Chapter 5

Capital Structure
Theories
Capital Structure Theories- An Overview
Net Income Approach
Net Operating Income Approach
Traditional Approach
Modigliani and Miller (MM) Approach

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 Introduction
• The basic objective of financial management is to
maximize the shareholders wealth. Therefore, all
financial decisions in any firm should be taken in
the light of this objective.
• Whenever a company is required to raise long-
term funds the finance manager is required to
select such a mix of sources of finance so that the
overall cost of capital is minimum (i.e., value of
the firm/wealth of shareholders is maximum).
• Mix of long-term sources of finance is referred as
“capital structure”.
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 Concept of Capital Structure
• Capital structure refers to the long - term sources of
funds employed by firm, viz, equity shares,
preference shares, reserves and debt capital.
• According to Gerestenberg, "Capital structure of a
company refers to the composition or make – up of
its capitalization and it includes all long - term
capital resources, viz, loans, bonds, shares and
reserves”
• Thus capital structure is made - up of debt and
equity securities and refers to permanent financing
of a firm.
• Shortly, Capital Structure is the mix of long term
financial securities used to finance the firm.
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 …Concept of Capital Structure
• Capital structure is the mix (or proportion) of a
firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.
• It signifies the kinds of securities and their
proportion in the total capitalization of a firm.

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 …Concept of Capital Structure
• In line with the objective of maximizing the value of
the company, deciding the optimal capital structure is
a prime one.
• Our goal is to see if there is an optimal way for firms
to finance.
– Should a firm have a higher or lower D/E ratio.
– What factors affect the optimal D/E choice?

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 …Concept of Capital Structure
• The source and quantum of capital is decided
keeping in mind the following factors:
• Control: capital structure should be designed in
such a manner that the existing shareholders
continue to hold majority stack.
• Risk: capital structure should be designed in such
a manner that financial risk of the company does
not increases beyond tolerable limit.
• Cost: overall cost of capital remains minimum.
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 …Concept of Capital Structure
• Practically it is difficult to achieve all of the
above three goals together hence a finance
manager has to make a balance among these three
objectives.
• Value of the firm = EBIT/Overall cost of capital /
Weighted average cost of capital
• Ko = (Cost of debt × weight of debt) + (Cost of
equity × weight of equity)
• Ko = [{Kd × D/ (D+S)} + {Ke × S/(D+S)}]
•

