UNIT IV

CAPITAL STRUCTURE
 CAPITAL STRUCTURE
• It is the make up of a firm’s capitalization.
• Represents the mix of different sources of
long term funds in total capitalization of
company.
• Capital structure is concerned with how the
firm decides to divide its cash flows into two
broad components:
– a fixed component – to meet obligations towards
debt capital and
– a residual component - that belongs to equity
shareholders
 Factors determining Capital Structure
1. Trading on equity
2. Retaining control
3. Nature of the enterprise
4. Legal requirements
5. Purpose of financing
6. Period of finance
7. Market sentiment
8. Requirement of investors
9. Size of company
10. Government policy
11. Provision for future
 Optimum Capital Structure
• It is that combination or mix of debt and
equity that leads to the maximum value of the
firm”.
 Features of Sound / Appropriate
Capital structure
• Return
• Risk (threatens solvency of company)
(Solvency is the ability of the company to
meet its obligations)
• Flexibility – capacity to alter
• Capacity (debt capacity)
• Control
 Capital Structure Theories
• I. Net Income Approach (NI Approach)
• II. Net Operating Income (NOI) Approach
• III. Modigiliani – Miller (MM) Approach
• IV. Traditional Approach
 Capital Structure Theories
Assumptions:
1. companies employ only two types of capital: debt
and equity
2. no corporate or personal income taxes
3. dividend payout ratio is 100% - no retained earnings
4. degree of leverage can be changed
5. investors have the same subjective probability
distributions of expected future operating earnings
6. business risk is assumed to be constant
7. operating earnings of the firm are not expected to
grow
 I. Net Income Approach (NI Approach)
• According to this approach, capital structure
decision is relevant to the valuation of firm.
• A change in capital structure causes
corresponding change in overall cost of capital as
well as total value of firm.
Higher financial Weighted Average Value of firm &
leverage cost of capital (ko) market value of
shares
↑ ↓ ↑
↓ ↑ ↓
 Assumptions of NI Approach
• There are no taxes.
• Cost of debt is less than cost of equity (kd < ke)
• Debt content does not change the risk
perception of investors.
 Effect of leverage on cost of capital
(NI Approach)
Cost of capital (%)

0.10 ke
ko
0.05 kd

0 0.2 0.4 0.6 0.8 Leverage

 Example Problem 1
• A company has an expected annual net
operating income of Rs. 10,00,000, an equity
rate, ke of 10%, and Rs. 50,00,000 of 7% debt.
• What is the value of the firm as per NI
approach?
 Solution
Value of the firm Amount (Rs.)
Net Operating Income (NOI) 10,00,000
Less: Total cost of debt (Rs. 50,00,000 X 7/100) 3,50,000
Net Income available to shareholders (NI) 6,50,000
Market value of equity (E) = NI / ke=6,50,000 / 65,00,000
0.10
Market value of debt (D) = 3,50,000 / 0.07 50,00,000
Market value of firm, V = E + D 1,15,00,000
ko = NOI / V = 10,00,000 / 1,15,00,000 = 0.087 (or) 8.7%

(OR) ko = kd (D/V) + ke (E/V)

