CAPITAL

STRUCTURE

BY
Prof. M.P.NAIDU
CAPITAL STRUCTURE

Capital Structure: Refers to the

composition of long-term funds such as
Debentures, Long –Term Borrowings,
Preference shares, Equity shares
(Including R/E) in the capitalization of a
company.
Optimum Capital Structure: It is that
capital structure at that level of debt –
equity proportion where the ,EPS &
Market value per share is maximum and
the cost of capital is minimum.
Capital Restructuring
We are going to look at how
changes in capital structure
impact the value of the firm,
all else equal.

Capital restructuring involves

changing the amount of leverage a
firm has without changing the
firm’s assets.
 Capital Restructuring
The firm can increase leverage by
issuing debt and/or repurchasing
outstanding shares

The firm can decrease leverage by

issuing new shares and/or retiring
outstanding debt
 Planning the Capital Structure
Important factors to be Considerations –
 Return: ability to generate maximum returns to the
shareholders, i.e., maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper
than equity due to tax shield on interest & no benefit on
dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs &
delays, to raise funds whenever required.
 CAPITAL STRUCUTRE
Factors to be considered in Capital Structure:
Factors determining capital structure

INTERNAL FACTORS EXTERNAL FACTORS

1. Cost of capital 1. Economic conditions
2. Risk factor 2. Interest Rates
3. Control factor 3. Policy of lending
4. Tax policies.
Cost :Kd < Kp<Kr< Ke
Type of source RISK COST CONTROL
Equity Capital Low Risk Most Expensive Dilution of Control
Preference Capital Moderate Moderate Moderate
Loan (Debt) Funds Risk is High Comparatively cheaper No Dilution of Control
 Capital structure &WACC (Ko)

Liabilities & Capital Assets

opt-1 opt-2 Assets ROCE= EBIT/CE
EC @20% 200 100 CE (FA) 400 400
PC @15% 100 100
DC @ 8% 100 200
LS 400 400
Ko= 15.75% 13.375%
Ko supposes
Value of the firm changes CA 100
CL 100
500 500
 Value of the Firm

Case-X company
• Source 10% 100 • CE 100
value of the firm =200 Operating (EBIT) 20
Case-Y company
• Source 10% 100 • CE 100
Buy = 100 operating (EBIT) 10

Case-Z company
• Source 10% 100 • CE 100
Buy = 50 operating (EBIT) 5
Value of the Firm
 EBIT – EPS
Analysis
• EBIT-EPS analysis should be considered
logically as the first step in the direction
of designing a firm’s capital structure.
• EBIT-EPS analysis shows the impact of
various financing alternatives on EPS at
various levels of EBIT.
• In this approach, it is analyzed that how
sensitive is EPS to the changes in EBIT
under different capital structure. (or
analyzing the impact of debt on EPS).
 EBIT – EPS Analysis
Nature &Objective
NATURE:
An approach for selecting the capital structure that
maximizes earnings per share(EPS) over the expected
range of earnings before interest and taxes (EBIT).

OBJECTIVE:
Does EPS rule favors debt ? ( increases ) if we analyze
the behavior of EPS in response to changes in Leverage
(use of sources of funds bearing fixed financial
payments like Debt in capital structure)
 Usage of EBIT – EPS analysis
• This analysis is useful for two reasons
• The EBIT-EPS analysis information can be
extremely useful to finance manager in
arriving at an appropriate (optimum capital
structure)financing decision.
• The EPS is the measure of firms performance
given the P/E ratio, the larger the EPS the
larger would be the value of the firm
 EBIT – EPS Analysis
Advantage or Disadvantage of Using of Debt & Not Using of Debt by the Firm

If ROI > Cost of Debt If ROI < Cost of Debt

Case
Effect on EPS Effect on F. Risk Effect on EPS Effect on F. Risk

1. Use of more debt Decrease & it Increases threat

in capital Increase Increases may (-) EPS also of insolvency
structure.