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 Capital Structure Decision
• The capital structure decision is a financing
decision. It is about Designing an Optimal
Capital Structure
• Capital Structure decision refers to
– deciding the forms of financing (which sources to
be tapped);
– their actual requirements (amount to be funded)
and
– their relative proportions (mix) in total
capitalization.
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 Capital structure and Financial Structure
• Some authors use capital structure and financial structure
interchangeably. But, they are different concepts.
• Financial structure refers to the way in which the total
assets of a firm are financed. In other words, financial
structure refers to the entire liabilities side of the balance
sheet i.e. long-term as well as short-term sources of finance.
• Capital structure represents only long - term sources of
funds and excludes all short - term debt and current
liabilities. It is represented by shareholders’ funds and long-
term loans. Capital structure is a part of the financial
structure.
• Thus, financial structure is a broader one and capital
structure is only a part of it.
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 Capital structure planning and
policy
• Theoretically, the financial manager should plan
an optimum capital structure for the company.
The optimum capital structure is one that
maximizes the market value of the firm.
• The capital structure should be planned generally,
keeping in view the interests of the equity
shareholders and the requirements of a company.
• While developing an appropriate capital structure
for its company, the financial manager should
inter alia aim at maximizing the long-term market
price per share.
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 Optimum Capital Structure
• The capital structure is said to be optimum when the firm
has selected such a combination of equity and debt so that
the wealth of firm (shareholder) is maximum. At this point
of capital structure, the cost of capital is minimum and
market price per share is maximum.
• It is very difficult to find out optimum debt and equity mix
where capital structure would be optimum because it is
difficult to measure a fall in the market value of an equity
shares on account of Increase in risk due to high debt
content in capital structure.
• Hence, in practice, the expression “appropriate capital
structure” is more realistic expression than ‘optimum capital
structure’.
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 Features of an appropriate capital
structure
• An appropriate capital structure should have the
following features :
i. Profitability : The capital structure of the company
should maximize the earnings per share while
minimizing cost of financing.
ii. Solvency: Excessive use of debt threatens the
solvency of the company. Therefore, the debt capital
should be employed up to such a level that the
financial risk is within manageable limits.
iii. Flexibility: The capital structure should be flexible
enough to meet the changing conditions. It must be
possible for the company to provide funds whenever
needed to finance any profitable activities.
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…Features of an appropriate capital structure
iv. Conservatism: The capital structure of the
company should be conservative in the sense
that the debt component of the firm should not
exceed debt capacity of the firm. The debt
capacity of the firm depends on its ability to
generate enough future cash flows for meeting
interest obligation and repayment of principal
when it becomes due.
v. Control: The capital structure should be designed
in such a way that it involves a minimum loss of
control of the company by the existing
shareholders/directors
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Value of the Firm and Capital Structure
• Value of the firm depends on the earnings of the
firm and earnings of the firm depend upon the
investment decisions of the firm.
• Investment decision influences the size of the
EBIT.
• The EBIT is shared among three main claimants:
1. The debt holders who receive their share in the
form of interest.
2. The government which receives its share in the
form of taxes.
3. The shareholders who receive the balance (In the
form of Dividend).
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 …Value of the Firm and Capital
Structure
• Thus, the investment decisions of the firm
determine the size of the EBIT pool while the
capital structure mix determines the way it is to be
sliced. The total value of the firm is the sum of the
value to the debt holders and its shareholders.
• Therefore, investment decision can increase the
value of the firm by increasing the size of the EBIT
whereas capital structure mix can affect the value
only by reducing the share of the EBIT going to the
government in the form of taxes.
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 Theories of Capital Structure
The four major theories of approaches which
explain the relationship between capital
structure, cost of capital and valuation of firm
are:
1. Net Income (NI) Approach
2. Net Operating Income (NOI) Approach
3. The Traditional Approach
4. Modigliani-Miller (MM) Approach
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 Theories of Capital Structure
Assumptions
• Firms have only two sources of funds viz., debt and equity.
• The total assets of firm are given. The degree of leverage
can be changed by selling debt to repurchase shares or
selling shares to retire debt.
• There are no retained earnings. It implies that entire profits
are distributed among shareholders. (100 % dividend
payout ratio)
• The operating profit of firm is given and expected to grow.
• The business risk is assumed to be constant and is not
affected by the financing mix decision.
• There are no corporate or personal taxes.
• The investors have the same subjective probability
distribution of expected earnings.
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 1. The Net Income Approach
• The Net Income (NI) approach is the
relationship between leverage and cost of
capital and value of the firm.
• This theory states that there is a relationship
between capital structure and the value of the
firm and therefore, the firm can affect its value
by increasing or decreasing the debt
proportion in the overall financing mix.

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 …1. The Net Income Approach
• The NI approach starts from the argument that
change in financing mix of a firm will lead to
change in Weighted Average Cost of Capital
(WACC) of the firm, resulting in the change in
value of the firm.
• According to the Net Income approach, capital
structure has relevance, and a firm can increase
the value of the firm and minimize the overall
cost of capital by employing debt capital in its
capital structure.
• Therefore, the greater the debt capital employed,
the lower shall be the overall cost of capital and
more shall be the value of the firm.
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 …1. The Net Income Approach
Assumptions under the Net Income Approach
The NI approach makes the following additional
assumptions:
i. The cost of debt is less than cost of equity.
ii. The risk perception of investors is not affected
by the use of debt. As a result, the equity
capitalization rate (ke) and the debt -
capitalization rate (kd) don't change with
leverage.
iii. There are no corporate taxes.

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 …1. The Net Income Approach
• According to the above assumptions, cost of
debt is cheaper than cost of equity and they
remain constant irrespective of the degree of
leverage.
• If more debt capital is used because of its
relative cheapness, the overall cost of capital
declines and the value of the firm increases.

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 …1. The Net Income Approach
According to the NI approach, the total market
value of the firm (V) is
V = S+D where
V = Total market value of the firm
S = Market value of equity shares
D = Market value of debt
The overall cost of capital (Ko) Or Weighted
average cost of capital (WACC) is calculated as
Ko or WACC = EBIT/V
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 …1. The Net Income Approach
• Market value of equity (S) = NI/Ke
Where,
– NI = Earnings available for equity shareholders,
– Ke = Equity capitalization rate.
• Under the NI approach, the value of the firm
will be maximum at a point where average cost
of capital is minimum.

