Presented to: Presented by:

Ms. Anita Sharma Deepika yadav

(1802580007)
 Capital structure refers to the mix of long-term
sources of funds, such as, debentures, long-term
debts, preference share capital and equity share
capital including reserves and surplus.
 Optimum capital structure : It is that capital
structure at that level of debt – equity proportion
where the market value per share is maximum and
the cost of capital is minimum.
 Optimum capital structure is that combination of
debt and equity that maximises the total value of
the firm or minimises the weighted average cost
capital.
David Durand
 According to Net Income Approach, the capital structure
decision is relevant to the valuation of the firm that
means change in the financial leverage of a firm will
lead to a corresponding change in the Weighted Average
Cost of Capital (WACC) and also the value of the firm.
 The Net Income Approach suggests that with the
increase in leverage (proportion of debt), the WACC
decreases and the value of firm increases.
 On the other hand, if there is a decrease in the leverage,
the WACC increases and thereby the value of the firm
decreases.
 There are no taxes
 The cost of debt is less than the equity –
capitalisation rate or the cost of equity.
 The use of debt does not change the risk perception
of investors .
 V= S+D
where,
V= the total market value
S= market value of equity share, net income equity
capitalization rate
D= market value of debt
 Consider a company with below figures:
 Earnings before Interest Tax (EBIT)=100,000
 Bonds (Debt part)=300,000
 Cost of Bonds issued (Debt)=10%
 Cost of Equity=14%

