Capital structure

Capital structure
can be defined as
the mix of owned
capital (equity,
reserves & surplus)
and borrowed
capital
(debentures, loans
from banks &
financial
institutions)
Theories of capital structure

Net Income Approach

Net Operating Income

Approach

Traditional Approach

Modigliani- Miller Model

NET INCOME APPROACH
A firm can minimise the average cost of
capital and increase the value of the firm as
well as market price of equity shares by Debt
financing to the maximum possible extent.

It states that there is a relationship between

capital structure and the value of the firm.

The firm can affect its value by increasing or

decreasing the debt proportion in the overall
financing mix.
Assumptions of Net Income
Approach
 The total capital requirement of the firm
are given and remain constant.
• Cost of debt (Kd) is less than cost of equity
(Ke).
 Both (Kd) and (Ke) remain constant.
The risk perception of the investors is not
changed by the use of Debt.
There are no taxes
 Net Income Approach
As the
proportion of
debt (Kd) in
Cost

ke, ko ke
capital structure
ko
increases, the
WACC (Ko)
kd kd

Debt reduces.
The total market value of the Firm on the basis of
Net Income Approach can be ascertained as
below:

V=S+D
S=market value of Equity share,
=earning available to equity share holders/Equity
Capitalization rate.
D=market value of Debt.

And overall Cost of Capital can be calculated as:

Ko=EBIT/V
Exp-(a)A company expects a net income of Rs 80,000.It has
Rs2,00,000,8%Debentures.The Equity capitalization rate of the company is 10%.
Calculate Value of the Firm and overall capitalization rate.
(b)If the Debenture Debt is increased to Rs 3,00,000 what shall be the Value of the firm
and Capitalization Rate.
Cont..
(b)Calculation of Value of the Firm If
Debenture Debt is raised to Rs. 3,00,000
NET OPERATING INCOME
APPROACH
Change in the Capital Structure of a
company does not affect the market value
of the firm and the overall cost of capital
remains constant irrespective of method of
financing .
The NOI approach is opposite to the NI
approach.
According to the NOI approach , the market
value of the firm depends upon the net
operating profit or EBIT and the overall cost
of capital.
The financing mix or capital structure does
not affect the value of the firm.
Thus there is nothing as Optimal capital
structure and every capital structure is the
optimum capital structure.

This approach is also known as

independence hypothesis.
Assumptions of Net Operating Income
approach:
The investors see the firm as a whole and
thus capitalises the total earnings of the
firm to find the value of the firm.

The overall cost of capital (Ko), of the firm

is constant at every level of debt Equity
mix.

The cost of debt is also taken as constant.

The increase in Ke completely offset the
benefits of employing cheaper debt.
The cost of debt remains constant with the
increasing proportion of debt as the
financial risk of the lender is not affected.
There are no corporate tax.
Net Operating Income Approach
 Cost of capital (Ko) is
constant.
 As the proportion of
Cost
ke debt increases, (Ke)
increases.
 No effect on total cost
ko
of capital (WACC)
kd

Debt
The value of the firm on the basis of
Net Operating Income approach can be
determine as follows:
V=EBIT/ Ko
Market value of the Equity, according
to this approach is the residual
value(i.e.
S=V-D
The cost of Equity or Equity
capitalization rate can be calculated;
cost of equity(Ke)=EBIT-I/V-D
 Exp- (a)A company expects a net operating income of Rs
1,00,000.It has Rs 5,00,000,6% Debentures.The overall
capitalization rate is 10%. Calculate value of the firm and the
Equity capitalization rate(cost of Equity).
(b) if the Debenture debt is increased to Rs 7,50,000,what will be
the effect on the value of the firm and Equity Capitalization Rate
 A) Net Operating income------------------------------------------------=Rs
1,00,000
 Overall Cost of capital ----------------------------------------------------=10%
 Market Value of the Firm(V)-------------------------=EBIT/Ko

=1,00,000/10%=Rs 10,00,000
 Market value of the firm is-------------- =Rs 10,00,00
 Less; market value of the Debenture--=Rs 5,00,000
 Total market value of Equity =Rs 5,00,000
 Now
 Equity capitalization rate(Ke)= (EBIT-T/V-D) = 1,00000 --30,000
x100
 10,00,000-5,00,000
 =14%
b)If the Debenture Debt is increased to Rs 7,50,000

 Value of the Firm remain same (i.e.) Rs 10,00,000

 But Equity capitalization rate will change because more
use of Debenture(risk perception of investors will
increase)

 Equity capitalization rate (Ke)=EBIT-T/V-D

 =1,00,000 - 45,000
x100
 10,00,000-7,50,000
 Ke=22%
TRADITIONAL APPROACH
The value of the firm can be increased
initially or cost of capital can be decreased
by using more Debt, as the debt is the
cheaper source
A practical viewpoint.
It takes a mid way between the NI
approach and the NOI approach.
It suggests that there should be the best
combination of both Debt & Equity.
It focuses on optimum capital structure.
Thus optimum capital structure can be
reached by a proper debt-Equity mix.

