Capital Structure

1|Page Capital Structure: Irrelevance Theory
INTRODUCTION
Capital is the major part of all kinds of business activities, which are decided by the size,
and nature of the business concern. Capital may be raised with the help of various sources.
If the company maintains proper and adequate level of capital, it will earn high profit and
they can provide more dividends to its shareholders.
Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization. It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term
source financing such as equity capital, preference share capital and debt capital. Deciding
the suitable capital structure is the important decision of the financial management because
it is closely related to the value of the firm.
Capital structure is the permanent financing of the company represented primarily by
long-term debt and equity.
The following definitions clearly initiate the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term capital
resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock equity”.
According to the definition of Presana Chandra, “The composition of a firm’s
financing consists of equity, preference, and debt”.
According to the definition of R.H. Wessel, “The long term sources of fund employed
in a business enterprise”.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.
FACTORS DETERMINING CAPITAL STRUCTURE
The following factors are considered while deciding the capital structure of the firm.
Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost
financing such as debt, equity and preference share capital. It is closely related to the
overall cost of capital.

Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm.
Normally long- term finance such as equity and debt consist of fixed cost while mobilization.
When the cost of capital increases, value of the firm will also decrease. Hence the firm
must take careful steps to reduce the cost of capital.
(a) Nature of the business: Use of fixed interest/dividend bearing finance depends
upon the nature of the business. If the business consists of long period of
operation, it will apply for equity than debt, and it will reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a firm. If the firm
belongs to large scale, it can manage the financial requirements with the help of
internal sources. But if it is small size, they will go for external finance. It consists
of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the considerations while
dividing the capital structure of a firm. For example, banking companies are
restricted to raise funds from some sources.
(d) Requirement of investors: In order to collect funds from different type of
investors, it will be appropriate for the companies to issue different sources of
securities.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy
regarding the capital structure.

CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relationship
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
ASSUMPTIONS OF THE THEORY OF CAPITAL STRUCTURE
a. The gearing of a company (ratio of debts & preference shares if any to
equity) is changed immediately by issuing debt to purchase shares, or by
issuing to repurchase debt.
b. The earnings of the company are expected to remain constant in perpetuity
and all security holders share the same expectations about the future
earnings.
c. The company pays out all the earnings as dividend.
d. Business risk is constant regardless of how the company invests its fund.
There are two major approaches to theories explaining the relationship between capital
structure, cost of capital and value of the firm.
These are:
1. Relevant theory and
2. Irrelevant theory
For the purpose of this study we shall be focusing on irrelevant theory.

1. Net operating Income approach
2. Modigliani- Miller approach
NET OPERATING INCOME (NOI) APPROACH
This approach was proposed by Durand. According to him, Capital Structure decision is
irrelevant to the valuation of the firm, because the market value of the firm is not at all affected
by the capital structure changes.
According to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the overall cost of capital.
NOI approach is based on the following important assumptions;
1. Cost of debt will remain constant regardless of the level of gearing
2. The WACC will remain unchanged as the gearing increases
3. The cost of equity will rise in such a way as to keep the WACC constant
RETURN
Ke
Kw
Kd
GEARING
Value of the firm (V) can be calculated with the help of the following formula
Vo = NOI
KO
Where,
V = Value of the firm
NOI = Net Operating income
Ko = Overall cost of capital
Illustration 1.
A company has #15,000 of debt @ 10% interest, and earns 15,000 a year before interest is paid.
There are 5,500 issued shares, and the WACC of capital of the company is 20%.
Requirements
a. (i) what is the company’s market value?
(ii) what is the cost of equity capital?
(iii) what is the market value per share of its equity?
b. Suppose the company issues 10,000 additional debt @10% interest to purchase shares at
the price, calculated in (iii) above. If WACC remain unchanged;
(i) Calculate the number of shares that were repurchased?
(ii) What is the new cost of equity capital?
(iii) What is the new market value per share of its equity?
Solution 1
a. (i) Earnings 15,000

WACC 20%
Company’s total market value (15000/.20) = #75,000
(ii) Company’s total market value (15,000/.20) 75,000
Less market value of debt (15,000)
Market value of equity 60,000
The Ke = 15,000 – 1500 = 13,500 * 100 = 22.5%

