Explain different theories of capital structure - More useful to the students of Universities in Kerala

2. C A P I TA L S T R U C T U R E
 Capital the basic requirement for financing different assets
 What is capital
 Capital = Assets - Liabilities
 Known by different names
Owners’ equity = owners’ fund = Equity share capital + Preference
share capital + Various reserves and surpluses
 Creditors‘ equity = Long term debt + current liabilities
 Traditionally, current liabilities or short term debts are excluded
from the concept ‘capital’
 Thus in capital structure only long term funds are only considered
(long term debt and equity)

3. Capital Structure
• The proportion or combination of debt and equity in total
financing
• Financing will be different in different firms
• Thus, capital structure vary from firm to firm and in certain
firms from time to time
• Capital structure “represents the proportionate relationship
between debt and equity”
• It is the combination of debt and equity in financing a firm
Financial Structure?
The various means of financing a firm represents its financial
structure. Financial structure include both short term and
long term funds

4. Why Capital Structure Decisions?
 Financing decision
 A manager has to take finance decisions
– At the time of inception or formation
– At the time of expansion
– Dividend distribution
 Objective of financing decision
 Consider the aims while taking the decision
 Maximization of profit and wealth can only be achieved
through minimization of cost
 Cost of operation and cost of financing
 Cost of financing results in cost of capital
 Minimization of cost of capital

5. Factors Affecting Capital Structure
1. Control
2. Risk
3. Income (return on
investment)
4. Tax considerations
5. Cost of capital
6. Investors’ attitude
7. Flexibility
8. Financial market
conditions
9. Legal provisions
10.profitability
11.Growth rate
12.Government policy
13.Marketability
14.Company size
15.Financing purpose

6. O p t i m u m C a p i t a l S t r u c t u r e
 That capital structure or debt equity combination which
leads to maximization of value of the firm and
minimization of the overall cost of capital
 Favorable leverage (ROI>Interest and Tax deductibility)
increases EPS and market price of shares
 At the same time high debt increases financial risk and
consequently cost capital
 Increased financial risk and high cost of capital depress
the market price of shares
 Thus debt capital is a two edged weapon and the firm has
to use carefully
 Has to plan the “appropriate capital structure” or “sound
capital structure” – the Optimum capital structure

7. Capital Structure Theories
Remember these concepts and answer the questions
Financial leverage
Capital gearing
Trading on equity
Do the above concepts affect earnings and risk?
Will the increased earnings result in increase in the
value of the firm and wealth of the share holders?
• Financial leverage increases financial risk
• Investors loath to invest in risky enterprises
• To meet the increased risk, they expect more return
• This increased expectation increases the cost of
capital
• Thus, a financial manager has to consider several
points while taking capital structure decisions

8. While taking decisions, the financial manager has
always to be born in mind that “the value of the firm
is maximized”
Thus, our discussion is that whether capital structure,
financial leverage will affect value of the firm or not
There are divergent opinions
Capital structure theories explain the effect of capital
structure decision upon cost of capital and value of
the firm
Certain theories argue that capital structure is relevant
upon the value of the firm and cost of capital while
some other argue irrelevance

9. Important capital structure theories are:-
 Net Income Approach
 Net Operating Income Approach
 Traditional Theory and
 MM Theory

10. NET INCOME APPROACH
 On the basis of capital structure the firms can be divided into (a)
Levered firm and (b) Unlevered Firm
 A firm with debt and equity in its capital structure – levered
 A firm with no debt in capital structure - unlevered
 Proposed by David Durand
 Capital structure decision is relevant to the valuation of the firm
and affect overall cost of capital
 There is a positive relationship between capital structure and
value of the firm
 Argues that a change in the capital structure results a change in
overall cost of capital and total value of the firm
 Higher proportion of debt results in high financial leverage and
decline in overall or weighted average cost of capital
 This results in increasing the value of the firm and increase in the
value of equity

11. Assumptions
a. Corporate taxes do not exist
b. Debt element does not change the risk perception of the
investors
c. Cost of debt is less than that the cost of equity i.e., debt
capitalisation rate is less than the equity capitalization rate
 On the basis of the above assumptions, increased use of
debt magnifies EPS and value of the firm and leads to a
decline in overall cost of capital.
 There exist optimal capital structure – when EPS is
maximum, value of the firm is maximum and overall cost of
capital is minimum
 Argues that through judicious mix of debt and equity a firm
can have optimal capital structure

