The document discusses capital structure, which refers to the mix of debt and equity used by a company to finance its long-term operations. It covers definitions of capital structure, forms of capital, the difference between capital structure and financial structure, theories of capital structure including net income, net operating income, and Modigliani-Miller approaches. The document also discusses the concept of optimal capital structure, which maximizes firm value and minimizes the weighted average cost of capital.

1. 20th August 2017
Prepared by: Niruja Rajakulanajagam
Capital Structure

2. Learning Objectives:
After completing this lesson you should able to:
• define the meaning of capital structure
• identify forms of capital
• differentiate capital structure from financial structure
• identify the optimum capital structure
• understand the theories of capital structure
• calculate cost f capital

3. Capital Structure
Coverage –
• Capital Structure concept
• Capital Structure Concept
of Value of a Firm
• Significance of Cost of
Capital (WACC)
•Capital Structure theories–
 Net Income
 Net Operating Income
 Modigliani-Miller
 Traditional Approach

4. Capital Structure
Capital Structure refers to the
combination of mix of debt and equity
which a company uses to finance its
long term operations.

5. Capital Structure
proportions or combinations of
equity share capital, preference share
capital, debentures, long-term loans,
retained earnings and other long-
term sources of funds in the total
amount of capital which a firm
should raise to run its business

6. Capital Structure
“Capital structure refers to the mix of
long-term sources of funds, such as,
debentures, long-term debts,
preference share capital and equity
share capital including reserves and
surplus.”—I. M. Pandey.

7. Capital Structure vs. Financial
Structure
• Capital structure is defined as the amount of,
long-term debt and common equity used to
finance a firm.
• Financial structure refers to the amount of total
current liabilities, long-term debt, preferred stock,
and common equity used to finance a firm.

8. Capital Structure =
Financial Current
Structure liabilities

9. Example of Capital Structure
Long term debt is LKR. 30,000
Equity Share Capital is LKR. 70,000
Pref. Share Capital is LKR. 10,000
Retained Earnings are LKR. 5000
-------------------------------------
Total Long term Fund = LKR. 115000
============================
Capital Structure vs. Financial
Structure

10. Example of Financial Structure
Long term debt is LKR. 30,000
short term debt is LKR. 20,000
Equity Share Capital is LKR. 70,000
Pref. Share Capital is LKR. 10,000
Retained Earnings are LKR. 5000
-------------------------------------
Total Fund = LKR 135000
============================
Capital Structure vs. Financial
Structure

11. Assets Structure
Total asset = Current assets + Fixed assets

12. •Fixed claim
•Tax deductible
•High priority to financial
trouble
•Fixed maturity
•No management control
•Residual claim
•Not tax deductible
•Lowest priority to financial
trouble
•Infinite
•Management control
Debt
Bank debt
Commercial papers
Corporate bonds
Equity
Owner’s equity
Venture capital
Common stocks
warrants
Hybrid securities
Convertible debt
Preferred stock
Option-linked bonds
The choice in financing

13. Capital structure and value of the firm
• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V = B + S
• If the goal of the firm’s
management is to make the firm
as valuable as possible, then the
firm should pick the debt-equity
ratio that makes the pie as big as
possible.
Value of the Firm
S BS BS BS B

14. Value of the Firm

15. Importance of Capital Structure:
• Enables one to “optimize” the value of a
firm or its WACC by finding the “best mix”
for the amounts of debt and equity
• Provides a signal that the firm is following
proper rules of corporate finance to
“improve” its balance sheet. This signal is
central to valuations provided by market
investors and analysts

17. Optimal Capital Structure
Capital structure or combination of debt
and equity that leads to maximum value
of firm.
Maximises value of company and
wealth of owners.
Minimises the company’s cost of
capital.

18. Capital Structure Terminology
• Optimal capital structure
– Minimizes a firm’s weighted average cost of
capital
– Maximizes the value of the firm
• Target capital structure
– Capital structure at which the firm plans to
operate
• Debt capacity
– Amount of debt contained in a firm’s optimal
capital structure

19. Planning the Capital Structure –
Important Considerations
 Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs & delays, to
raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.