2. Use of Less debt Relatively less Relatively less Relatively less Relatively less
in capital increase increase decreases increase
structure
Illustration:
 EBIT – EPS analysis
• In general, the relationship between EBIT – EPS is
as follows;
EPS = (EBIT-I) (1-t) -PD
N
EPS= earning per share
EBIT= earnings before interest and tax
I= interest
T= Tax
N= number of equity shares
 Summary

• The EBIT–EPS approach evaluates capital structures in

light of the returns they provide the firm’s owners and
their degree of financial risk.
• The major shortcoming of EBIT–EPS analysis is that it
concentrates on maximizing earnings (returns) rather
than owners’ wealth, (Current Market Price) which
considers risk as well as return.
• The best capital structure can be selected by using a
valuation model to link return and risk factors. (i.e. P/E
Ratio)
Particulars Alt-1 Alt-2 Alt-3
A) Capital Structure.
10,00,000 10,00,000 10,00,000
I) Existing
Equity(1000,000 shares) Rs 2.50,000 ------- ------
NEW Is (25,000 shares )
2.50,000 ------
II) Debt @ 8% ------
2.50,000
III) Preference (8% ------ -----
dividend)
12,50,000
Total Capital 12,50,000 12,50,000
Employed: (I+II+III)

EBIIT 3,12,500 3,12,500 3,12,500

INTEREST ON DEBT (8%) ----- 20,000 ----

EBT 3,12,500 2,92,500 3,12,500
TAX. (50%) 156,250 146,250 156,250
EAT 156,250 146,250 156,250
PREFERENCE DIVIDEND --- ----- 20,0000
EAEASH 156,250 146,250 136,250
NO OF SHARED 1,250,0000 100,000 100,000
ESP = EASSH/NO. OF SHARE RS 1.25 1.4625 1.3625
 INDIFFERENCE POINT/ EPS EQUIVALENCY POINT
Meaning :
Indifference point refers to that level of EBIT at which EPS would be
same irrespective of the method of financing the new funds
requirements.
Relevance of Indifference Point:
Indifference point enables the management to know a point:
1. Before which equity alternative is favorable to raise the necessary
finance.
2. Beyond which debt alternative is favorable to raise the necessary
finance.
3. At which, either of the alternative is favorable to raise the necessary
finance.
 INDIFFERENCE POINT/ EPS EQUIVALENCY POINT
Plan -1
EPS Plan-2
(Rs) Advantage of Debt

Indifference point

Disadvantage of debt &

advantage of equity

0 A B EBIT (Rs)
Interpretation based on EBIT – EPS indifference Point:
Company’ EBIT Level Preferable Method of Finance Reason
1.EBIT Below the Option with lower debt (low ROI & EBIT are low
Indifference point interest burden)
2.EBIT Equal the Any Method of Finance chosen Same EPS
Indifference point
3.EBIT Above the Option with Higher Debt ROI & EBIT are higher
Indifference point
Calculation of indifference point

• The EPS formula under all-equity plan is

• The EPS formula under debt–equity plan is:

• Setting the two formulae equal, we have:

 Calculation of indifference point

• Sometimes a firm may like to make a choice between two

levels of debt. Then, the indifference point formula will be:

• The firm may compare between an all-equity plan and an

equity-and-preference share plan. Then the indifference
point formula will be:
Financial
Break
Even
Point
 FINANCIAL BREAK-EVEN POINT

Meaning :
on Debt and Preference Dividend. It refers to that level
of EBIT at which firm is just able to meet all Fixed
financial payments like interest
Or

It is the level of EBIT at which ESP=0 , EAESH =0

Financial Break Even Point ( FBEP) = Interest + Preference Dividend

(1 – tax )
Effect of FBEP on EPS:
EBIT>FBEP : EPS will have favorable effect

EBIT < FBEP: EPS will have adverse effect.

THEORIES OF CAPAITAL STRUCTURE
 • Capital Structure: Refers to
the composition of long-
term funds such as
CAPITAL Debentures, Long –Term
STRUCUTRE Borrowings, Preference
shares, Equity shares
(Including R/E) in the
capitalization of a company.
 Is the capital structure or Debt and Equity
mix at which the weighted average cost of
capital is minimum and thereby maximum
value the firm ( by increasing market price
of the share).

OPTIMUM The optimum capital structure minimizes

the firm's overall cost of capital and
CAPITAL maximizes the value of the firm(market
STRUCUTRE price increase).

The Financial manager should plan the “

Optimum capital structure” for its
company.
 Features of an Appropriate Capital Structure:
A sound or Appropriate Capital structure should have the following features.

1. Profitability ( maximize EPS)

2. Solvency( with Minimum Risk, if there is

more risk it becoming insolvent) ………….