= 0.07 (50,00,000 / 1,15,00,000) + 0.10 (65,00,000 /
1,15,00,000) = 0.0304 + 0.0565 = 0.0869 (or) 8.7%
Suppose the company is assumed to have
used a debt of Rs. 70,00,000 instead of Rs.
50,00,000.
What will be the impact on the Value of
the firm and the overall cost of capital?
 Impact of increase in debt upon the value
of firm and overall cost of capital
Value of the firm Amount (Rs.)
Net Operating Income (NOI) 10,00,000
Less: Total cost of debt (Rs. 70,00,000 X 7/100) 4,90,000
Net Income available to shareholders (NI) 5,10,000
Market value of equity (E) = NI / ke=5,10,000 / 51,00,000
0.10
Market value of debt (D) = 4,90,000 / 0.07 70,00,000
Market value of firm, V = E + D 1,21,00,000
ko = NOI / V = 10,00,000 / 1,21,00,000
= 0.0826 (or) 8.26%
(OR) ko = kd (D/V) + ke (E/V)
= 0.07 (70,00,000 / 1,21,00,000) + 0.10 (51,00,000 /
1,21,00,000) = 0.0405 + 0.0421 = 0.0826 (or) 8.26%
 Conclusion
• By increasing the debt content in the capital
structure, the firm is able to increase the value
of the firm (increased from Rs. 1,15,000 to Rs.
1,21,000) and lower the overall cost of capital
(decreased from 8.7% to 8.26%).
 II. Net Operating Income (NOI)
Approach
• NOI approach is just opposite of NI approach.
• According to this theory, the market value of
company is not at all affected by the changes
in the capital structure.
• Any change in capital structure will not lead to
any change in the total value of firm and
market price of shares, as the overall cost of
capital is independent of the degree of
leverage.
 Assumptions of NOI Approach
• Overall cost of capital (ko) remains constant
for all combinations of debt-equity mix.
• Market capitalizes value of firm as a whole
and split between debt and equity is not
relevant.
• By using debt which has a low cost will
increase the risk of equity shareholders which
leads to increase in equity capitalization rate.
• Corporate taxes do not exist.
• Value of firm (V) = NOI / k0
• Value of Equity (E) = Value of firm (V) – Value
of debt (D)
• Equity capitalization rate (ke) = NOI – I x 100
V–D
• Where I = amount of interest on debentures
• V = Value of firm
• D = Value of debt
• Overall cost of capital (k0) = kd (D/V) + ke (E/V)
 Effect of leverage on cost of capital
(NOI Approach)
Cost of capital (%)
ke

0.10 k0

0.5 kd

0 0.2 0.4 0.6 0.8 Leverage

 Example Problem 2
• A firm has an annual Net Operating Income of
Rs. 10,00,000, an average cost of capital ko of
10%, and an initial debt of Rs. 50,00,000 at 7%
rate of interest.
• What is the value of the firm according to Net
Operating Income approach?
 Solution
Value of the firm Amount (Rs.)
Net Operating Income (NOI) 10,00,000
Market Value of firm V = E + D (or) 1,00,00,000
V = NOI / ko = Rs. 10,00,000 / 0.10
Market value of debt, D 50,00,000
Market value of Equity, E = V – D 50,00,000

ke = (NOI – Interest) / (V – D)
(OR) = NI / E
= (10,00,000 – 3,50,000) / (10,00,000 – 50,00,000)
= 6,50,000 / 50,00,000 = 0.13 (or) 13%
(OR) ke = ko + (ko – kd) D = 0.10 + (0.10 – 0.07)
= 0.10 + 0.03 = 0.13 (or) 13%
• ko is a constant
• ko = kd (D/V) + ke (E/V)
• = 0.07 (50,00,000 / 1,00,00,000) + 0.13 (50,00,000 /
1,00,00,000)
• = 0.07 (0.50) + 0.14 (0.50) = 0.035 + 0.065
• = 0.10 (or) 10%
 If the proportion of debt is increased from Rs.
50,00,000 to Rs. 70,00,000, the value of the firm would
still remain at Rs. 1,00,00,000. But what would happen
to the value of equity? It will decrease to Rs. 30,00,000.
• ke = (NOI – Interest) / (V – D) = NI / E
• = (10,00,000 – 4,90,000) / 30,00,000
• = 5,10,000 / 30,00,000 = 0.17 (or) 17%