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 …1. The Net Income Approach

As the proportion of debt in capital structure increases, the

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 …1. The Net Income Approach
• As can be observed from the diagram, as the proportion
of debt in capital structure increases, the WACC (Ko)
reduces.
– when degree of leverage is zero (i.e. no debt capital
employed), overall cost of capital (WACC) is equal to cost
of equity (ko = ke).
– As more and more debt capital is employed (which is
relatively cheaper than cost of equity), the overall cost of
capital declines, and it becomes equal to cost of debt (kd)
when leverage is one (i.e. the firm is fully debt financed).
• Thus, according to this theory, the firm's capital
structure will be optimum, when degree of leverage
is one.
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 …1. The Net Income Approach
• Example 1. Expected EBIT of the firm is
200,000. The cost of equity (i.e., capitalization
rate) is 10% and Debenture interest rate is 6%.
Find out the value of Firm and overall cost of
capital if leverage (debt) is:
A. 200000
B. 500000
C. 700000

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…1. The Net Income Approach

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 …1. The Net Income Approach
• Conclusion: Firm is able to increase its value and
to decrease it’s (WACC) by increasing the debt
proportion in the capital structure.
• The NI approach, though easy to understand,
ignores perhaps the most important aspects of
leverage that the market price depends upon the
risk, which varies in direct relation to the
changing proportion of debt in capital structure.

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 2. The Net Operating Income
Approach
• The Net Operating Income (NOI) approach is the
opposite of the NI approach.
• According to the NOI approach, the market value of
the firm depends upon the net operating profit and
the overall cost of capital, WACC.
• The financing mix or the capital structure is
irrelevant and does not affect the value of the firm.
• In other words, the value of the firm and the weighted
average cost of capital are independent of the firm’s
capital structure. In the absence of taxes, an individual
holding all the debt and equity securities will receive
the same cash flows regardless of the capital structure
and therefore, value of the company is the same.
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 …2. The Net Operating Income
Approach
 Assumptions under the NOI Approach
o WACC is always constant, and it depends on the
business risk.
o Value of the firm is calculated using the overall
cost of capital i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.

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 …2. The Net Operating Income
Approach
• For a given value of EBIT, the value of the firm remains
the same, irrespective of the capital composition
(structure) and instead depends on the overall cost of
capital.
• The value of the equity may be found by deducting the
value of debt from the total value of the firm i.e.,
• V =EBIT/Ko
• E= V–D Where
– E = Value of equity
– V = Value of firm.
– D = Market value of debt
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– Ko= Overall Cost of Capital
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 …2. The Net Operating Income
Approach
• Ke=(EBIT-Interest)/(V-D) OR Ke= EBT/Value of
Equity or simply Ke= EBT/Equity
• Thus, the financing mix is irrelevant and does not
affect the value of the firm. The value remains
same for all types of debt-equity mix. Since there
will be change in risk of the shareholders as a
result of change in debt-equity mix, therefore, the
Ke will be changing linearly with change in debt
proportions.

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 …2. The Net Operating Income
Approach

 Cost of capital (Ko) is constant.

 As the proportion of debt increases, (Ke) increases.
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 No effect on total cost of capital
Tadele H. (PhD) (WACC) 34
 …2. The Net Operating Income
Approach
• The above diagram shows that the cost of debt
(Kd), and the overall cost of capital (Ko) are
constant for all levels of leverage.
• As the debt proportion increases, the risk of the
shareholders remains constant because increase in
Ke is just sufficient to offset the benefits of
cheaper debt financing.
• The NOI approach considers Ko to be constant
and therefore, there is no optimal capital structure
as good as any other and so every capital structure
is an optimal one.
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 …2. The Net Operating Income
Approach
• Example 2:
• A firm has an EBIT of Br 200,000 and belongs
to a risk class of 10%. What is the value of
cost of equity capital, if it employs 6% debt to
the extent of 30%, 40% or 50% of the total
capital fund of Br1,000,000 ?
• Solution on the next slide

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 …2. The Net Operating Income
Approach
The effect of changing debt proportion on the cost
of equity capital can be analyzed as follows:

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 …2. The Net Operating Income
Approach
• The NI and the NOI approach hold extreme
views on the relationship between the
leverage, cost of capital and the value of the
firm. In practical situations, both these
approaches seem to be unrealistic.
• Both the Net Income approach (NI) and the
Net Operating Income approach (NOI) were
identified by David Durand.

