Capital Structure

Content
• Meaning,
• Introduction,
• Factors effecting capital structure decision
and optimum capital structure
 Learning Outcome
• Elicit the conceptual knowledge about the
basic concepts to be considered while
designing capital structure of the firm
• Capital structure refers to the specific mix of debt and
equity used to finance a company’s assets and
operations.
• From a corporate perspective, equity represents a more
expensive, permanent source of capital with greater
financial flexibility. Debt, on the other hand, represents a
cheaper, finite-to-maturity capital source that legally
obligates the company to fixed, promised cash outflows
with the need to refinance at some future date at an
unknown cost.
 Capital Structure

The objective of a firm should be directed

towards maximization of the firm’s value.

The capital structure or financial leverage

decision should be examined from the
point of its impact on the value of the
firm.
 Elements of Capital Structure
Capital mix

Maturity and priority

Terms and conditions

Currency

Financial innovations
 Framework for Capital
Structure:
The FRICT Analysis
• Flexibility
• Risk
• Income
• Control
• Timing

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 Practical Considerations in
Determining Capital Structure
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack

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 Optimum Capital Structure
• 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 financial
requirements of a company.
 Optimum Capital Structure
• An optimal capital structure is the best
mix of debt and equity financing that
maximizes a company's market value
while minimizing its cost of capital.
Minimizing the weighted average cost of
capital (WACC) is one way to optimize for
the lowest cost mix of financing.
Capital Structure

Relevance Theories
 Content
• Net Income Approach
• Traditional Approach
 Learning Outcome
• Understand about theories working behind
capital structure decisions and whether or
not these theories are applicable in real
life.
 Net Income Approach
• This approach was suggested by Durand
and he was in favor of financial leverage
decision. According to him, a change in
financial leverage would lead to a change
in the cost of capital.
• Net Income Approach suggests that value
of the firm can be increased by decreasing
the overall cost of capital (WACC) through
higher debt proportion.
 Net Income Approach
• The capital structure of a company/firm
plays a very important role in determining
the value of a firm.
• Levered firm
• Unlevered firm
Net Income (NI) Approach
• According to NI approach
both the cost of debt and
the cost of equity are
independent of the capital
structure; they remain
constant regardless of
how much debt the firm
uses. As a result, the
overall cost of capital
declines and the firm value
increases with debt. This
approach has no basis in
reality; the optimum
capital structure would be The effect of leverage on the cost of
100 per cent debt capital under NI approach
financing under NI
approach.
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 1.
• ABC LTD. Co. expects operating profit
(EBIT) of Rs. 1,00,000. The company has
raised 12 per cent debentures of Rs.
3,00,000. The company’s equity capital
cost is 13%. Determine the value of the
firm and cost of capital.
 Solution:
• Calculation of Net Income= EBIT- Deb Int

• EBIT- Rs.1,00,000
• (-) Deb Int
• (Rs. 3,00,000*12%) 36,000
• Net Income 64,000
• Value of Firm= E+D
• Market value of equity(NI/Ke)
• (64,000/0.13)= Rs. 4,92,307.69
• Add: Market value of debt Rs. 3,00,000
 Calculation of Cost of Capital
• Ko= (EBIT/V)100
• = (1,00,000/7,92,307.69)
• = 12.62%
 Traditional Approach
• The traditional approach
argues that moderate Cost
degree of debt can lower
ke
the firm’s overall cost of
capital and thereby,
increase the firm value. ko

The initial increase in the

cost of equity is more than kd
offset by the lower cost of
debt. But as debt
increases, shareholders Debt

perceive higher risk and

the cost of equity rises
until a point is reached at
which the advantage of
lower cost of debt is more
than offset by more 22
expensive equity.
The traditional theory on the relationship
between capital structure and the firm
value has three stages:
• First stage: Increasing value
• Second stage: Optimum value
• Third stage: Declining value

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 Criticism of the Traditional
View
• The contention of the traditional theory, that
moderate amount of debt in ‘sound’ firms does not
really add very much to the ‘riskiness’ of the shares,
is not defensible.

• There does not exist sufficient justification for the

assumption that investors’ perception about risk of
leverage is different at different levels of leverage.

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• Irrelevance Theories
Net Operating Income Approach
• Just opposite to the net income approach.
• Acc. to this approach, the capital structure
decisions of a firm are irrelevant.
• It says that any change in debt proportion
in capital structure will not lead to any
change in the value of the firm.
• The (V, Ko and share price) are
independent of financial leverage.
 Assumptions
• Overall Cost of Capital (Ko) remains
unchanged for all degrees of leverage.
• The market capitalizes the total value of
the firm as a whole and no importance is
given for split of value of firm between
debt and equity.
• The market value of equity is residue.(i.e.
Total value of the firm minus market value
of debt)
 Assumptions
• The use of debt funds increases the
perceived risk of equity investors, thereby
Ke increases.
• The debt advantage is set off exactly by
an increase in cost of equity.
• Cost of debt (Ki) remains constant.
• There are no corporate taxes.
 2.
• V.I. Co. Ltd., expects an operating income
of Rs. 1,00,000. The company has 12 per
cent debt of Rs. 3,00,000. The company’s
overall cost of capital is 13%. Calculate
the total value of the firm and the equity
capitalization rate(Ke).
 Solution:
• Value of the Firm = EBIT / Ko
= Rs. 1,00,000/0.13
= Rs. 7,69,230.77
• Market value of equity= V-D
= Rs. 7,69,230.77- Rs. 3,00,000
= Rs. 4,69,230.77
• Cost of equity/Equity Capitalization
Rate(Ke)
Ke=EBIT-I/V-D= NI/E
EBIT is NOI
V is market value of the firm
D is market value of debt
E is market value of the equity (V-D)
100000-36000/469230.77=
IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES

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 MM Approach Without Tax:
Proposition I
• MM’s Proposition I is that,
for firms in the same risk
class, the total market
value is independent of the
debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e., the
opportunity cost of capital)
appropriate to that risk
class.
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 MM’s Proposition I: Key
Assumptions
• Perfect capital markets
• Homogeneous risk classes
• Risk
• No taxes
• Full payout

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The cost of capital under MM
proposition I

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• MM’s approach is a net operating income
approach because the value of the firm is the
capitalized value of NOI.

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 Arbitrage Process
• Suppose two identical firms, except for their capital
structures, have different market values. In this situation,
arbitrage (or switching) will take place to enable
investors to engage in the personal or homemade
leverage as against the corporate leverage, to restore
equilibrium in the market.

• On the basis of the arbitrage process, MM conclude that

the market value of a firm is not affected by leverage.
Thus, the financing (or capital structure) decision is
irrelevant. It does not help in creating any wealth for
shareholders. Hence one capital structure is as much
desirable (or undesirable) as the other. 37
 MM’s Proposition II
• Financial leverage causes two opposing effects: it
increases the shareholders’ return but it also increases
their financial risk. Shareholders will increase the
required rate of return (i.e., the cost of equity) on their
investment to compensate for the financial risk. The
higher the financial risk, the higher the shareholders’
required rate of return or the cost of equity.
• The cost of equity for a levered firm should be higher
than the opportunity cost of capital, ka; that is, the
levered firm’s ke > ka. It should be equal to constant ka,
plus a financial risk premium.

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 THANK YOU

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