Calculating the value of a company

 EBIT =100,000
 Less: Interest cost (10% of 300,000) (I) =30,000
 Shareholders’ Earnings(NI) =70,000
 Equity capitalisation rate (ke) =0.14
 Market value of Equity (NI/ke) (S) =500,000
 Market value of Debt (B) =300,000
Total value of the firm (S+B=V) =800,000
 Overall cost of capital=EBIT/(Total value of firm)
=100,000/800,000=12.5%
 Now, assume that the proportion of debt increases from
300,000 to 400,000 and everything else remains same.
 (EBIT) =100,000
 Less: Interest cost (10% of 400,000) (I) =40,000
 Earnings (since tax is assumed to be absent)
=60,000
Shareholders’ Earnings =60,000
Equity capitalisation rate (ke) =0.14
 Market value of Equity (60,000/14%)(S) =428,570
(approx)
 Market value of Debt(D) =400,000
Total Market value(S+D=V ) =828,570
 Overall cost of capital=EBIT/(Total value of firm)
=100,000/828,570
=12% (approx)
 As observed, in case of Net Income Approach,
with increase in debt proportion, 300,000 to
400,000
 The total market value of the company increases
i.e., (800000 to 828570) and
Cost of capital decreases i.e., (12.5% to 12%)
 Reason for this conclusion is assumption of NI
approach that irrespective of debt financing in
capital structure, cost of equity will remain same.
 Further, cost of debt is always lower than cost of
equity, so with increase in debt finance cost of
capital reduces and value of firm increase.
 Now, assume that the proportion of debt decreases from
300,000 to 200,000 and everything else remains same.
 (EBIT) =100,000
 Less: Interest cost (10% of 200,000)(I) =20,000
 Earnings (since tax is assumed to be absent)
=80,000
Shareholders’ Earnings(NI) =80,000
o Equity capitalisation rate (ke) =0.14
 Market value of Equity (80,000/14%)(S) =571428
(approx)
 Market value of Debt(D) =200,000
Total Market value(S+D=V) =771428
 Overall cost of capital=EBIT/(Total value of firm)
=100,000/771428
=12.9% (approx)
 If we decrease the value of debt from 300,000 to
200,000 ,
 According to NI approach
The total value of the firm will decrease i.e.,
(800000 to 771428)
The overall cost of capital increase i.e.,
(12.5% to 12.9% )
Thus we find that the decrease in leverage has increased
the overall cost of capital and has reduced the value of
firm.
PROPOUNDED BY : DAVID DURAND
 According to Net Operating Income Approach
which is just opposite to NI approach, the
overall cost of capital and value of firm are
independent of capital structure decision and
change in degree of financial leverage does
not bring about any change in value of firm
and cost of capital.
 The firm is evaluated as a whole by the market. Accordingly,
overall capitalization rate is used to calculate the value of the
firm. The split of capitalization between debt and equity is not
significant.
 Overall capitalization rate remains constant regardless of any
change in degree of financial leverage.
 Use of debt as cheaper source of funds would increase the
financial risk to shareholders who demand higher cost on their
funds to compensate for the additional risk. Thus, the benefits
of lower cost of debt are offset by the higher cost of equity.
 The cost of debt would stay constant.
 The firm does not pay income taxes.
 Value of the firm (v) = EBIT / Ko (overall cost of
capital)
 Market value of equity (S) = V – D
S= Market value of equity capital
V=Value of the firm
D=Market value of the Debt
 Cost of equity / Equity capitalization rate (Ke) =
EBIT – I / S X 100
Ke= Equity capitalization Rate or C
I = Interest on debt
S= Market value of Equity Capital
Let us assume that a firm has :
Earnings before Interest Tax (EBIT)=100,000
Bonds (Debt part)=300,000
Cost of Bonds issued (Debt)=10%
WACC=12.5%
Calculating the value of the company:
Market value of the company =EBIT/WACC
=100,000/12.5% =800,000
Total Equity =Total market value – Total debt
=800,000 - 300,000 =500,000
Shareholder’s earnings = EBIT - Interest on debt
=100,000 - 10% of 300,000 =70,000
 Cost of equity=70,000 / 500,000 =14%
Now, assume that the proportion of debt increases
from 300,000 to 400,000 and everything else
remains same.
 (EBIT)=100,000, WACC=12.5%, Debt=400,000
Market value of the company=EBIT/WACC
=100,000/12.5% =800,000
Total Equity=Total market value – total debt
=800,000-400,000 =400,000
Shareholders’ earnings=EBIT-interest on debt
=100,000-10% of 400,000 =60,000
 Cost of equity=60,000/400,000 =15%
As observed, in the case of Net Operating
Income approach, with the increase in debt
proportion, the total market value of the
company remains unchanged, but the cost of
equity increases.
 The traditional approach to capital structure
advocates that there is a right combination of
equity and debt in the capital structure, at
which the market value of a firm is maximum.
 As per this approach, debt should exist in the
capital structure only up to a specific point,
beyond which, any increase in leverage would
result in the reduction in value of the firm.
 It is a compromise between the two approaches.
It is also known as “intermediate approach”.
 There are no taxes.
 There are only two sources of funds used by
a firm; debt and shares.
 The firm pays 100% of its earning as
dividend.
 Business risk is constant over time.
 Stage I:
 The first stage starts with introduction of debt in the
firm’s capital structure. As a result of the use of low
cost debt the firm’s net income tends to rise; cost of
equity capital (Ke) rises with addition of debt .Cost of
debt (Kd,) remains constant or rises only modestly.
Combined effect of all these will be reflected in
increase in market value of the firm and decline in
overall cost of capital (K0).
Stage II:
 In the second stage further application of debt will
raise costs of debt and equity capital so sharply as to
offset the gains in net income. Hence the total market
value of the firm would remain unchanged.
 Stage III:
 After a critical turning point any further dose of debt to
capital structure will prove fatal. The costs of both debt
and equity rise as a result of the increasing riskiness of
each resulting in an increase in overall cost of capital
which will be faster than the rise in earnings from the
introduction of additional debt. As a consequence of
this market value of the firm will tend to depress.
 The overall effect of these stages suggests that the
capital structure decision has relevance to valuation of
firm and cost of capital up to favorably affects the
value of a firm. Beyond that point value of the firm will
be adversely affected by use of debt.
 Let us consider an example where a company has
20% debt and 80% equity in its capital structure.
The cost of debt for the company is 9% and the
cost of equity is 14%. According to the traditional
approach the overall cost of capital would be:

WACC = (Weight of debt x cost of debt) + (Weight
of equity x cost of equity)

⇒ (20% x 9%) + (80% x 14%)

⇒ 1.8 + 11.2 ⇒ 13%

 If the company wants to raise the debt portion in the capital
structure to be 50%, the cost of debt as well as equity would
increase due to the increased risk of the company. Let us assume
that the cost of debt rises to 10% and the cost of equity to 15%.
After this scenario, the overall cost of capital would be:
WACC = (50% x 10%) + (50% x 15%)
⇒ 5 + 7.5 ⇒ 12.5%

 In the above case, although the debt-equity ratio has increased, as

well as their respective costs, the overall cost of capital has not
increased, but has decreased. The reason is that debt involves
lower cost and is a cheaper source of finance when compared to
equity. The increase in specific costs as well the debt-equity ratio
has not offset the advantages involved in raising capital by a
cheaper source, namely debt.
 Now, let us assume that the company raises its debt
percentage to 70%, thereby pushing down the equity
portion to 30%. Due to the increased and over debt
content in the capital structure, the firm has acquired
greater risk. Because of this fact, let us say that the cost
of debt rises to 15% and the cost of equity to 20%. In
this scenario, the overall cost of capital would be:

WACC = (70% x 15%) + (30% x 20%)

⇒ 10.5 + 6 ⇒ 16.5%

This decision has increased the company's overall cost

of capital to 16.5%.
 Using the cheaper source of funds, namely debt,
does not always lower the overall cost of capital. It
provides advantages to some extent and beyond
that reasonable level, it increases the company's
risk as well the overall cost of capital.
Devised by Modigliani and Miller during
the 1950s.
 The Modigliani-miller approach is similar to the net operating
income approach when taxes are ignored.
 The theory proves that there is no relationship between the capital
structure decision and the value of the firm and its overall cost of
capital.
THE MODIGLIANI-MILLER APPROACH-WHEN THE
TAXES ARE IGNORED.
The theory propounds that a change in capital structure(i.e. debt-
equity ratio)does not affect the overall cost of capital and the total
value of the firm. The reason behind the theory is that although the
debt is cheaper to equity, with the increased use of debt as a source
of finance ,the cost of equity increases and increase in cost of equity
offset the advantage of low cost of debt. Thus, although the change
in the debt-equity ratio affects ,the overall cost of capital remains
constant.
 Capital markets are perfect: Securities are traded in a perfect capital
market situation.
a) The investors are free to buy or sell securities;
b) There is no transaction costs, i.e. ,the cost of buying and selling do not
exist;
c) The investor can borrow without restrictions on the same terms and
conditions as the firm can
d) Information is perfect and freely available to investors; and
e) Investors behave rationally.
 No corporate taxes: There are no corporate tax(this assumption is later
withdrawn)
 Homogeneous risk classes of the firm: Firms can be grouped into
homogeneous risk classes. In other words, the expected earning of a group
of a firm have identical risk characteristics.
 Expectations about the net operating income: All the investors have
same expectations about the net operating income of the firm with which to
evaluate its value.
 100% payout ratio: The dividend payout ration is 100%,i.e.all the
earnings are distributed to the shareholders.
 The fundamental theory of mm approach, if we ignore the taxes, is that
the total value of a firm must be constant irrespective of the degree of
leverage, i.e. debt –equity ratio.
 The basic preposition of the mm approach is that the capital structure
decision is irrelevant.
 Modigliani and miller provide behavioral justification for the irrelevance
of the capital structure decision. The justification lies in arbitrage
process.
 Arbitrage process involves buying and selling of those securities which
are out of equilibrium in the capital market.-It involves buying of
securities whose prices are lower (undervalued securities)and selling
those securities whose prices are higher (overvalued
securities).Buying of undervalued securities will increase their demand
and will result in raising their prices and the selling of overvalued
securities will increase their supply thereby bringing down their prices.
 This will continue till the equilibrium is restored.
 Example
A (Leverage) B(Unleverage)
i. No of ordinary shares 1,00,000 1,50,000
ii. 8% debentures 50,000 -
iii. Market price per share 1.30 1.00
iv. Profit before interest 20,000 20,000
The above table shows that both the firms are identical in nature in terms of
capital and profit but have different capital structure.
In opinion of mm approach two firms identical in nature in every aspect
except in capital structure cannot have different market value but above two
company has different capital structure.
 In that case suppose that the investor have 10% holding in the company
A and we will see how the investor will involve in the arbitrage process
to earn riskless profit.
 This investor will sell 10% holding of the company
A=1,00,000*10/100*1.30=13,000
 The market value of the firm A is higher than of B so the investor is
involving in arbitrage process and selling the holding of A further he
raise a loan in the same proportion i.e. that 10/100*50,000=5000.
 He is doing so in order to take advantage of personal leverage
against the corporate leverage.
 Rs 13000+5000=18000 which is equal to 12% holding in
company B.
 The investor was holding 10% in company A but involving in
the arbitrage process he have 12% of holding in company B.
 THE EFFECT OF ARBITRAGE PROCESS ON THE INCOME
OF THE INVESTOR:

PROFIT BEFORE INTEREST OF THE COMPANY A 20,000

-(LESS) INTEREST ON DEBT(8% ON 50,000) 4000
PROFIT AFTER INTEREST = 16000
NET INCOME =1600
(16000*10/100)
 B
PROFIT BEFORE INTREST AND TAX 20,000
LESS -
PROFIT AFTER INTEREST 20,000
SHARE OF INVESTOR(20,000*12/100) 2,400
-LESS (INTREST PAID ON LOAN ) -400
NET INCOME 2000
By getting involved in the arbitrage process the income of the
investor has increases from 1600 to 2000 and the arbitrage process
will continue till the shares prices of the company A will fall and
that of company B will rise.
Thus the arbitrage process ensures that two firms which are
exactly similar in all respect except leverage cannot have
different values. Hence the capital structure decision of a firm
does not affect its market value.
 MODIGLIANI AND MILLER agree that the value of the firm increase and
the cost of capital will decline with the use of debt if corporate taxes are
considered. Since interest on debt is tax deductible, the effective cost of
borrowing will be less than the rate of interest. Hence the value of the
leverage firm would exceed that of unleveraged firm by an amount equal to
leverage firm’s debts multiplied by the tax rate.
 VALUE OF THE LEVERAGED FIRM CAN BE CALCULATED ON THE
BASIS OF THE FOLLOWING EQUATION:

 Equation implies that the value of the leveraged firms equals the value of
an unleveraged firm plus tax saving resulting from the use of the debt.
 The trade-off theory of capital structure is the idea
that a company chooses how much debt finance and
how much equity finance to use by balancing the costs
and benefits .
 It states that there is an advantage to financing with
debt, the tax benefits of debt and there is a cost of
financing with debt, the costs of financial distress
including bankruptcy costs of debt
 The trade-off theory states that the optimal capital
structure is a trade-off between interest tax shields
(benefit) and cost of financial distress.
 Value of firm = Value if all-equity financed + PV(tax
shield) - PV(cost of financial distress)
 The starting point is the value of the all-equity financed
firm illustrated by the black horizontal line in Figure .
The present value of tax shields is then added to form
the red line. Note that PV(tax shield) initially increases
as the firm borrows more, until additional borrowing
increases the probability of financial distress rapidly.
 The cost of financial distress is illustrated in the
diagram as the difference between the red and blue
curve. Thus, the blue curve shows firm value as a
function of the debt level. Moreover, as the graph
suggest an optimal debt policy exists which maximized
firm value.
 The trade-off theory states that capital structure is
based on a trade-off between tax savings and
financial distress costs of debt. Firms with safe,
tangible assets and plenty of taxable income to
shield should have high target debt ratios.
Developed by Jensen and Meckling
(1976)
 Agency theory is a principle that is used to explain and
resolve issues in the relationship between business
principals and their agents. Most commonly, that
relationship is the one between shareholders, as
principals, and company executive, as agents.
 Agency theory suggests that, in imperfect labor and
capital markets, managers will seek to maximize their
own utility at the expense of corporate shareholders.
 Agents have the ability to operate in their own self-
interest rather than in the best interests of the firm
because of asymmetric information (e.g., managers know
better than shareholders whether they are capable of
meeting the shareholders’ objectives).
 Agency costs are defined as those costs borne by
shareholders to encourage managers to maximize
shareholder wealth rather than behave in their own
self-interests. Such as
 Expenditures to monitor managerial activities,
such as audit costs;
 Costs which are incurred when shareholder-
imposed restrictions, such as requirements for
shareholder votes on specific issues, limit the
ability of managers to take actions that advance
shareholder wealth.
 In addition to the agency conflict between
stockholders and managers, there is a second class of
agency conflict between creditors and stockholders.
Creditors have the primary claim on part of the firm’s
earnings in the form of interest and principal
payments on the debt as well as a claim on the firm’s
assets in the event of bankruptcy.
 Creditors commonly write restrictive covenants into
loan agreements to protect the safety of their funds.
These arrangements involve time and money both in
initial set-up, and subsequent monitoring, these being
referred to as agency costs
It was initially suggested by Donaldson.
In 1984, Myers and Majluf modified
the theory
 The pecking order theory has emerged as alternative theory to the
trade-off theory. The key assumption of the pecking order theory
is asymmetric information. Asymmetric information captures that
managers know more than investors and their actions therefore
provides a signal to investors about the prospects of the firm.

 The pecking order theory suggests that there is an order of

preference for the firm of capital sources when funding is needed.

 The firm will seek to satisfy funding needs in the following order:
 Internal funds
 External funds
 Debt

 Equity
 There are three factors that the pecking order
theory is based on and that must be considered by
firms when raising capital.

1. Internal funds are cheapest to use (no issuance costs)

and require no private information release.
2. Debt financing is cheaper than equity financing
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmetric information, Therefore, to
compensate for information asymmetry, external
users demand a higher return to counter the risk
that they are taking. In essence, due to information
asymmetry, external sources of finances demand a
higher rate of return to compensate for risk.

Equity financing inference – firm is currently overvalued

Debt financing inference – firm is correctly or undervalued
 The pecking order theory suggests that the firm will
first use internal funds. More profitable companies
will therefore have less use of external sources of
capital and may have lower debt-equity ratios.

 If internal funds are exhausted, then the firm will

issue debt until it has reached its debt capacity .

 Only at this point will firms issue new equity.

 This theory also suggests that there is no target debt-

equity mix for a firm.
 Inthe context of the pecking order theory , retained
earnings financing (internal financing) comes directly
from the company and minimizes information
asymmetry. As opposed to external financing such as
debt and equity financing where the company must
incur fees to issue external financing, internal
financing is the cheapest and most convenient source
of financing.
On the other hand, when a company finances an investment
opportunity through external financing (debt and equity), a
higher return is demanded because creditors and investors
possess less information regarding the company as opposed to
managers. In terms of external financing, managers prefer to
raise debt over equity – the cost of debt is lower compared to
the cost of equity.

When thinking of the pecking order theory, it is useful to

consider the seniority of claims to assets. Debt holders require
a lower return as opposed to stockholders because they are
entitled a higher claim to assets (in the event of a bankruptcy).
Therefore, when considering sources of financing, the cheapest
is through retained earnings, second through debt, and third
through equity.