60,000 60,000
(iii) Market Value per share = 60,000 = #10.91

5,500
b. (i) Number of the purchased shares = 10,000 = 917 shares

10.91
(ii) New Ke = 15,000 – 2,500 * 100 = 25%
50,000
(iii) New market value of share = 50,000 = #10.91
4583
The conclusion of the Net Income Approach is that level of gearing is a matter of indifference to
an investor, because it does not affect the market value of the company, nor of an individual
share. This is because at the level of gearing rises so does the cost of equity in such a way as to
keep both the WACC and market value of the shares unchanged. Although with the example
above, the dividend per share rise from #2 to #2.37 the increase in the cost of equity in such that
the market value per share remain at 10.91

ILLUSTARTION 2
XYZ expects a net operating income of N 200,000. It has 800,000, 6% debentures.
The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate (Cost of Equity) according to the net operating income approach.
If the debentures debt is increased to N 1,000,000.00 What will be the effect on volume
of the firm and the equity capitalization rate?
Solution
Net operating income = N 200,000
Overall cost of capital = 10%
Market value of the firm (V) = 200,000/.10
= N 2,000,000.00
Market value of the firm = N 2,000,000
Less: market value of Debentures= N 800,000
VALUE of Equity N 1,200,000
Equity capitalization rate (or) cost of equity (Ke) = NET OPERATING INCOME
VALUE OF EQUITY
=200,000 – 48,000 ×100

1,200,000.00
=12.67%
If the debentures debt is increased to N 1,000,000, the value of the firm shall remain
unchanged to N 2,000,000. The equity capitalization rate will increase as follows:
Equity capitalization rate (or) cost of equity (Ke)= NET OPERATING INCOME
VALUE OF EQUITY
=200,000 – 60,000 ×100

1,000,000.00
=14.00%
From the above calculation, level of gearing is a matter of indifference to an investor, because it
does not affect the market value of the company, nor of an individual share. This is because at
the level of gearing rises so does the cost of equity in such a way as to keep both the WACC and
market value of the shares unchanged
M-M’S SUPPORT OF THE NET OPERATING INCOME APPROACH
The original normative theory of company valuation and capital structure was put forward in
form of a behavioral justification of the Net operational Income Approach by Franco Modigliani
and Melton H. Miller (M-M) in 1958.
In order to appreciate the propositions by M-M, it will be better to understand the M-M
assumptions which are as stated below.
ASSUMPTIONS OF THE 1958 THEORY OF MODIGLIANI AND MILLER
1. Investors have the same expectations, which are the same with that of the company.
(Homogeneous expectations)
10 | P a g e C a p i t a l S t r u c t u r e : I r r e l e v a n c e T h e o r y
2. Perfect capital market exists i.e. no transaction cost of insolvency is nil, information is
freely available to all investors, individuals can borrow infinitely large sums at the same
rate with corporate bodies, for every transaction there is a seller and a buyer.
3. Companies are categorized into equivalent return classes and companies that belong to
the same category generate the same earnings and have identical risk.
4. Taxation is ignored (initially).
For these assumptions, MM set out their three propositions
Proposition 1
This states that a company cannot change the total value of its securities just by splitting its cash
flows into different streams: the company’s value is determined by its real assets, not by the
securities it issued. Thus, capital structured is irrelevant as long as the company’s investment
decisions are taken as given.
Proposition 2
The expected rate of return on equity of a geared company increases in proportion to the debt-
equity ratio (i.e DEBT/EQUITY), expressed in market values; the rate of increase depends on the
spread between the expected rate of return on a portfolio of all the company’s securities, and the
expected return on debt
Proposition 3
This provides a rule for optimal investment policy by the company: “ the cut off point for the
investment in a company will in all cases be the WACC and will be completely unaffected by the
type of security used to finance the investment.

Consequently, if the first two propositions hold, the cut-off rate used to evaluate investments will
not be affected by the type of funding used to finance them. Whatever maybe the capital
structure. The gain from using debt (at lower cost) is offset by the increased cost of equity ( due
to increased risk) and WACC therefore remains unchanged.
THE M –M PROPOSITIONS, IGNORING TAXES

At this point there is need to set out the propositions of M-M, ignoring tax relief on the interest
charged on debt capital.
M-M made a suggestion that the total market value of any company is independent of its capital
structure, and it is given by discounting the company’s expected return at the appropriate rate.
Consequently the value of a geared company is therefore given as follows i.e. The total market
value of a company and the WACC (ignoring taxation)
Vg = Vg
Vg = Profit before interest
WACC
Vu = Vg = Earnings in an ungeared company
r
Where;
Vg = the market value of a geared company
Vu = the market value of an ungeared (all equity) company
R = the cost of equity in an ungeared company
THE COST OF EQUITY IN A GEARED COMPANY (IGNORING TAXATION)