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 3. The Traditional Approach
• The traditional approach takes a compromising
view between the two and incorporates the basic
philosophy of both.
• It has been popularized by Ezra Solomon.
• It takes a midway between the NI approach (that
the value of the firm can be increased by
increasing the leverage) and the NOI approach
(that the value of the firm is constant irrespective
of the degree of financial leverage).
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 …3. The Traditional Approach
• The traditional viewpoint states that the value
of the firm increases with increase in financial
leverage but only up to a certain limit.
• Beyond this limit, the increase in financial
leverage will increase its WACC and hence the
value of the firm will decline.

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 …The Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk (financial risk) and hence Ke increases. Kd also rises
due to higher debt, WACC increases & value of firm
decreases.
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…3. The Traditional Approach

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 …3. The Traditional Approach
• It is evident from the Figure that the overall
cost of capital declines with an increase in
leverage up to point L and it increases with
rise in the leverage after point L1
• Hence, the optimum capital structure
lies in between L and L1.

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 …3. The Traditional Approach
Example3 ABC Ltd., having an EBIT of Br150,000 is
contemplating to redeem a part of the capital by introducing
debt financing. Presently, it is a 100% equity firm with
equity capitalization rate, Ke, of 16%. The firm is to redeem
the capital by introducing debt financing up to 3,00,000 i.e.,
30% of total funds or up to Br. 500,000 i.e., 50% of the total
funds. It is expected that for the debt financing up to 30%,
the rate of interest will be 10% and the equity capitalization
will increase up to 17%. However, if the firm opts for 50%
debt financing, then interest will be payable at the rate of
12% and the equity capitalization rate will be 20%. Find out
the value of the firm and its overall cost of capital under
different levels of debt financing.
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 …3. The Traditional Approach
Solution

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 …3. The Traditional Approach
• The example shows that with the increase in
leverage from 0% to 30%, the firm is able to
reduce its WACC from 16% to 14.9% and the
value of the firm increases from 937,500 to
1,005,882.
• This happens as the benefits of employing
cheaper debt are available and the cost of
equity does not rise too much.

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 …3. The Traditional Approach
• However, thereafter, when the leverage is increased
further to 50%, the cost of debt as well as the
cost of equity, both, rises to 12% and 20%
respectively.
• The equity investors have increased the
equity capitalization rate to 20% as they are now
finding the firm to be more risky (as a result of
50% leverage).
• The increase in cost of debt and the equity
capitalization rate has increased the cost of equity,
hence as a result, the value of the firm has reduced
from 10,05,882 to 9,50,000 and Ko has increased
from 14.9% to 15.8%.
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 …3. The Traditional Approach
• According to the traditional approach, an
optimal capital structure can be achieved
where the weighted average cost of capital is
minimal

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 4. The Modigliani–Miller
• The
approach
Modigliani–Miller approach is similar to the Net
Operating Income (NOI) approach.
• In other words, according to this approach, the value of a
firm is independent of its capital structure. However, there
is a basic difference between the two.
• The NOI approach is purely conceptual. It does not
provide operational justification for irrelevance of the
capital structure in the valuation of the firm.
• While MM approach supports the NOI approach providing
behavioral justification for the independence of the total
valuation and the cost of capital of the firm from its capital
structure.
• In other words, MM approach maintains that the weighed
average cost of capital does not change in the debt equity
mix or capital structure of the firm.
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 …4. The Modigliani–Miller
approach
• Modigliani and Miller argued that, in the absence
of taxes the cost of capital and the value of the
firm are not affected by the changes in capital
structure.
• In other words, capital structure decisions are
irrelevant and value of the firm is independent of
debt - equity mix.

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…4. The Modigliani–Miller
approach