(OR) ke = ko + (ko – kd) D/E

= 0.10 + (0.10 – 0.07) (70,00,000 / 30,00,000) = 0.17 (or) 17%

ko = kd (D/V) + ke (E/V) = 0.07 (70,00,000 / 1,00,00,000) + 0.17

(30,00,000 / 1,00,00,000)
= 0.049 + 0.051 = 0.10 (or) 10%
 Interpretation
• Thus, we conclude that ko is constant and the
ke increases from 13% to 17% as debt is
substituted for equity capital.
 III. Modigiliani – Miller (MM)
Approach
• Similar to NOI approach.
• According to this approach, value of firm is
independent of its capital structure.
• The only difference is that the NOI approach
does not operational justification for
irrelevance of capital structure with firm’s
value while MM approach provides
behavioural justification for it.
 Basic Propositions
• Overall cost of capital (k0) and value of firm (V)
are independent of capital structure (k0 and V
are constant for all levels of debt).
• Cost of equity = Equity capitalization rate + A
premium for financial risk
• Cut-off rate for investment purposes is
completely independent of the way in which
investment is financed.
 Assumptions of MM Approach
• Capital markets are perfect when investors
– are free to buy and sell securities
– can borrow like the firm
– are well informed and behave rationally
• All firms within same class will have same degree
of business risk.
• All investors have same expectation of firm’s net
operating income (EBIT).
• Dividend payout ratio is 100% - no retained
earnings
• No corporate taxes
• No transaction costs
 Arbitrage Process
• is the operational justification of MM
hypothesis.
• Arbitrage – refers to an act of buying an asset
/ security in one market having lower price
and selling it in another market at a higher
price.
• The use of debt by investor for arbitrage is
termed as “home-made” or “personal
leverage”.
 Example Problem 3
• Take the case of two companies: one is an unlevered
firm and another is a levered firm.
• They both have the same expected NOI of Rs.
1,00,000.
• The value of levered company is Rs. 11,00,000, i.e., the
value of equity shares being Rs. 6,00,000 & the value
of debt is Rs. 5,00,000.
• The value of the unlevered company is Rs. 10,00,000.
• Levered company has borrowed at the expected rate
of return of 7%.
• Let us assume that Ram holds 10% shares of the
levered company.
• What is Ram’s return from his investment in the
shares of levered company?
• Solution:
• Ram owns 10% of the Levered company’s shares and so
he is entitled to 10% income from equity.
• Ram’s Return = 0.10 (NOI – Interest)
• = 0.10 (1,00,000 – 0.07 X 5,00,000)
• = 0.10 (1,00,000 – 35,000) = Rs. 6,500
• Value of Ram’s investment = 0.10 (600,000) = Rs.
60,000
• Ram can earn same return at less investment through
alternate investment strategy.
• Ram can sell his investment in Levered company’s
shares for Rs. 60,000 and borrow on his personal
account an amount equal to his share of Levered
company’s corporate borrowing at 7% interest:
Rs. 5,00,000 X 10/100 = Rs. 50,000.
• He has Rs. 1,10,000 with him and can buy 10% of
Unlevered company’s shares.
• Ram’s investment = Rs. 10,00,000 X 10% = Rs. 1,00,000
• Ram’s return = Rs. 1,00,000 X 10% = Rs. 10,000
• Interest on Borrowings = Rs. 50,000 X 7% = Rs. 3,500
 Net Return for Ram
Rs.
• Equity return from Unlevered firm = 10,000
(Rs. 1,00,000 X 10%)
• Less: Interest from personal borrowing = 3,500
• Net return for Ram = 6,500