20. Factors Affecting Capital Structure:
• Business Risk
• Tax structure: Debt’s tax deductibility
• Ability to raise capital under adverse terms
• Managerial decisions Business risk of the firm
• Extent of potential financial distress (e.g., bankruptcy)
• Agency costs
• Role played by capital structure policy in providing signals
to the capital markets regarding the firm’s performance
• Government and other regulations
20

21. Factors determining capital structure

22. What are the risks associated with capita
structure decisions?
• Meaning of risk : variability in income is called risk.
• Business risk = it is the situation, when the EBIT may
vary due to change in capital structure. It is
influenced by the ratio of fixed cost in total cost. If
the ratio of fixed cost is higher, business risk is higher.
• Financial risk = it is the variability in EPS due to
change in capital structure. It is caused due to
leverage. If leverage is more, variability will be more
and thus financial risk will be more.

23. What is the optimal debt-equity
ratio?
• Need to consider two kinds of risk:
– Business risk
– Financial risk

24. Theories of Capital Structure
1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach

25.  Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no
change in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
Capital Structure Theories
-Assumptions

26. Where, V = value o f firm
D = market value of debt
E = market value of equity
V = D + E

27. Where, D = market value of debt
I = Annual interest rate
kd = Cost of debt
D = I/kd

28. Where, E = market value of equity
NI = earnings available to
- common stockholders
ke = Cost of equity
E = NI/ke

29. Where,
ko= the firm’s overall cost of capital or
capitalization ratio
EBIT = earnings before interest and tax
V = Value of the firm
ko = EBIT/V

30. Where,
WACC= weighted average cost of
capital/ cost of capital
ke= cost of equity
we = weight of equity(E/V)
kd= cost of debt
wd = weight of debt(D/V)
WACC/ko=(ke*we)+(kd*wd)

31. ASSUMPTIONS:
1. COST OF DEBT < COST OF EQUITY
2. NO TAXES
3. RISK NOT INFLUENCED BY DEBT’S
USAGE
Capital Structure Theories –
1) Net Income Approach (NI)

32. Capital Structure Theories –
1) Net Income Approach (NI)
 Net Income approach proposes that there is a definite
relationship between capital structure and value of the
firm.
 The capital structure of a firm influences its cost of
capital (WACC), and thus directly affects the value of the
firm.

33.  As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value
at a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
Capital Structure Theories –
1) Net Income Approach (NI)
ko = EBIT/V

34. IMPLICATIONS
Increase in FIRMS’ VALUE
and MARKET PRICE of the
equity shares
WACC decreases
Proportion
of DEBT
INCREASES

35. CONT…
decrease in
FIRMS’VALUEand
MARKET PRICE of
the equity shares
Financial leverage is
reduced
WACC increases
Proportion of DEBT FINANCING
DECREASES

36. ke
ko
kd
Debt
Cost
kd
ke, ko
As the proportion of
debt (Kd) in capital
structure increases,
the WACC (Ko)
reduces.
Capital Structure Theories –
1) Net Income Approach (NI)

37. Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000Ke = 10%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Kd = 6%
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000
Ke 10% 10% 10%
Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)
Value of Debt 500,000 700,000 200,000
Total Value of Firm 2,200,000 2,280,000 2,080,000
WACC 9.09% 8.77% 9.62%
(EBIT / Value) * 100
Capital Structure Theories –
1) Net Income Approach (NI)

38. 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:
(a) the value of the firm & overall capitalization rate.
(b) If the debenture debt is increased to Rs 3,00,000, what
shall be the value of the firm & overall capitalization
rate?
Capital Structure Theories –
1) Net Income Approach (NI)

39. Solution
Particulars
Net income
Less interest on 8% debentures of
Rs .2,00,000/3,00,000
Earnings available to equity shareholders
Equity capitalization rate
Market value of equity(s)
Market value of debentures(D)
Value of the firm (S+D)
Overall cost of capital
Rs
80,000
(16000)
64000
10%
6,40,000
2,00,000
8,40,000
(80,000/8,40,000)
X100
=9.52%.
Rs
80,000
(24000)
56,000
10%
5,60,000
3,00,000
8,60,000
(80,000/8,60,00
0)X100
=9.30%

40. Capital Structure Theories –
B) Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent
upon its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.