12. Cost of capital
Under this approach cost of debt (Kd) and cost of
equity (Ke) remain constant.
Since Kd<Ke, use of more and more debt will result
in the decline of Overall cost of capital (Ko) or
weighted average cost of capital.
Optimal capital structure occur at the point where
Ko is the minimum.
Under this approach firm will have maximum
value and minimum overall cost of capital when
the firm is 100% debt financed

13. Ke
Ko
Kd

14. According to this approach
Value of the firm (V) = E+D
where E = Market value of Equity
D = Market value of Debt
Market value of equity =
where NI = Net income available to equity shareholders
Ke = Cost of Equity
D = Value of debt
Overall cost of capital (Ko) =

15. NET OPERATING INCOME APPRROACH
• Proposed by David Durand
• Just opposite of NI Approach
• Overall cost of capital and value of the firm
are independent upon capital structure
• Change in leverage will not lead to changes in
the cost of capital or value of the firm
• Argues that there is nothing called “optimal
capital structure”

16. Assumptions or Propositions:-
1. Value of the firm is evaluated as a whole by the market and
not fragmented as debt and equity.
Thus, overall cost of capital (Ko) is used to determine the
value of the firm. The debt in debt and equity (capital
structure) is insignificant
2. Overall capitalization rate remains constant regardless of
any change degree of financial leverage
3. Use of low cost debt increases the financial risk. Thus,
equity shareholders demand more on their funds. Thus,
lower cost debt is offset by higher cost of equity
4. Cost of debt remain constant
5. No income tax

17. Value of the Firm
• Value of the firm is obtained by dividing NOI or EBIT by
overall cost of capital
Value of Equity
Value of Equity is the residual value obtained by deducting
value of debt from the value of the firm
E= V- D
E = Market value of Equity V = Market value of the firm
D = Market value of debt Ko = Overall cost of capital

18. Cost of Equity Capital
According to this approach, cost of capital
and equity capitalization rate (Ke) increases
with the degree of financial leverage
Financial leverage increases financial risk,
equity holders expect and demand more
leading to an increase in cost of equity

19. Ke
Ko
Kd

20. Traditional Approach
 NI and NOI approach, though proposed by
David Durand are mutually conflicting
 Traditional approach is a compromising one
 Resembles to the NI approach that leverage
will affect value of the firm and overall cost
of capital
 But does not agree that equity cost of capital
is constant and overall cost of capital will
decline as the degree of financial leverage
increases

21. Traditional approach argues that, up to a certain level,
leverage will lead to enhance value of the firm and reduce
the overall cost of capital.
Beyond that level, further induction of debt will not lead to
increase value of the firm and to reduce the overall cost of
capital
Thus, through judicious mix of debt and equity, the firm can
reach optimal capital structure
According to this approach, optimal capital structure is the
point at which overall cost capital begins to rise faster
than the increase in the EPS due to the induction of
addition debt
Optimal capital structure, the marginal real cost of debt will
be equal to that of equity.
Before this, the marginal real cost of debt < marginal real
cost equity. Beyond MRCdebt > MRCEequity

22. According to this approach, there are three stages
Stage – I
In the initial stage, the firm introduces debt in the
capital structure
As a consequence of the low cost debt, the firm
net income tends to increase and the cost of
equity capital (Ke) also tends to rise
But the rate of increase in the cost of equity is less
than the rate of increase in the net earnings rate
Cost of debt either remains constant or rises
moderately
Combined effect leads to a decline of overall cost
of capital

23. Stage – II
In this stage , due to further introduction of debt raises cost
of debt and cost of equity, which neutralizes the rate of
increase in net income.
Thus, overall cost of capital remains constant in this stage
and market value remains unchanged
Stage – III
Further induction of debt leads to increase in the cost debt
as well as cost of equity
As a result of the increased risk, overall cost of capital also
rises
The rate of increase in the overall cost of capital will be
higher than that of the increase in Net income
At this stage market value of the firm begins to fall

24. Ke
Ko
Kd
Stage I
Stage II Stage III