• Sale of L’s shares = Rs. 6,00,000 X 10% = 60,000

• Add: Borrowing Rs. 5,00,000 X 10/100 = 50,000
• Less: Investment in Unlevered Company = 1,00,000
Rs. 10,00,000 X 10%
• Remaining cash = 10,000
 Criticism of MM hypothesis
• lending and borrowing rates discrepancy for
individuals and firms
• non-substitutability of personal and corporate
leverage
• transaction costs involved
• institutional restrictions – LIC, UTI, Commercial
banks, etc. restrict switching option of investors
• existence of corporate taxes frustrate MM
hypothesis because interest is deductible for tax
and so cost of debt is less than contractual rate of
interest.
 IV. Traditional Approach
• It is also known as an intermediate approach.
• It is compromise between NI and NOI approach.
• According to this view, the value of the firm can be
increased or the cost of capital can be reduced by a
judicious mix of debt and equity capital.
• It implies that cost of capital decreases within reasonable
limit of debt and then increases with leverage.
• Therefore, an optimum capital structure exists, and it
occurs when the cost of capital is minimum or the value of
the firm is maximum.
• The cost of capital declines with leverage because debt
capital is cheaper than equity capital within reasonable, or
acceptable, limit of debt. The WACC will decrease with the
use of debt.
• The manner in which the overall cost of capital reacts to
changes in capital structure can be divided into 3 stages:
• First stage: Increasing value
Ke remains constant or rises slightly with debt.
Kd remains constant or rises negligibly.
Value of firm (V) increases (or) ko falls with increasing
leverage
• Second stage: Optimum value
Once the firm has reached a certain degree of leverage,
increases in leverage have a negligible effect on the value of
the firm or the cost of capital.
Within that range or at the specific point, the value of firm
will be maximum or the cost of capital will be minimum.
• Third stage: Declining stage
Beyond the acceptable limit of leverage, V decreases with
leverage or ko increases with leverage.
Effect of leverage on cost of capital
(Traditional Approach)
 Example Problem 4
• A firm is expecting a NOI of Rs. 1,50,000 on a total
investment of Rs. 10,00,000.
• The equity capitalization rate is 10%, if the firm
has no debt; but it would increase to 10.56%
when the firm substitutes equity capital by issuing
debentures of Rs. 3,00,000 and to 12.5% when
debentures of Rs. 6,00,000 are issued to
substitute equity capital.
• Assume that Rs. 3,00,000 debentures can be
raised at 6% interest rate, whereas Rs. 6,00,000
debentures are raised at a rate of interest of 7%
• What is the value of the firm?
 Solution: Market value and Cost of Capital of
firm (Traditional Approach)
Particulars I II III
No debt 6% Rs. 3,00,000 7% Rs. 6,00,000
debt debt
Net Operating Income (NOI) 1,50,000 1,50,000 1,50,000
Less: Total cost of debt 0 18,000 42,000
(interest)
Net Income (NI) 1,50,000 1,32,000 1,08,000
Cost of equity (ke) 0.10 0.1056 0.125
E = (NOI – Int) / ke 15,00,000 12,50,000 8,64,000
D 0 3,00,000 6,00,000
V=E+D 15,00,000 15,50,000 14,64,000
ko = NOI / V 0.10 0.097 0.103
 MCQ – Capital Structure
1. The term "capital structure" refers to:
a. long-term debt, preferred shares and equity shares
b. current assets and current liabilities
c. total assets minus liabilities
d. shareholders' equity
2. A capital structure with appropriate mix of debt
and equity is called
a. Maximum Capital Structure
b. Minimum Capital Structure
c. Optimum Capital Structure
d. Average Capital Structure
 Correct Answer
1 A. long-term debt, preferred shares and equity shares

2 C. Optimum Capital Structure

 MCQ – NI Approach
1. With regard to Net Income Approach, when the
debt proportion is increased, the overall cost of
capital.
a. Decreases
b. Increases
c. Constant
d. None of the above
2. State the TRUE statement out of the following:
a. Higher equity is better
b. Higher debt is better
c. Debt proportion is irrelevant
d. None of the above
 Correct Answer
1 A. Decreases

2 B. Higher debt is better

 MCQ – NOI Approach
1. Identify the incorrect statement out of the following
statements regarding the net operating income approach?
a. The overall capitalization rate, ko is constant
b. The cost of debt funds, kd, is constant
c. The required return on equity, ke, is constant
d. The total value of the firm is unaffected by changes in
financial leverage
2. What is the market value of equity according to NOI approach?
The company has an expected net operating income of Rs.
5,000 and Rs. 4,000 market value of debt. The overall
capitalisation rate is assumed to be 20%.
a. Rs. 5,000
b. Rs. 21,000
c. Rs. 20,000
d. Rs. 25,000
 Correct Answer
1 C. The required return on equity, ke, is constant

2 D. Rs. 21,000
 MCQ – MM Approach
1. MM Theory is similar to ______ theory.
a. Traditional theory
b. Net Income theory
c. Net Operating Income theory
d. All of the above
2. In MM model, the irrelevance of capital structure
rests upon which of the following:
a. Arbitrage process
b. Cost of debt and equity
c. Decreasing overall cost of capital
d. All of the above
 Correct Answer
1 C. Net Operating Income theory

2 A. Arbitrage process
 MCQ – Traditional Approach
1. The traditional approach towards the valuation of a
company assumes that _____.
a. the cost of capital is independent of the capital structure of
the firm.
b. the firm maintains constant risk regardless of the type of
financing employed.
c. there exists no optimal capital structure
d. that management can increase the total value of the firm
through the judicious use of financial leverage
2. Which one of the following remains constant in the
traditional approach?
a. Cost of equity
b. Cost of debt
c. Weighted Average cost of capital
d. None of the above
 Correct Answer
1 D. that management can increase the total value of
the firm through the judicious use of financial
leverage.

2 D. None of the above