Optimum 3. Flexibility (the capital structure should

capital be such that the company can raise funds
whenever needed)
structure
4. Conservatism ( with in the Debt Capacity,
which the company can bear)

5. Control (Minimum risk of loss or dilution

of control of the company)…………….
 Why capital structure is important?
 Capital structure affects the value of the firm by
effecting either:
 Cost of Capital (Ko or WACC)
 Expected Earnings (EBIT) , or
 Both
Where, EBIT
Value of the Firm = Ko(WACC)
KO or WACC = Cost of Equity Ke (E/V) + Cost of Debt Kd (D/V)
 Does The basic question is:
Capital
structure
matters?
Is it possible for firms
to create value by
altering their Capital
structure ?
 Capital structure
&Value of the Firm

Net Operating Income

Approach (NOI)

Tradition Approach

MM or Miller & Modigliani

approach
 • The firm has perpetual ( i.e., Going concern)

THEORIES OF • There only two sources i.e., Debt & Equity

CAPITAL • Not taxation (corporate or personal).

STRUCUTRE • 100% payout (No Retained earnings & Growth).i.e., EBIT –I

= EAESH
Assumptions • The total Financing remains constant.( changes only Debt
& Equity)

• No change in investment(assets) decision ( i.e., due to

change of Financing Mix).
• The investors have the same expectation for the future
expected EBIT for a given firm.
• Business risk is constant over time & is assumed to be
independent of its capital structure and Financial Risk.
Approaches to Capital Structure & Value of the Firm
• Traditional approach

• Net Operating Income NOI approach

• Modigliani & Miller/ MM approach

1. Theories which suggest that capital structure affects WACC (Ko)

( impacts market value of the firm ).
Value of the Firm (V) = EBIT/WACC (Ko)
2. Theories which suggest that capital structure does not affects
WACC or Ko, which is constant (market value of the firm is
constant).

LEVERAGE: Means use of source of funds bearing fixed (interest) financial payments like
Debt in the capital structure.
 Capital structure &
Value of the firm

1.Theories which suggest that capital structure

affects WACC (Ko)( impacts market value of the
Value of the Firm (V) =
firm ).

EBIT/WACC (Ko)

2. Theories which suggest that capital structure

does not affects WACC or Ko, which is constant
(market value of the firm is constant).
 NET OPERATING INCOME
(NOI) APPROACH
(Irrelevance of Capital
Structure )

•Net Operating Income Approach -- A

theory of capital structure in which the
weighted average cost of capital and the
total value of the firm remain constant as
financial Leverage is changed.
•According to NOI approach, WACC of a
firm is Independent of its capital structure.
 NET OPERATING INCOME APPROACH
Effect of Change in Leverage on Equity
Capitalization (Ke) and WACC (Ko) under NOI
approach ( Graphic Approach)

Assumptions :
1. Constant Kd
2. Constant Ko ( WACC)
3. No split (as whole) i.e., thus
the split between debt &
Equity is not important.
4. Neutralization.
5. No taxes Degree of Leverage ( % of Debt)
Effect of Change in Leverage on Equity Capitalization (Ke) and WACC (Ko) under NOI approach

Relationship:
EBIT ------------------ xxx 1. No taxes
Less Interest--------- ----- xxx 2. 100% payout
EBT Or EAESH xxx

Step 1: Calculation of total Value of the firm (V)

Value of the Firm (V) = EBIT ( net operating income)
WACC (Ko )
Step 2: Calculation of Market Value of the Debt (D)
interest .
Value of the Debt (D) =
rate of interest (Kd )
Step 3: Calculation of Market Value of the Equity ( E):
Value of the Firm (V) = M.V of Equity ( E) + M. V of Debt (D):
Or E = V– D
Step 4: Calculation of Equity Capitalization rate (Ke ):
Equity Capitalization rate (K )= Net income (EAESH) or EBIT - Interest
e
 NET OPERATING INCOME (NOI) APPROACH
(Irrelevance of Capital Structure ) (Proof)
Example: Assume that a firm has Rs 1,000 in debt at 10% interest, the expected
NOI (EBIT) is Rs 1,000 and the overall capitalization ( Ko) rate is 15%.
Calculate the Value of the Firm. Assume the number of share is 100.
Value of the Firm (V) = EBIT ( net operating income) 1,000 = Rs 6,667
WACC (Ko ) 15%

Value of the Firm (V) = E + D Where, Debt (D) = 1,000

Market Value of Equity (E)= 6,667 – 1,000 = 5,667
EBIT ------------------ 1,000
Less Interest--------- ----- 100
EBT Or EAESH 900
(as there is no taxes and 100% payout)
Net income (EAESH) or EBIT - Interest 900 = 15.88%
Equity Capitalization rate (Ke )= 5,667
Market value of the Equity (E)
Suppose if the Firm raised debt to Rs 3,000 (from Rs 1,000)
According to this approach Value of the Firm is remain same (V) =Rs 6,667