41. ASSUMPTIONS:
1. MARKET CAPITALISES VALUE OF FIRM AS A WHOLE
2. BUSINESS RISK REMAINS CONSTANT AT EVERY LEVEL
OF DEBT EQUITY MIX
3. NO CORPORATE TAXES
Capital Structure Theories –
B) Net Operating Income (NOI)

42.  NOI propositions (i.e. school of thought) –
– The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
– Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
– A higher cost of equity (Ke) nullifies the advantages gained due
to cheaper cost of debt (Kd )
– In other words, the finance mix is irrelevant and does not affect
the value of the firm.
Capital Structure Theories –
B) Net Operating Income (NOI)

43. INCREASED USE OF
DEBT INCREASES
FINANCIAL RISK OF
THE EQUITY
SHAREHOLDERS.
COST OF EQUITY
INCREASES.
ADVANTAGE OF
USING CHEAP
SOURCE OF FUND
i.e., DEBT IS EXACTLY
OFFSET BY
INCREASED COST OF
EQUITY.
OVERALL COST OF
CAPITAL REMAINS
THE SAME.
Capital Structure Theories –
B) Net Operating Income (NOI)

44.  Cost of capital (Ko)
is constant.
 As the proportion
of debt increases,
(Ke) increases.
 No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost
Capital Structure Theories –
B) Net Operating Income (NOI)

45. Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%
Value of the firm 2,000,000 2,000,000 2,000,000
Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000
Interest @ 6 % 18,000 24,000 30,000
EBT (EBIT - interest) 182,000 176,000 170,000
Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
Capital Structure Theories –
B) Net Operating Income (NOI)

46. 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 the value of
the firm & cost of equity according to net operating
income approach. If the debenture debt is increased to
Rs 7,50,000. What will be the effect on the value of the
firm % the equity capitalization rate?
Capital Structure Theories –
B) Net Operating Income (NOI)

47. Solution
PARTICULARS
Net operating income
Overall cost of capital (Ko)
Market value of the firm=
EBIT/Ko (100000x100/10)
Market value of the firm(v)
Less market value of
debentures (D)
Total market value of equity
Cost of equity=
(EBIT-I) x 100
(V-D)
RS
1,00,000
10%
10,00,000
10,00,000
(5,00,000)
5,00,000
(1,00,000-30,000) x 100
10,00,000-5,00,000
=14%.
RS
1,00,000
10%
10,00,000
10,00,000
(7,50,000)
2,50,000
(1,00,000-45000) x 100
10,00,000-7,50,000
=22%

48. Capital Structure Theories –
C) Traditional Approach
 The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital
and the value of a firm.
 Traditional approach (‘intermediate approach’) is a
compromise between these two extreme approaches.
 Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
 As per this approach, a best possible mix of debt and
equity will maximize the value of the firm.

49. The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to
higher debt, WACC increases & value of firm decreases.
Capital Structure Theories –
C) Traditional Approach

50. D)Traditional approach
USE OF DEBT
INITIALLY
VALUE OF FIRM
INCREASES
COST OF CAPITAL
DECREASES
BUT..
INCREASED
USE OF DEBT
FINANCIAL RISK
OF EQUITY
SHAREHOLDERS
INCREASE
COST OF
EQUITY
INCREASES
OVERALL COST
OF CAPIAL
INCREASES
Implications:

51.  Cost of capital (Ko)
is reduces initially.
 At a point, it settles
 But after this point,
(Ko) increases, due
to increase in the
cost of equity. (Ke)
Capital Structure Theories –
C) Traditional Approach
O
K
o
Ke
K
d
Degree of Leverage
CostofCapital(percent)
.
Stage II
Stage I
Stage
III

