SABIH TARIQ
Capital Structure refers to the combination of
mix of debt and equity which a company uses to
finance its long term operations.
k
i
= the yield on the company’s debt
Annual interest on debt
Market value of debt
I
B
= = k
i
FORMULA
E
S
= =
k
e
= the expected return on the company’s equity
Earnings available to
common shareholders
Market value of common
stock outstanding
k
e
E
S
FORMULA
O
V
= =
k
o
= an overall capitalization rate for the firm
Net operating income
Total market value of the firm
k
o
O
V
FORMULA
Capitalization Rate, k
o
– The discount rate used to
determine the present value of a stream of expected
cash flows.
k
o
k
e
k
i
B
B + S
S
B + S
= +
Capitalization Rate
 To reduce capital structure
 To increase e value of firm

 Net Income Approach
 Net Operating Income Approach
 MM( Modigliani-Miller) Approach

ASSUMPTION OF THEORIES

1. No Taxes (personal or corporate)
2. No bankruptcy cost
3. No transaction cost
4. Total Financing remains constant.
5. Paying of Dividend 100%.
6. Perpetual life of firm
 Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.

 NI approach assumptions –
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (K
d
) is less than cost of equity (K
e
) [i.e. K
d
< K
e
]
o Corporate income taxes do not exist.

 As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus, as per NI approach, a firm will have
maximum value at a point where WACC is
minimum, i.e. when the firm is almost debt-
financed.

Net operating income theory means to
change the capital structure does not affect
overall cost of capital and market value of
firm. At each and every level of capital
structure, market value of firm will be same.
 As per NOI approach, value of a firm is not dependent
upon its capital structure.

 Assumptions –
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 (K
d
) is constant.
o Corporate income taxes do not exist.
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (K
e
)

A higher cost of equity (K
e
) nullifies the advantages gained due
to cheaper cost of debt (K
d
)

In other words, the finance mix is irrelevant and does not affect
the value of the firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches. Traditional approach
confirms the existence of an optimal capital structure;
where WACC is minimum and value is the firm is maximum.

 As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
1) Value of the firm increases with an increase in borrowings
(since K
d
< K
e
). 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 K
e
increases. K
d
also rises due
to higher debt, WACC increases & value of firm decreases.

Financial Leverage (B / S)
0.25
0.20
0.15
0.10
0.05
0
C
a
p
i
t
a
l

C
o
s
t
s

(
%
)

k
i
k
o
k
e
Optimal Capital Structure
Optimal Capital Structure:

MODIGILLIANI MILLER MODEL

 Modigiliani – Miller model (MM) was presented in 1958 on
the relationship between the leverage, cost of capital and the
value of the firm

 They have shown that the financial leverage does not matter
and the cost of capital and value of firm are independent of the
capital structure.
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.

 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, &
switch between securities.
o Investors can borrow without restrictions at par with the firms.
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
 Proposition I

The capital structure decision a firm makes will have
no effect on value of the firm. If there is no taxes,
no transaction cost, the real investment policy of
firm is not affected by its capital structure decision.

V FIRM = V ASSESTS = V DEBT + V EQUITY
Proposition II:

Two sources of risk:
Business risk is reflected in required return on the firm’s assests
(K ASSETS )
Financial risk reflects that the firm’s financing decision have on
riskiness of the cash flows that the stockholder will achieve.

It states that the cost of a firm’s common stock is directly related
to the debt-to-equity ratio

KCS = K ASSETS + (V DEBT/ VCS) (K ASSETS- K DEBT)

 Bankruptcy cost
 Agency cost
 In this theory managers trade off the benefits
against the cost of using debt to identify the
optimal capital structure of a firm
 In financing projects, managers first use
retained earnings, which they viewed as the
least expensive form of capital, then debt and
finally externally raised equity, which they
view as the most expensive.

 Financial management and policy 12
th
edition
by VANHORNE (CHAPTER 9)

 Fundamental of corporate Finance by Robert,
David and Thomas (CHAPTER 16)