Value of the Firm (V) = E + D

Where, Debt (D) = 3,000

Market Value of Equity (E)= 6,667 – 3,000 = 3,667
 NET OPERATING INCOME (NOI) APPROACH
(Irrelevance of Capital Structure )
EBIT ------------------ 1,000
Less Interest--------- ----- 300
EBT Or EAESH 700
700
Ke = = 19.09%
3,667

Not only is the total value of the company unaffected, but also share price too, as
Proof:
At 1,000 debt the market price per share is = Rs 5667/100 = Rs 56.67
If the company issues addition debt of Rs 2,000 (total debt becomes Rs 3,000) , and
the same time, repurchase Rs 2,000 worth of shares at 56.67 per share or 35.29
(2,000/56.67) shares.
Then the outstanding shares = (100 shares – 35.29 shares) = 64.71 shares
The above we saw that the market value of Equity after issuing additional debt is = Rs
3,667

Then , market value per share = Rs 3,667/64.71 = Rs 56.67

 Optimal Capital Structure:
Traditional Approach

Traditional Approach

ke
.25
ko
.20
Capital Costs (%)

Stage-III
.15 Stage-II
ki
.10
Stage-I Optimal Capital Structure
.05

0
Financial Leverage (B / S)
 TRADITIONAL APPROACH
1. The pretax cost of debt (Kd) remains constant up to a certain degree
of leverage and /but rises thereafter of an increasing rate.

2.The cost of equity capital (Ke) remains constant rises slightly up to a

certain degree of leverage and rises sharper there after, due to
increased perceived risk.

3.The over all cost of capital (Ko), as a result of the behavior of pre-tax
cost of debt (Kd) and cost of equity (Ke) behavior the following
manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I
increasing firm value];
(b) Remains more or less unchanged for moderate increase in leverage
thereafter [stage II optimum value of firm], and
(c) Rises sharply beyond certain degree of leverage [stage III
decline in firm value].
M.M. APPROACH ( Total Value principle)
No Taxes
M.M. MODIGLIANEI & MILLER are two economists
APPROACH who demonstrated that with perfect financial
( Total Value markets Capital structure is Irrelevant.(WACC
is independent)
principle)
The M.M thesis relating to the relationship between
the capital structure, cost of capital and valuation is akin
(helps) to the NOI approach. (it is an extension of NOI)

The NOI approach does not provide operational or

behavioural justification for the irrelevance of the capital
structure.

The significance of M.M approach lies in the fact that it

provides behavioural justification for constant overall
cost of capital and therefore total value of firm.
The Modigliani and
Miller Irrelevance
Theorem
Capital Structure Decisions
21 -
50

The Modigliani and Miller

(M&M) Irrelevance Theorem
M&M and Firm Value
• The theorem that concludes (under some
simplifying assumptions) that the value of the firm
should not be affected by the manner in which it is
financed.
– How the firm is financed is irrelevant.
 (M&M) Irrelevance
Theorem
Assumptions
Assumptions about the Real World:
• Markets are perfect in the sense that there
are no transactions costs or asymmetric
information problems
• No taxes
• There is no risk of costly bankruptcy or
associated financial distress

Modeling Assumptions:
• There exist two firms in the same “risk class”
with different levels of debt
• The earnings of both firms are perpetuities

21 - 51
(M&M) Irrelevance
Theorem
Arbitrage Argument

• Arbitrage is a powerful economic force in

capital markets.
• Where two identical assets trade at
different prices, market traders will spot the
opportunity to earn riskless profits.
• Traders will sell the overvalued asset
and buy the undervalued asset.
• This activity will cause the price of
the overvalued asset to fall, and the
price of the undervalued asset to
rise until the two are priced the
same.
• The traders will earn abnormal
profits from these trades until the
prices of the two securities move
into equilibrium.

21 - 52
 (M&M) Irrelevance
Theorem
Arbitrage Argument

Market participants who find

levered investments trading for
a greater value, can undo the
leverage and earn abnormal
profits.

Arbitrage will force assets with

equal payoffs to trade for the
same price.

