Business Finance ch3

1. Capital Structure

2. Capital structure
 Capital structure is defined as the mix of debt and equity or any other long-term
sources of funds used to finance a firm’s investment and operating activities.
 The capital structure of a given firm reflects its financing decisions;
 Capital structure is the mix of the long-term sources of funds used by a firm. It
is made up of debt and equity securities and refers to permanent financing of a
firm. It is composed of long-term debt, preference share capital and
shareholders’ funds.

3. Importance of Capital Structure
• Capital structure maximizes the market value of a firm, i.e. in a firm
having a properly designed capital structure the aggregate value of the
claims and ownership interests of the shareholders are maximized.
Value
Maximization
• By determining a proper mix of fund sources, a firm can keep the
overall cost of capital to the lowest.
Cost
Minimization
• Capital structure maximizes the company’s market price of share by
increasing earnings per share of the ordinary shareholders.
Increase in Share
Price
• Capital structure increases the ability of the company to find new
wealth- creating investment opportunities.
Investment
Opportunity
• Capital structure increases the country’s rate of investment and growth
by increasing the firm’s opportunity to engage in future wealth-creating
investments..
Growth of the
Country

4. Understanding Capital Structure
 The objective of capital structure decisions is the judicious use of different sources
of long-term funds such that the overall cost of capital of the firm is optimized,
thereby maximizing the value of the firm and its shareholders.
 Looking at the balance sheet of a company, we find two broad parts and two major
critical decisions which the managers must make carefully.
1. Financial structure
2. Capital structure
 A firm based up on its financing policy may choose any of the following options and
financing pattern.
1. It may either have half debt half equity finance
2. All equity finance, no debt
3. It may have more of debt and less of equity
4. Or it may have less of debt and more equity

5. Factors determining capital structure
• Trading on equity refers to additional profits that
shareholders earn because of issuance of
debentures and preference shares.
Trading on equity
• in a company it is the directors who are so called
representatives of equity shareholders.Degree of control
• in an enterprise, the capital structure should be
such that there are both contractions as well as
relaxations in plans.
Flexibility with
financial plan:
• a capital structure gives enough choice to all kind
of investors to invest.Choice for investors
• in the life time of the company, the market price
of shares has got an important influence.
Capital market
conditions

6. Factors determining capital structure
• when company wants to raise finance for short
period, it goes for loans from banks and other
institutions, while, for long period financing, it goes
for issue of shares and debentures.
Period of
financing
• in a capital structure, the company has to look to the
factor of cost when securities are raised.
Cost of
financing
• an established business which has a growing market
and high sales turnover, the company is in a
position to meet fix commitments.
Stability of
sales
• the bigger the size, the wider is the total
capitalization.
Size of
company:

7. Theories of capital structure
 Many theories have been developed in different times by many authors about
capital structure and cost of capital.
 Some of these theories developed are about capital structure relevance with
value of firm i.e., capital structure is having a direct impact on the cost of
capital. Example debt as cheapest source of fund.
 There is no relationship between capital structure and value of firm based on
certain assumption where market is perfect.
 The capital structure theories can be demarcated into two categories.
1. Relevance theories
2. Irrelevance theories

8. Relevance theories
 The relevant theories state that capital structure decisions are relevant for the
firm’s value.
 They affect the value of the firm. Thus, this view believes that an optimal
capital structure reduces its overall cost of capital and maximizes its value.
 The main theories of this group are
1. Net income approach
2. Traditional approach theory.

9. The Net Income Approach
 The net income approach states that the capital structure of any given firm
creates an impact on the value of the firm.
 Therefore, the use of debt creates an impact both on the overall cost of capital
and the value of the firm.
 The net income approach states that the average cost of capital (ko) of a firm
decreases as the debt proportion in its capital increases.

10. The Net Income Approach
 Use of debt benefits a firm in the following ways:
• Debt is less costlier than equity
• Debt bears a tax advantage that lowers its effective costs
 Thus, those firms which use debt in their capital structure are at advantage.
 Example 1: Company A has AFS 10,000 debt with EBIT of AFS 5,000 and cost of
shareholders’ fund is Ke= 10%. The cost of debt funds for the firm is 5% per annum.
Total value of the firm A (in AFS): 55000, K0=9.07%
 Example 2: Now we take up another company B, similar in all respects to company
A except for its capital structure. Company B has 3,500 shares at AFS 10 each at par
and holds debt of AFS 20,000 at 5% per annum.
Total value of the firm B (in AFS): 60000, K0=8.33%

11. The Traditional Approach
 The traditional view holds that there is an optimal capital structure. At this
optimal capital structure, the weighted average cost of capital (WAAC) is
minimized thereby maximizing the firm’s market value.
 Thus, when the firm increases its debt level, the cost of equity increases slowly
at first; however, the cost of equity rises steeply under extreme debt
borrowing.
 The traditional approach further states that after a certain debt level, any
increase will result in an increase in cost of debt too.
Thus, at same EBIT
lowering of ko
causes maximization of V
or value of the firm.

