
predictable adverse conditions. At the time of planning the capital structure, the
ratio of net cash inflows of fixed charges (debt – servicing ratio) should be
examined carefully. It focuses on the liquidity and solvency of the firm over a
long-period of time.

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Q 14 ”….the analysis of debt to equity ratios alone can be deceiving, and an analysis of
the magnitude and stability of cash flow relative to fixed changes is extremely
important in determining the appropriate capital structure-.” Give your opinion.
A 14 The cash flow analysis indicates firm’s ability to service debt obligations even
under the adverse conditions, by examining the debt-servicing ratio. It indicates
the number of times the fixed financial obligations are covered by the net cash
inflows generated by the company. The greater the coverage, the greater is the
amount of debt a company can use. The impact of debt-equity ratio should be
evaluated in terms of value, rather than EPS. It is possible for a high-growth
profitable company to suffer from cash shortage if its liquidity management is
poor. Hence, the debt capacity should be thought in terms of cash flows rather
than debt-ratios.

Q 15 What are the implications of growth opportunities for the financial leverage?
A 15 To exploit growth opportunities, a firm needs funds. Hence, firms with growth
opportunities will tend to borrow more debt in addition to utilising internal funds.

Q.16 What is meant by financial flexibility? Is a flexible capital structure costly?

A 16 Flexible capital structure means firm’s ability to adapt its capital structure to the
needs of the changing conditions. The company should be able to raise funds,
without undue delay and cost, whenever needed, to finance the profitable
investments. The financial plan of the company should be flexible enough to
change the composition of capital structure as warranted by operating needs. It is
costly on account of restrictions imposed by loan covenants, pre-maturity
repayment charges in case of retirement of loan or early redemption of
debentures, flotation costs, etc.

Q 17 What is the importance of marketability and flotation costs in the capital structure
decision of a company?
A 17 The internal conditions of a company dictate the marketability of securities in
addition to readiness of investors to purchase a security in a given period of time
and to demand reasonable return. Due to changing market sentiments, the
company has to decide whether to raise funds with an equity issue or debt issue.
Flotation cost is not very important factor influencing the capital structure of a
company. Flotation costs occur only when the funds are externally raised.
Generally, the flotation cost of debt is less than cost of equity issue. The flotation
costs can be an important consideration in deciding the size of a security issue.
Generally, the flotation costs as a percentage of funds raised will decline with
larger amount of funds.

Q 18 How do the considerations of control and size affect the capital structure decision
of the firm?
A 18 Capital structure decision is governed by desire of management to continue
control over the company. The ordinary (equity) shareholders elect the directors
of the company. This may result into dilution of control by present management
or owner. In the case of widely-held company, the shares of such company are

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widely scattered, and by issues of new shares, there is a risk of dilution of control.
The risk of loss of control can be reduced by distribution of shares widely and in
small lots.
The closely-held small company would like to maintain control. Because of fear
of sharing control and being interfered by others, the closely held company would
like to raise debt capital instead of equity issue. To avoid the risk of loss of
control, small companies may slow down their rate of growth or issue preference
share capital or raise debt capital. A very excessive debt capital can also cause
serious liquidity problem, and render the company sick, which means complete
loss of control.
The size of company may influence its capacity and availability of funds from
different sources. A small company finds it difficult to raise long term debt or
long term loan at acceptable rate of interest and convenient terms. If small
companies are able to approach capital markets, the cost of issuing shares is
generally more than larger companies.