CAPITAL STRUCTURE AND

FIRM VALUE
 Capital Structure and its Theories

Capital Structure means a combination of all long-

term sources of finance. It includes Equity Share
Capital, Reserves and Surplus, Preference Share
capital, Loan, Debentures, and other such long-term
sources of finance. A company has to decide the
proportion in which it should have its own finance
and outsider’s finance, particularly debt finance.
Based on the proportion of finance, WACC and Value
of a firm are affected. There are four capital
structure theories for this, viz. net income, net
operating income, traditional and M&M approaches.
 Capital Structure

Capital structure is the proportion of all types of capital viz. equity,

debt, preference, etc. It is synonymously used as financial leverage
or financing mix. Capital structure is also referred to as the degree
of debts in the financing or capital of a business firm.
Financial leverage is the extent to which a business firm employs
borrowed money or debts. In financial management, it is a
significant term and it is a very important decision in business. In
the capital structure of a company, broadly, there are mainly two
types of capital i.e. Equity and Debt. Out of the two, debt is a
cheaper source of finance because the rate of interest will be less
than the cost of equity and the interest payments are a tax-
deductible expense.
Capital structure or financial leverage deals with a very
important financial management question. The question is –
‘what should be the ratio of debt and equity?’ Before scratching
our minds to find the answer to this question, we should know
the objective of doing all this. In the financial management
context, the objective of any financial decision is to maximize
the shareholder’s wealth or increase the value of the firm. The
other question which hits the mind in the first place is whether
a change in the financing mix would have any impact on the
value of the firm or not. The question is a valid question as
there are some theories that believe that financial mix has an
impact on the value and others believe it has no connection.
Sometimes, the management also uses the pecking order
theory concept for their capital structure.
 Assumptions of Capital Structure Theories

To examine the relationship between capital structure and cost

of capital (or firm value) the following simplifying assumptions
are commonly made:
• There is no income tax, corporate or personal.
• The firm pursues a policy of paying all of its earnings as
dividends. Put differently a100 percent dividend payout ratio
is assumed.
• Investors have identical subjective probability distributions of
operating income (earnings before income and taxes) for each
company.
• The operating income is not expected to grow or decline over
time.
• A firm can change its capital structure almost instantaneously
without incurring financial costs
In terms of the above definitions, the question of interest to us is:
What happens to rD, rE, and rA when financial leverage, DIE,
changes?
Net Income (NI) Approach
The degree of leverage is plotted along the X-axis whereas K e, Kw and Kd are on
the Y-axis. It reveals that when the cheaper debt capital in the capital structure
is proportionately increased, the weighted average cost of capital, K w, decreases
and consequently the cost of debt is Kd.
Thus, it is needless to say that the optimal capital structure is the minimum
cost of capital if financial leverage is one; in other words, the maximum
application of debt capital.
The value of the firm (V) will also be the maximum at this point.
According to NI approach a firm may increase the total value of the firm
by lowering its cost of capital.
• When cost of capital is lowest and the value of the firm is greatest, we
call it the optimum capital structure for the firm and, at this point, the
market price per share is maximised.
• Using more debt capital with a corresponding reduction in cost of
capital, the value of the firm will increase.
The same is possible only when:
(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes;
(iii) The use of debt does not change the risk perception of the investors
since the degree of leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted
average cost of capital decreases which leads to increase the total value
of the firm. So, the increased amount of debt with constant amount of
cost of equity and cost of debt will highlight the earnings of the
shareholders.
Net Operating Income (NOI) Approach:
Under this approach, the most significant assumption is that the K w is constant
irrespective of the degree of leverage. The segregation of debt and equity is not
important here and the market capitalises the value of the firm as a whole.

Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the
corresponding increase in the equity- capitalisation rate. So, the weighted average
Cost of Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to
mention here that, as the firm increases its degree of leverage, it becomes more
risky proposition and investors are to make some sacrifice by having a low P/E
ratio.
Net Operating Income (NOI) Approach:
Assumptions of the approach
(i)The overall capitalisation rate of the firm K w is constant for all degree of
leverages;

(ii) Net operating income is capitalised at an overall capitalisation rate in order to

have the total market value of the firm.

Thus, the value of the firm, V, is ascertained at overall cost of capital (K w):
• V = EBIT/Kw (since both are constant and independent of leverage)

(iii) The market value of the debt is then subtracted from the total market value in
order to get the market value of equity.
• S – V =T

(iv) As the Cost of Debt is constant, the cost of equity will be

• Ke = EBIT – I/S