21 - 53
 M.M. APPROACH
Total Value principle (Proposition-I)
1. The market value of a firm & its cost of capital are
Independent of its capital structure.
2. The cost of equity capital is equal to capitalization rate of
pure equity stream plus a premium for financial risk.
The financial risk increased with more debt content in the
capital structure.(like NOI) as a result , Ke increases in a
manner to offset exactly the use of less expensive source
of funds.
3. The cut off rate for investment proposes is completely
independent of the way in which the investment is
financed.
4. If the two firms, which are identical in all respects except
for the degree of leverage , have , arbitrage or switching
will start and the investor will substitute personal or
home – made leverage for corporate leverage. The
switching option brings the value of the two identical
firms at equilibrium point in the market.
Capital Structure and Firm Value under
M&M Proposition -1
 M.M. APPROACH ( Total Value principle)

Cost of capital %
Value of the Firm (V) = EBIT
Ko -------------------------------- V

Ko

Degree of Leverage

We can rearrange the above equation as

 M.M. APPROACH
Total Value principle

Two firms that are alike in every respect EXCEPT

capital structure MUST have the same market
value.
Otherwise, arbitrage is possible.

Arbitrage -- Finding two assets that are essentially the

same and buying the cheaper and selling the more
expensive.
 Effect of Arbitrage Process:
1. The price of the equity share of
the overvalued firm whose shares
are being sold by the investor will
decrease.
2. The price of the equity shares of
the undervalued firm whose
shares are being purchased by the
investor will increase.
ARBITRAGE 3. This will continue till market prices
of two firms become identical

When Will this Arbitrage Process come

to an End ?
According to MM, this arbitrage process
will come to an end when the value of
both companies become identical.
 Example

Shifting from Levered Firm to Unlevered Firm:

Step 1: Earning of the Interest in Company M

a) Profit Statement :
EBIT Rs 20,000
(-) Interest ( 100,000 x 7%) Rs 7,000
EAESH 13,000

% of holding = 10%
Earnings of the investor = 13000 x 10%
= 1300
Step 2:
Arbitrage
NSP on Sales of shares in Company M
( 213043 – Debt: 100,000 ) x 10% = 11,304.3

Amount required to invest 10% in Company N

( 2,00,000 x 10% x ) = 20,000
Less : NSP on sales of Shares in Company M = 11,304.3
Amunt required to be borrowed 8,695.7
 Example
Step 3
Earnings of the Investor in Company N:
Assume he went for personal borrowings of Rs 8695.7
Profit Statement :
EBIT Rs 20,000
(-) Interest 0 .
EAESH 20,000

% of holding = 10%
Net earning of the Investor = Rs 2000
Less ( personal borrwings ( 8695.7 of 7%) = Rs 608.7
Net surplus = Rs 1391.30

Since there is an increase in earnings of Rs 91.30 the investor can switch his holding
from Company M to Company N.
 M.M. APPROACH (Proposition-II)
RELEVANCE OF CAPITAL STRUCTURE – UNDER
CORPORATE TAXES
MM show that the value of the firm will
increase with debt due to the
deductibility of interest charges for tax
computation, and the value of the levered
firm will be higher than of the unlevered
firm.

M.V. Of the Levered Firm = M.V of the

Unlevered Firm + Tax shield on Debt.
 M.M. APPROACH (Proposition-II)
RELEVANCE OF CAPITAL STRUCTURE – UNDER
CORPORATE TAXES
PROPOSITION
–II
Value of the Levered Firm

67
TRADE OFF & PECKING ORDER THEORIES
Two Theories of Capital Structure
• THE TRADE-OFF THEORY
– The trade-off theory of capital structure says that
managers choose a specific target capital structure
based on the trade-offs between the benefits and
the costs of debt.
– The theory says that managers will increase debt
to the point at which the costs and benefits of
adding an additional dollar of debt are exactly
equal because this is the capital structure that
maximizes firm value.
Exhibit 16.8: Trade-Off Theory of Capital
Structure
The Pecking-Order Theory
Theory stating that
firms prefer to issue
debt rather than equity
if internal financing is
insufficient.
Rule 1
Use internal financing first
Rule 2
Issue debt next,
new equity last
 PECKING ORDER THEORY
• The “pecking order” theory is based on the assertion
that managers have more information about their
firms than investors. This disparity of information is
referred to as asymmetric information.
• The manner in which managers raise capital gives a
signal of their belief in their firm’s prospects to
investors.
• This also implies that firms always use internal finance
when available, and choose debt over new issue of
equity when external financing is required.
73
PECKING ORDER THEORY
THE END