Capital structure Theory

According to Gestenberg, Capital structure refers to the make up if a firm s capitalisation. It represents the mix of different sources of long-term funds. PATTERNS OF CAPITAL STRUCTURE 1. With Equity shares only 2. With both equity and preference shares 3. With equity shares and debentures 4. With equity shares, preference shares and debentures

Ca ital Str ct r D finiti n and Patt rns

PATTERNS OF CAPITAL STRUCTURE Net Incomes (NI) Approach 2. Net Operating Income (NOI) Approach 3. Modigliani-Miller (MM) Approach 4. Traditional Approach
1.

Net Inc mes (NI) A

y Net Income (NI) Approach

r ac

Suggested by Durand. Acc. to this approach, capital structure decision is relevant to the valuation of the firm. A higher debt content (high financial leverage) will result in decline in the overall cost of capital or WACC. Reverse will happen in a converse situation.

Net Inc mes (NI) A

r ac

..

y Assumptions of Net Income (NI) Approach: 1. There are no corporate taxes 2. Cost of debt is less than cost of equity 3. Debt content does not change the risk perception of

the investors V=S+B, where V=Value of Firm, S=Market value of equity, B=Value of debt and S=NI/Ke, where NI=earnings available for equity sh.holders and Ke=Equity capitalisation rate. Ke=Earnings available to eq.shareholders /V-B

Net O erating Inc me (NOI) A r ac

y Net Operating Income (NOI) Approach

Suggested by Durand. Opposite of NI approach. Acc. to this approach, market value of the firm is not at all affected by capital structure changes. Market value of the firm is ascertained by capitalising the net operating income at the overall cost of capital k, which is considered to be constant.

Net O erating Inc me (NOI) A r ac ..

y Assumptions of Net Operating Income (NOI) Approach 1. 2. 3.

4. 5. 6.

Overall cost of capital K remains constant. No corporate taxes exist Use of debt having low cost increases the risk of equity shareholders. The advantage of debt is set off by increase in equity capitalisation rate. Valuation of Firm = EBIT / K Value of Equity = V-B, where V=value of firm and B=value of debt Ke=Earnings available to eq.shareholders / V-B

Modigliani-Miller A

roac

y Similar to Net Operating Income (NOI) Approach

Acc. to this approach, market value of the firm is independent of capital structure. MM has given behavioural justification for this approach whereas NOI approach is purely definitional or conceptual approach. Arbitrage process

Mo iglia i-Miller pproach ..

y Assumptions of MM Approach:

Overall cost of capital and value of the firm are independent of capital structure. 2. Capital markets are perfect. 3. Dividend pay out ratio is 100% 4. No corporate taxes exist 5. All investors have the same expectation of a firm s EBIT with which to evaluate the value of the firm. Total value of the firm = EBIT / Overall cost of capital
1.

Traditional A

roac

y NI approach and Net Operating Income (NOI)

Approach are exact opposite. y MM approach supports NOI approach. y MM approach with its assumptions is of doubtful validity.
y TRADITIONAL APPROACH is mid-way between the

two approaches.

Traditional A
y ITS FEATURES : 1.

roac

Similar to NI approach to the extent that it accepts that the capital structure or leverage affects the cost of capital. 2. Subscribes to NOI approach that beyond a certain degree of leverage, k increases resulting of the total value of the firm. y ESSENCE OF TRADITIONAL APPROACH: A firm through judicious use of debt-equity mix can increase its total value and thereby reduce its overall k.

Traditional A
y Market value of shares

roac

= Earnings available to Eq. Sh holders Equity capitalisation rate

y Average cost of capital

EBIT . Market value of the firm

Factors Determining t e Ca ital Str ct re

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Financial Leverage Growth and stability of sales Cost of capital Ability of cash flow Nature and size of the firm Control over the firm Flexibility in capital structure Requirement of Investors Capital market conditions Corporate tax rate and legal requirements