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 …4. The Modigliani–Miller
approach
• Basic Propositions of the MM approach:
i. The overall cost of capital (Ko) and the value of the
firm are independent of the capital structure. The
total market value of the firm is given by
capitalizing the expected net operating income by
the rate appropriate for that risk class.
ii. The financial risk increases with more debt content
in the capital structure. As a result cost ofequity (K)
increases in a manner to offset exactly the low -
cost advantage of debt. Hence, overall costof
capital remains the same.
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 …4. The Modigliani–Miller
approach
Assumptions of the MM Approach :
1. There is a perfect capital market. Capital markets are perfect
when i) investors are free to buy and sell securities, ii) they
can borrow funds without restriction at the same terms as the
firms do, iii) they behave rationally, iv) they are well
informed, and v) there are no transaction costs
2. Firms can be classified into homogeneous risk classes. All the
firms in the same risk class will have the same degree of
financial risk.
3. All investors have the same expectation of a firm's net
operating income (EBIT).
4. The dividend payout ratio is 100%, which means there are no
retained earnings.
5. There are no corporate taxes. This assumption has been
removed later.
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 …4. The Modigliani–Miller
Arbitrage Process
approach
• Arbitrage process refers to switching of investment
from one firm to another (an act of buying a security
in one market having lower price and selling it in
another market at higher price.) It is the operational
justification of MM hypothesis.
• According to M-M, two firms identical in all
respects except their capital structure, cannot have
different market values or different cost of capital. In
case, these firms have different market values,
investors will try to take advantage of it by selling
their securities with high market price and buying the
securities with low market price. The use of debt by
the investors is known as personal leverage or home
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 …4. The Modigliani–Miller
approach
• Because of this arbitrage process, the market price
of securities in higher valued market will come
down and the market price of securities in the
lower valued market will go up, and this
switching process is continued until the
equilibrium is established in the market values.
•

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 …4. The Modigliani–Miller
approach
Example 4 : The Modigliani–Miller approach
with no taxes
• Two firms X Ltd. & Y Ltd. are alike and identical
in all respects except that X Ltd. is a levered firm
and has 10% debt of Br 3,000,000 in its capital
structure. On the other hand Y Ltd. is an
unlevered firm and has raised funds only by way
of equity capital. Both these firms have same
EBIT of Br1,000,000 and equity capitalization
rate (Ke) of 20%. Under these parameters, the
total value and the WACC of both the firms may
be ascertained as follows:
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…4. The Modigliani–Miller
approach

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 …4. The Modigliani–Miller
approach
As can be seen from the illustration, though EBIT is same,
value of both the firm and WACC are different. MM
argue that this position can not persist for a long; and
the following measure will be taken to restore to
equilibrium.
Assume Mr. A is holding 10% equity shares in X Ltd. The
value of his holding is Br 350,000 i.e. (10% of
Br 3,500,000 total value of equity). Further, he is
entitled for 70,000 income (i.e., 10% of total profits of
700,000).
In order to earn more income, he disposes off his holding
in X Ltd. for Br 350,000 and buys 10% holding in Y
Ltd. For this purpose, he adopts following steps
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 …4. The Modigliani–Miller
approach
• Step 1: In order to buy 10% holding in Y Ltd,
he requires total funds of Br 500,000, whereas
his proceeds are only Br 350,000. Therefore,
he borrows 300,000 loan @ 10% i.e. (10% of
Debt of X Ltd). Thus, he substitutes personal
loan for corporate loan.

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 …4. The Modigliani–Miller
approach
Step 2
Sale proceeds 350,000
Plus 10% personal loan 300000
Mr. A now has total funds of Br 650,000
Less Investment in shares of Y Ltd shares 500,000
Surplus funds (which he invests 150,000 150,000
in some other securities say at 10%)

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 …4. The Modigliani–Miller
approach
Step 3 Mr. A will earn more through arbitrage process.

Profits available to A from Y Ltd. (10% of 100,000

10,00,000)
Less: interest on borrowing (10% 30,000,000) – 30,000
+ Interest income on some other investment + 15,000
(150000 × 10%)
Total income after Arbitrage Process 85,000

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 …4. The Modigliani–Miller
approach
Conclusion
• MM model argues that this opportunity to earn extra
income through arbitrage process will attract so
many investors. The gradual increase in sales of
shares of the levered firm X Ltd. will push down its
prices and the tendency to purchase the shares to
unlevered firm Y Ltd. Will drive its prices up.
• These selling and purchasing processes will continue
until the market value of the two firms is equal. At
this stage, the value of the leverage and unleveled
firm and also their cost of capital are same. Thus
overall cost of capital is independent of the financial
leverage.
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62
Tadele H. (PhD)
 …4. The Modigliani–Miller
approach
• Modigliani and Miller later recognized ,the
importance of the existence of corporate taxes.
• Accordingly, they agreed that the value of the
firm will increase or the cost of capital will
decrease with the use of debt due to tax
deductibility of interest charges.
• Thus, the optimum capital structure can be
achieved by maximizing debt component in the
capital structure.
FM for MBA Chapter 5 capital Structure
63
Tadele H. (PhD)