M-M went on to argue that the expected return on ashare in a geared company equals the
expected cost of equity in a similar but ungeared company, plus a premium related to financial
risk.
The premium for financial risk can be calculated as the debt\equity ratio multiply by the
difference between the cost of equity for an ungeared company and the risk-free cost of debt
capital.
rE = r + (r - rD) * D
E
Where;
D = the market value of the debt capital in a geared company which is similar in every respect
to the ungeared company (same profits before interest and same business risk) except for its
capital structure. The debt capital is assumed, for simplicity to be irredeemable.
E = the market value of the equity in the geared company
r = the cost of equity in an ungeared company
rE = the cost of equity in the geared company
rD = the cost of debt capital
M & M THEORY
The M & M theory states that the value of a firm should depend on its capital structure. The
theory argues further that a company should have the same market value and the same WACC at
all capital structures because the value of a company should depend on the return and risk of its
operations and not on the way in which it finances those operations.
It is pertinent to mention that this proposition does not seem to align with the traditional
view that debt capital is cheaper than equity.

To justify their case M-M demonstrated that if two companies have the same annual earnings
and are also subject to the same business risk but they do not have the same market values purely
because of the difference in their capital structures, then investors could make profit by selling
their shares in the company that has the higher market value and buy shares in the company with
the lower market value. THIS IS KNOWN AS ‘ARBITRAGE’.
ARBITRAGE
The arbitrage procedure involves that an investor will sell his shares in the company having the
higher market value ( and by extension having the lower WACC) and move to the company
having the lower market value ( and by extension the higher WACC) lending or borrowing in
oreder to carry out the arbitrage transaction. The original M-M arbitrage procedure involves the
conversion of corporayte gearing to personal gearing this is known as home – made gearing.
The demonstration by M – M shows that the advantage of the cheap ‘explicit cost of debt’
finance is exactly balanced by the increase in the required return of equity share holders that
results from the increased variability of their returns ( financial risk). This increase in the cost of
equity is referred to as the ‘hidden’ or ‘implicit cost of debt’.
The M-M theory concludes that in a world without taxes, where the levels of business risk and
earnings of two companies are equal, their total market values and their WACC must also be
equal. If this were not the case then arbitrage transactions would soon bring the companies back
to the equilibrium position.
WEAKNESS IN THE M-M THEORY
M & M theory has been criticized on for main grounds.

1. The markets for securities are not perfect, transaction costs exist and these hinder the
effective working of the arbitrage process.
2. The risks for the investor may differ between personal gearing and corporate gearing.
There is also support for the view that at high level gearing any significant number of risk
seeking investors will buy the shares for the first time.
The effect of this change is that at extreme leverage, the cost of capital will start to rise.
3. In practice, companies can usually borrow more easily at lower cost than individuals.
4. A tax-free environment does not actually exist. The effect of taxation reduces the cost of
debt finance substantially.
This will leads to a steady decline in cost of capital.
Further weakness in the M-M theory are stated below;
a. In practice, it may be possible to identify firms which identical risk and operating
characteristics.
b. Some earnings may be retained and so the simplifying assumption of paying out all
earnings as dividend would not apply.
c. Investors are assumed to act rationally which may not be the case in practice.
THESE WEAKNESSES ARE NOT CRITICAL ENOUGH AND WOULD NOT ON THEIR
OWN INVALIDATE M-M THEORY
PROCEDURE FOR SOLVING ARBITRAGE (WITHOUT TAX) PROBLEMS
1. Draw up two companies capital structures using market values.
2. Apply earnings using EBIT. Remember that taxation is irrelevant at this point in time.
3. Calculate the Ke, Kd and WACC for both companies.
4. Proceed to answer the questions asked by the examiner
ILLUSTRATION 1. (Moving from geared to ungeared-another example)