Beyond a particular point ,the cost of Equity

increases because increased Debt increases
the financial risk of the equity shareholders.

The advantage of cheaper debt at this point

of capital structure is offset by increased
cost of Equity.
 Traditional Approach
 Cost of capital (Ko)
Cost
reduces initially.
ke
 At a point, it
ko settles
 But after this
kd
point, (Ko)
increases, due to
Debt
increase in the
cost of equity. (Ke)
Exp- Compute Market value of the firm ,value os the
shares and average cost of capital from the following
information;
 Net Operating Income---------------------------------
Rs 2,00,000
 Total investment-----------------------------------------
Rs 10,00,000
 Equity capitalization rate;
 A) if firm uses no debt---------------------------------
10%
 B) if firm uses Rs 40,000debt-------------------------
11%
 C) if fimr uses Rs 6,00,000debt-----------------------
13%
 Assume that Rs 4,00,000 debenture can be
raised at 5% rate of interest whereas Rs
Solution:
 MODIGLIANI –MILLER APPROACH
 MM Approach recognises the irrelevancy of the
capital structure.
 Behavioural justification of the NOI approach.
 Arbitrage is the behavioural phenomena (Act of
simultaneous buying and selling the same
commodity in two different markets with a view to
earn profit)
 The overall cost of capital(Ko) and the value of
the company(V) are independent of the capital
structure(i.e. Ko and V remain constant
irrespective of Debt-Equity mix).
 The cut-off rate for investment purpose is
completely independent of the way in which an
Assumptions of MM Model
The capital markets are perfect and
complete information is available to all the
investors.
The securities are infinitely divisible.
Investors are rational and well-informed
about the risk-return of all the securities.
The personal leverage and the corporate
leverage are perfect substitute.
Exp-Two companies X ltd(levered) and Y
ltd(unlevered) are identical in all respects except
the capital structure. Details as follows;
 X ltd.
Y ltd
 EBIT------------------------------------------4,00,000
4,00,000
 Debt-----------------------------------------10,00,000
------------
 Rate of interest on debt----------------14%
------------
 Equity capitalization rate----------------20%
17.5%
 Find out value of the both companies.

 Solution;
 Since both the companies are identical in all respects,
They should have same value ,and if in any case and
Let us first calculate the value of the two companies;
 X ltd
Y ltd
 EBIT-------------------------------------4,00,000
4,00,000
 Less; interest on debt---------------- 1,40,000
------------
 Earning to Equity Share holders 2,60,000
4,00,000
 Equity capitalization rate 20%
17.5%
 Market value of equity(S)= 13,00,000
22,85,714
 Market vale of Debt (D) = 10,00,000
-------------
 Market value of the company = 23,00,000
Let us assume that Mr. A has 10% holding shares of X ltd
 Therefore his dividend income will be Rs 26000(i.e. 10% of
2,60,000).Since both the companies have equal EBIT but the
market value of Y ltd is less,Mr A would sell his holding in X ltd for
Rs 1,30,000(10% of Rs13,00,000) just to acquire10% shares in Y
ltd.he will be in need of Rs 2,28,571. But he has only Rs
1,30,000,in order to meet shortfall ,he will have to borrow the
funds. He will borrow Rs 1,00,000 @14% just to maintain the same
financial risk which he was exposed to as investor in X ltd.
 Mr A would be having total amounting
1,30,000+1,00,000=2,30,000
 Where as he required only 2,28,571 thus leaving surplus of Rs
1,428.
 In company Y ltd Mr A will get Rs 40,000 as dividend (10% of Rs
4,00,000)
 Out of Rs 40,000 he will pay interest @14% on Rs1,00,000 that’s
14,000 despite that he would have Rs26ooo in hand plus Rs 1,428.
HAPPY LEARNING