52. • Stage I Increasing Value : Ke either remains constant Ke does not
increase fast enough to offset the advantage of low-cost debt. During
this stage Kd remains constant. Ko decreases with increasing
leverage and value of firm V also increases.
• Stage II Optimum Value : Beyond stage I any subsequent increase in
leverage have a negligible effect on Ko and hence value of the firm.
Increase in Ke due to the added financial risk just offsets the
advantage of low cost debt. Within this range, at a specific point Ko
will be minimum and the value of the firm will be maximum.
• Stage III Declining Value : Beyond the acceptable level of leverage,
the value of the firm decreases with leverage as Ko increases with
leverage. Investors perceive a high degree of financial risk and
demand a higher equity capitalization rate which exceeds the
advantage of low-cost debt.

53. EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
Capital Structure Theories –
C) Traditional Approach

54. Compute:
Market value of Firm, Value of shares, and Average cost
of Capital
Particulars
Net operating income
Total investment
Equity capitalization rate
a. If the firm uses no debt
b. If the firm uses Rs 4,00,000
debentures
c. If the firm uses Rs 6,00,000
debentures
Rs.
2,00,000
10,00,000
10%
11%
13%
Assume that Rs. 4,00,000 debentures can be raised at 5% rate
of interest whereas Rs. 6,00,000 debentures can be raised at
6% rate of interest.

55. Solution
Net operating income
Less int.
Earnings available to
eq. Sh.Holders
Eq. Capitalization rate
Market value of shares
Market value of debt
Market value of firm
Average cost of
Capital =EBIT/v
(a) No debt
2,00,000
-
2,00,000
10%
20,00,000
-
20,00,000
2,00,000/20,00,000X100
=10%
(b) Rs 4,00,000 5%
debentures
2,00,000
(20,000)
1,80,000
11%
16,36,363
4,00,000
20,36,363
2,00,000/20,36,363X100
=9.8%
(c) Rs. 6,00,000 6%
debentures
2,00,000
(36,000)
1,64,000
13%
12,61,538
6,00,000
18,61,538
2,00,000/18,61,538X
100
=10.7%

56. Capital Structure Theories –
D) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, & switch
between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention

57. (IN THE ABSENCE OF TAXES)
ASSUMPTIONS:
THERE ARE NO CORPORATE TAXES
THERE IS A PERFECT MARKET
INVESTORS ACT RATIONALLY
THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL
RISK CHARACTERSTICS
ALL EARNINGS ARE DISTIBUTED TO THE SHAREHOLDERS
Capital Structure Theories –
D. Modigliani & Miller Approach

58. Implications
 Cost of capital not influenced by changes in
capital structure
 Debt-equity mix is irrelevant in
determination of market value of firm
CostofCapital(%)
K
o

59. MM Model proposition –
1.Value of a firm is independent of the capital structure.
2.Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate (i.e.
WACC).
3.Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC
Capital Structure Theories –
D) Modigliani – Miller Model (MM)

60. (B) WHEN TAXES ARE ASSUMED TO
EXIST (Proposition I & II)
USE OF DEBT
COST OF
CAPITAL
DECREASE
ACHIEVEMENT
OF OPTIMAL
CAPITAL
STRUCTURE
Implication:

61. • Overall cost of capital (ko) and the Value of
the firm (V) remains constant.
• Independent of the capital structure.
• The total value can be obtained by capitalizing
the operating earnings stream
• Size of the corporate pie = PV of cash flows
• V=EBIT/ko
Proposition I

62. Proposition II
• The cost of capital (ke) equals the
capitalization rate of a pure equity stream and
a premium for financial risk.
• Ke=ko+Risk premium
• The premium for financial risk is equal to the
difference between the pure equity
capitalization rate and kd times the debt-
equity ratio.
• Ke=ko+(ko-kd)(D/E)

63. Limitations of MM approach
• Investors cannot borrow on the same terms
and conditions of a firm
• Perfect Capital Markets
• Existence of transaction cost
• Floatation costs
• Asymmetric information
• Existence of corporate tax
• Uncertainty