Pedro Plc, and Bariga Plc. Are two companies in the same line of business, with the same level
of risk and having the same profit before interest. Pedro Plc, is entirely equity financed with
2,000,000 – 25k ordinary shares currently quoted at N1.20 ex-div.
Bariga Plc is a geared company with 1,250,000 – 25k ordinary shares with market value of
N1.00 ex div and N1,500,000 of 10% irredeemable loan stock currently quoted at par. Both
companies generate an annual profit before interest of N360,000; all profit after interest is
distributed as a dividend, Mr Shomolu owns 62,500 shares in Bariga Plc. A friend, Mr Tinubu
has recommended he sells these, borrows sufficient fund at a rate of 10% and to use the proceeds
to buy ordinary shares in Pedro Plc.
You are required to;
(a) Calculate the cost of equity and weighted average cost of capital of each company;
(b) Advise Mr Shomolu as whether his proposed transaction is worthwhile both from the
point of view of increased income and considering the level of associated uncertainty
(c) Calculate the prices of the ordinary shares of Kaiama Plc, which would produce no gain
to Mr Shomolu on swithching funds assuming all other prices remain firm.
(d) Calculate the cost of equity and weighted average cost of capital for each firm at the
above equilibrium price.
SOLUTION
(a) Pedro Plc Bariga Plc
N N
Equity 2,400,000 1,250,000
Debt 1,500,000
2,400,000 2,750,000
N N
EBIT 360,000 360,000

Less Interest 150,000
Dividend 360,000 210,000
Cost of Equity = Dividend N360,000 * 100 N210,000 * 100
Market Value N2,400,000 N1,250,000
Ke = 15% 16.8%
Kd = - 10%
Kw = 15% N360,000
N2,750,000 = 13.09%
(b) Mr Shomolu’s switch
Current income from Bariga Plc = 62,500 shares * 100 i.e. 5%

1,250,000 shares
Income presently earned = 5% * N210,000 i.e N10,500
This 5% stake in shares could be sold for 62,500 * N1 = N62,500

To also borrow 5% of N1,500,000 = N75,000
Total to invest in Pedro Plc = N137,500
Income from Pedro Plc = N137,500 * N360,000

N2,400,000 = N20,625
Loan interest payable i.e 10% of N75,000 = N7,500
Net income from Poddy = N13,125
Gain on switching = N13,125 – N10,500 i.e. N2,625
In the view of the gain made on swithching funds transaction would appear to be
worth while. Alos by transferring funds in the manner prescribed it is felt that the
level of uncertainty associated with cash investment is identical. However, this is
assuming that the same risk can be associated to similar levels of personal and
corporate gearing.
(c) Equilibrum share price; N

Total market value of Bariga Plc = 2,750,000
Total market value of Pedro Plc = 2,400,000
Difference = 350,000
Market value of equity of Pedro Plc = 2,400,000
EQUILIBRUM PRICE = 2,750,000
The total market value of the two firms are equal at this price. This is the point at
which no gain on switching will result. Therefore 5% of the share capital of Pedro Plc
is worth N137,500, and Mr Shomolu will be entitled to 5% of N360,000 which is
N18,000 but will have to pay interest on the N75,000 borrowed which is 10% of
N75,000 i.e N7,500 resulting into a net sum of N10,500. The amount he was earning
before.
(d) Equilibrum cost of capital
The cost of Pedro Plc’s equity at equilibrium will be based on the equilibrium price
of N2.75million hence, the cost of equity =
N360,000 * 100 = 13.09%
N2,750,000
The cost of equity will also represent Pedro Plc’s weighted average cost of capital,
which is equal to Bariga Plc’s weighted average cost of capital.
ILLUSTRATION 11. (Moving from ungeared to geared)
Lanre owns 1% of the equity of Lubileye Plc, an ungeared company. A friend Tawa,
recommends that Lanre switch his funds to a similar but geared company, Lekenka Plc.
In order to maintain the risk associated with each investment funds in Lekanka Plc’s debentures.
The companies income and capital structures are shown below:
Lekanka Plc Lubileye Plc
N N
N1 Ordinary Shares: Nominal Value 200,000 300,000
Market Value 125,000 250,000
5% Debenture: Nominal Value 100,000 -
Market Value 100,000 -
Profit before debenture interest 25,000 25,000
Annual Dividend 20,000 25,000
Debenture Interest 5,000 -
(a) Calculate Lanre’s present income in Lubileye Plc
(b) Calculate his income on switching his funds, in the manner described, to Lakenka Plc.
(c) Calculate the price of Lakenka Plc’s equity at which it would no longer pay Lanre to
switch his funds, assuming no other market prices moved.
(d) Calculate the two companies costs of equity and average costs of capital at the prices
found in (c)
(e) Comment on the various calculations required above.
SOLUTION
N N
Equity 125,000 250,000
Debt 100,000 -
225,000 250,000
N N
EBIT 25,000 25,000