12. Irrelevance theories
 The irrelevance group of theories state the firm’s capital structure does not
affect its value. The firm’s value is independent of its capital structure.
 The firm’s value depends upon its investment decisions rather on its financing
decisions.
 Thus, financing and investment decisions of the firm are supposed to be
independent of each other.
 The main theories of this group are
1. Net operating income approach
2. Modigliani- Miller (MM) model.

13. Net operating income approach
 According to the net operating income approach, there is no optimal capital
structure for any firm, i.e. capital structure is irrelevant for a given firm.
 It states that the value of the firm depends upon its operating income and
business risk and not on its capital structure.
 Following are the key assumptions of the net operating income approach:
1. The overall cost of capital remains same or constant for any amount of
debt employed by the firm.
2. Firm’s value is independent of use of debt by the firm.
3. The capital structure is totally irrelevant for determining the value of
the firm. Hence, the total value of the firm remains same for all capital
structures.

14. Net operating income approach

15. Net operating income approach
 Example: Given is a firm X under two conditions of debt; condition A and
condition B. Under both the conditions, the firm is similar in its functioning and
size except that under condition B, the firm has more debt than under condition
A. Table 2.1 shows the financial data for the firm.
1. Cost of equity of Firm X under condition A is: 17.8%
2. Cost of equity of Firm X under condition B is: 22%

16. The Modigliani – Miller (MM) Theory
 In 1958, Modigliani and Miller published their research stating that the value of
a firm does not change with the change in the firm’s capital structure.
 However, their hypothesis was made under the assumption of no corporate taxes
and, and is often referred to as “MM without taxes”. In 1963, they corrected
their research to show the impact of including corporate taxes on the firm’s
value and is often referred to as “MM with taxes”.
 Assumptions of the MM model
1. There are no taxes.
2. Transaction cost for buying and selling securities as well as bankruptcy
cost is nil.
3. An investor will have access to same information that a corporate would
4. The cost of borrowing is the same for investors as well as companies.
 In real world no applications

17. The Modigliani – Miller (MM) Without Tax
 The debt is less expensive than equity. An increase in debt will increase the
required rate of return on equity.
 With the increase in the level of debt, there will be higher level of interest
payments affecting the cash flow of the company. Then equity shareholders will
demand for more returns.

18. MM propositions
1. Proposition I: in this proposition, the total market value of the firm and its cost
of capital are independent of its capital structure.
2. Proposition II: the II proposition of MM theory asserts that ‘the rate of return
required by shareholders increases linearly as the debt/equity ratio is
increased.
3. Proposition III: The overall cost of capital is completely unaffected by the
debt-equity mix. This implies a completed separation of investment and
financing decisions of the firm.
 The cost of equity of a geared firm is calculated as follows:

19. Example:
 ABC Ltd. has financed its project with 100% equity with a cost of 21%. This is
also the weighted average cost of capital of the company. XYZ Ltd., another
company identical to ABC Ltd., has financed its capital structure with 2:1 debt-
equity ratio. The cost of debt is 14%. Calculate the cost of equity of XYZ Ltd.
 Ans Kg= 35%
WACC= 21%

20. Example:
 XYZ Ltd. intends to set-up a project with capital of AFS 50, 00,000. It is
considering the three alternative proposals of financing:
1. 100% equity financing
2. D/E 1:1
3. D/E 3:1
 The estimated annual net cash inflow is @24% i.e. AFS 12, 00,000 on the
project. The rate of interest on debt is 15%. Calculate WACC for three different
alternatives and analyse the capital structure decision.

21. Arbitrage process
 Arbitrage process restores equilibrium in value of securities.
 This actually follows from the implication that the cost of capital is unaffected
by the change in leverage and from the assumption that the operating profits
are determined by the investment decisions rather than the financing
decisions.

22. Example
 A company has earnings before interest and taxes of AFS 100,000. It expects a
return on its investment at a rate of 12.5%. You are required to find out the total
value of the firm according to the MM theory.
 Ans 𝐴𝐹𝑆 800,000

23. The Modigliani – Miller (MM) With Tax
 The tax burden on the company will lessen to the extent of relief available on
interest payable on the debt, which makes the cost of capital cheaper which
reduces the weighted average cost of capital to the lowest where capital
structure of a company has debt component.

24. Example
 B Ltd. has the following capital structure
 Corporate tax rate is 40%. The cost of equity is assumed to be 24%.
Calculate WACC of the company.
 Ans 14.4%