Capital Structure

Capital structure is the particular combination

of debt and equity used by a company to
finance its overall operations and growth.
Capital structure of a company refers to the
combination or make-up of its capitalization
and it includes all long term capital resources
i.e., equity, preference , debt etc.
 Theories of Capital Structure
Different Kinds of theories have been propounded by
different authors to explain the relationship between
capital structure , overall cost of capital and value of
the firm. The important theories are as follows
1. Net Income Approach
2. Net operating Income Approach
3. Traditional Approach
4. Modigliani and Miller (M & M) Approach
 Formulas
Total Market value of a firm:
V=S+D
V= Total market value of a firm
S = Market value of equity shares
D= Market value of debt
S = V – D or D = V - S

S=
 Cont..d
Overall Cost Capital or Weighted Average Cost
of Capital can be calculated as:

K0 = Weighted Average Cost of Capital

EBIT= Earnings Before Interest & Tax

V= Total Market value of a firm

 1.Net Income Approach
According to this approach, a firm can minimize it’s
weighted average cost of capital and increase the value by
using debt financing to the maximum possible extent. This
theory propounds that a company can increase its value and
reduce the overall cost of capital by increasing the proportion
of debt in its capital structure. The theory based on following
assumptions:
(i) The cost of debt is less than cost of equity
(ii) There are no taxes
(iii) The risk perception of investors is not changed by the use
of debt
 Example 1
(a) A company expects a net income of Rs.
80,000. It has Rs.2,00,000, 8% Debentures.
The equity capitalization rate of the company
is 10%. Calculate value of the firm and overall
capitalization rate according to Net Income
Approach
(b) If the Debenture is increased to Rs.
3,00,000 ,what shall be the value of the firm
and overall capitalization rate.
 Solution
(a) Net Income Rs. 80,000
Less: Interest (8% on 2,00,000) Rs. 16,000
Earning Available to Equity Shareholder Rs. 64,000

Market Value of Equity (S)

S=

Given Market Value Debenture (D) = Rs. 2,00,000

Value of the firm (V) = S+D= 6,40,000+ 2,00,000 = Rs. 8,40,000
 Cont..d

Overall Cost of Capital

 (b)Value of the firm when Debenture
increased to Rs.300,000
Net Income Rs. 80,000
Less: Interest (8% on 3,00,000) Rs. 24,000
Earning Available to Equity Shareholder Rs. 56,000

Market Value of Equity (S)

S=

Given Market Value Debenture (D) = Rs. 3,00,000

Value of the firm (V) = S+D= 5,60,000+ 3,00,000 = Rs. 8,60,000
 Cont..d

Overall Cost of Capital

2. Net Operating Income Approach
According to this approach change in capital structure of a
company dose not affect the market value of the firm and the
overall cost of capital. Overall cost of capital remains constant
irrespective of method of financing . This theory presumes
that:
(i) The market capitalizes the value of the firm as a whole
(ii) The business risk remains constant at every level of debt
equity mix.
(iii) There are no corporate taxes
 Example 2
(a) A company expects a net income of Rs.1,00,000. It
has Rs. 5,00,000 ,6% debentures. The overall
capitalization rate is 10 %. Calculate the value of the
firm and the equity capitalization rate (cost of
equity) according to the Net operating Income
Approach
(b) If the debenture is increased to Rs. 7,50,000, what
will be effect on value of the firm and equity
capitalization rate.
 Solution
(a) Net Income = Rs.1,00,000
Overall cost of Capital (Ko) = 10%

Market Value of the Firm (V) =

=
Value of the firm (V) = 10,00,000
Less: Market value of debt (D) = 5,00,000
Market Value of Equity (S) = 5,00,000
 Cont…d

S=
 (b) If debenture will increase to
Rs.7,50,000

Value of the firm will remain same

Rs.10,00,000
 3. Traditional Approach
The traditional approach ,also known as
Intermediate approach, is a compromise
between the two extremes of net income
approach and net operating income approach.
According to this approach value of the firm
will increase and overall cost of capital will
decrease by using more debt initially, but after
a particular point use of excess debt will
decrease the value of the firm and increase the
overall cost of capital
 Example 3
Compute the market value of the firm and overall cost of capital
from following information:
Net Income Rs.2,00,000
Total Investment Rs.10,00,000
Equity Capitalization Rate

(Ke)
(a) If the firm uses no debt 10%
(b) If the firm uses Rs.4,00,000 debentures 11%
(c) If the firm uses Rs. 6,00,000 debentures 13%
Assume that Rs. 4,00,000 debenture have 5% rate of interest
and Rs. 6,00,000 have 6% rate of interest
 Conclusion
It is clear from the above that if debt of
Rs.4,00,000 is used the value of the firm
increases and overall cost of capital decreases.
But , if more debt is used to finance in place of
equity i.e. Rs.6,00,000 debentures, the value of
the firm decreases and overall cost of capital
increases
4. Modigliani and Miller Approach

This theory proves that the cost of capital is not

affected by changes in the capital structure or
say that the debt-equity mix is irrelevant in the
determination of the total value of a firm.
In the opinion of Modigliani & Miller , two
identical firms in all respects except their
capital structure cannot have different market
values or cost of capital because of arbitrage.
 Cont…d
An investor holding share in levered firm will
dispose off his holdings and invest in
unlevered firm by engaging himself in
personal leverage. This is known as arbitrage
process. This will continue till the market
value of two firm are identical.
After that if any investor is moving from
levered to unlevered he will make loss.
 Assumptions
1. There are no corporate taxes
2. There is a perfect market
3. Investors act rationally
4. The expected earnings of all the firms have
identical risk characteristics
5. All earnings are distributed to the
shareholders
 Example 3
The following is the data regarding two companies ‘A’ and ‘B’
belonging to the same equivalent risk class:
Company A Company B
Number of Equity shares 10,000 15,000
8% Debenture Rs. 50,000 ----
Market Price per share Rs.13 Rs. 10
EBIT Rs. 20,000 Rs. 20,000
All profits after paying debenture interest are distributed as
dividend. You are required to explain how under M & M
approach an investor holding 10% of share in company ‘A’
will be better off in switching his holding to company ‘B’.
 Solution
In the opinion of Modigliani and Miller two identical
firm in all respect except their capital structure cannot
have different market value because of arbitrage
process
In case two identical firms except their capital
structure have different market value, arbitrage will
take place and the investor will engage in ‘personal
leverage’ against corporate leverage
The investor will sell his 10 % share in company ‘A’
Rs. 13,000 (10% on Rs. 1,30,000)
 Cont…d
He will raise a loan of Rs.5,000 (10 % on 50,000) to take
advantage of personal leverage against corporate leverage as
company ‘B’ doesn't use debt in its capital structure
He invest Rs. 18,000 (13,000 + 5000) in company ‘B’.
Thus he will have 12 % share in company ‘B’
Income of investor in company ‘A’
Earnings Before Interest and Tax Rs.20,000
Less: Interest (8 % on 50,000) Rs.4000
Earnings After Tax Rs.16,000
Share of the Investor (10% on 16,000) Rs. 1600
 Cont…d
Income of the Investor in Company ‘B’
Earnings Before Interest and Tax Rs. 20,000
Less: Interest Nil
Earnings After Tax Rs.20,000
Share of the investor is 12% on 20,000 2400
Less: Interest on personal leverage (8 % on 5000) 400
Net Income of the Investor Rs.2,000