Less Interest (5000) -
20000 25,000
Cost of Equity = Dividend N20,000 * 100 N25,000 * 100

Market Value N125,000 N250,000
Ke = 16% 10%
Kd = 5% -
Kw = N25,000
N225,000 i.e.= 11.11% 10%
(a) Income from Lubileye Plc
Number of shares held = 3,000

Market value of Investment (1% of N250,000) = N2,500
Income from Lubileye Plc (1% of N25,000) = N250
(b) Income from Lekanka Plc
Sells and realizes the equity of Lubileye Plc. (1% of N250,000) = N2,500
Total value of investment (1% of N125,000) = N1,250
Therefore value of debentures bought = N1250
Income from shares (1% of N20,000) =N200.00
Income from debentures 5% of N1,250 = N62.50
Therefore total income from Lekenka Plc = N262.50
Income from Lubileye (1% of N25,000) = N250.00
Therefore gain on switching funds = N12.50
(c) Equilibrum price of Lekanka Plc’s equity

N
Total market value of Lubileye Plc = 250,000
Total market value of Lekenka Plc = 225,000
Difference = 25,000
Market value of equity of Lekenka Plc = 125,000
EQUILIBRUM PRICE = 150,000
(d) Costs of capital at equilibrium prices
N N
Equity 150,000 250,000
Debt 100,000 -
250,000 250,000
Costs of Equity = Dividend N20,000 * 100 N25,000 * 100

Market Value N150,000 N250,000
Ke = 13.33% 10%
Kd = 5% -
Kw = N25,000
N250,000 i.e. 10% 10%
(e) Comments
With the markets values as stated in the question, Lanre makes a gain on switching
funds between the companies. This arbitrage procedure was used by Modigliani and
Miller to justify their related positions that the cost of a company’s capital and its total
market value are not affected by its level of gearing. Arbitragers would drive the two
market prices if Lubileye Plc and Lekanka Plc together as shown. At the poin when no
gain occurs on switching, the two market values will be equal, as will their two average
costs of capital. This is seen in the final calculation.
ILLUSTRATION 3. (Moving between two geared companies)
Set out below are the capital structures of two quoted companies. Oniyangi Plc and Aworawo
PLc. Which are undertaking operations thought to have the same levels of risk.
Oniyangi Plc Aworawo Plc
N’000 N’000
N1 Ordinary shares 800 500
Reserves 400 100
8% Irredeemable debentures 250 625
1,450 1,225
Each company earns N100,000 before charging debenture interest and it is expected that they
will continue to earn this amount for the foreseeable future. All post interest profits will be
distributed as dividends. The shares of Oniyangi Plc are currently valued at N1.20 per share
and Aworawo Plc at 80k per share each ex div. the debentures of both of the companies are
valued at par debenture interest having been paid recently.
This information has been collected by Hakeem for his colleague Wasiu who recently owns
8,000 shares in Oniyangi Plc. Hakeem to Wasiu finishes with the recommendation that he
sells his 1% stake in Oniyangi Plc and buys 1% of the share capital of Aworawo Plc.
Any surplus funds should be invested in the debentures of Aworawo Plc.
You are reduced to Provide:
(a) Calculations showing the effect on Wasiu’s income of the transfer
(b) A comment of the effect on the associated levels of uncertainty
(c) A calculation of the equilibrium market value of Aworawo Plc’s share if several investors
took Hakeem advice assuming that no other prices moved.
SOLUTION
(a) Gain from the proposed transfer
Investment in Oniyangi Plc:

8,000 shares, 1% of equity, market value = 8000 * N1.20 = N9,600
Income = 1% of (N100,000 – 8% of N250,000) = N800
On selling investment in Oniyangi Plc for N9,600, Wasiu would buy 1% of the Equity of
Aworawo Plc for N4,000 (1% of 500,000 * 0.80) leaving N5,600 with which to buy
debentures in Aworawo Plc.
Income from Aworawo Plc: N
Dividend 1% of (N100,000 – 8% of N625,000) = 500
Interest: 8% of N5,600 = 448
=948
Gain on the transfer = N148
(b) COMMENT ON THE LEVEL OF UNCERTAINTY:
The above transfer of funds from one company to another with a resultant income follows
the type of arbitrage procedure suggested by Modigliani and Miller in defence of their
theories. The original arbitrage method was criticized by Heins and Sprenkle for the
precise reason that the increased income resulting from such a transfer was associated
with an increased level of uncertainty. The idea of maintaining the same percentage of
the equity of the two companies ( as in this example) was put forward by Heins and
Sprenkle as the manner in which a transfer could be made and income increased without
increasing associated level of uncertainty. Thus, on the face of it, the transfer suggested
here produces a greater level of income and no increased level of risk.
(c) Equilibrum Price of Aworawo Plc’s Shares:

The effect of the gain on the transfer indicated in part (a) would be to encourage other
investors to perform the same type of transfer as Wasiu. This would cause the price of
Oniyangi Plc’s equity to rise.
Equilibrium would be reached when there is no gain on the transfer. It is assumed (for
easy of calculation) that the only price that moves in that or Aworawo Plc’s equity for
there to be no gain on the transfer.
Total income from Aworawo Plc must = 800
Dividend income will always = 500
Thus debenture interest from Aworawo Plc will = 300
This is attained by buying N3,750 of debentures in Aworawo Plc.
Thus the shares in Aworawo Plc (1% of the equity) must cost N5,850 (since N9,600 is
available in all).
If 1% of Aworawo Plc’s equity is worth N5,850 the total equity is worth N585,000
With the debenture worth N625,000, the total value of Aworawo Plc = N1,210,000
The total value of Oniyangi Plc is N960,000 + N250,000 = N1,210,000


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1|Page Capital Structure: Irrelevance Theory

they can provide more dividends to its shareholders.

up capitalization. It is the mix of different sources of long-term sources such as equity

shares, preference shares, debentures, long-term loans and retained earnings.

it is closely related to the value of the firm.

Capital structure is the permanent financing of the company represented primarily by

long-term debt and equity.

According to the definition of Gerestenbeg, “Capital Structure of a company refers

According to the definition of Presana Chandra, “The composition of a firm’s

financing consists of equity, preference, and debt”.

Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.

2. Minimize the overall cost of capital.

Forms of Capital Structure

Normally the following forms of capital structure are popular in practice.

• Equity shares only.

• Equity and preference shares only.

• Equity and Debentures only.

• Equity shares, preference shares and debentures.

FACTORS DETERMINING CAPITAL STRUCTURE

overall cost of capital.

must take careful steps to reduce the cost of capital.

of high cost of capital.

restricted to raise funds from some sources.

(d) Requirement of investors: In order to collect funds from different type of

investors, it will be appropriate for the companies to issue different sources of

regarding the capital structure.

CAPITAL STRUCTURE THEORIES

ASSUMPTIONS OF THE THEORY OF CAPITAL STRUCTURE

a. The gearing of a company (ratio of debts & preference shares if any to

equity) is changed immediately by issuing debt to purchase shares, or by

issuing to repurchase debt.

b. The earnings of the company are expected to remain constant in perpetuity

c. The company pays out all the earnings as dividend.

structure, cost of capital and value of the firm.

1. Relevant theory and

For the purpose of this study we shall be focusing on irrelevant theory.

1. Net operating Income approach

2. Modigliani- Miller approach

NET OPERATING INCOME (NOI) APPROACH

by the capital structure changes.

NOI approach is based on the following important assumptions;

1. Cost of debt will remain constant regardless of the level of gearing

2. The WACC will remain unchanged as the gearing increases

V = Value of the firm

NOI = Net Operating income

Ko = Overall cost of capital

a. (i) what is the company’s market value?

(ii) what is the cost of equity capital?

(iii) what is the market value per share of its equity?

the price, calculated in (iii) above. If WACC remain unchanged;

(i) Calculate the number of shares that were repurchased?

(ii) What is the new cost of equity capital?

a. (i) Earnings 15,000

(ii) Company’s total market value (15,000/.20) 75,000

Less market value of debt (15,000)

Market value of equity 60,000

The Ke = 15,000 – 1500 = 13,500 * 100 = 22.5%

(iii) Market Value per share = 60,000 = #10.91

b. (i) Number of the purchased shares = 10,000 = 917 shares

the market value per share remain at 10.91

XYZ expects a net operating income of N 200,000. It has 800,000, 6% debentures.