capital structure theories

1. C.H.PADMAJAA s s t . P r o f
S T . J O S E P H ’ S D E G R E E C O L L E G E

2. CAPITAL
STRUCTURE
THEORIES

3. Theory of relevance
1.Net income approach
Theory of irrelevance
1. Net operating income approach
2.Modigliani Miller Approach
Neutral
Traditional Aproach

4. NET INCOME APPROACH
• THIS THEORY IS DEVELOPED BY DURAND.
• According to this theory, there exists relationship between
capital structure and value of the firm
• Ie., a change in debt equityratio in capital structure will lead to a
corresponding change in Ko and V

5. ASSUMPTIONS OF NI
APPROACH
• There are no taxes
• Cost of debt is less than cost of equity
• Use of debt in capital structure does not change risk perception
of investors
• Cost of debt and equity remains constant
• Optimum capital structure exists when value of firm is maimum
and Ko is minimum

7. EXAMPLE
Particulars With existing capital
structure
When debt is
increased by
1,00,000
When debt capital is
decreased by
1,00,000
10% debentures 2,00,000 3,00,000 1,00,000
EBIT 50,000 50,000 50,000
Ke 12.5 12.5 12.5
Interest 20,000 30,000 10,000
NO OF SHARES 2,40,000/100
=2,400 SHARES
2400-(1,00,000/100)
=1400 SHARES
2400+1000
=3400 SHARES

8. Particulars With existing capital
structure
When debt is
increased by 1,00,000
When debt capital is
decreased by 1,00,000
EBIT 50,000 50,000 50,000
-INTEREST 20,000 30,000 10,000
EARNINGS AVAILABLE 30,000 20,000 40,000
VALUE OF EQUITY NI/Ke NI/Ke NI/Ke
30,000*100/12.5
=2,40,000
20,000*100/12.5
=1,60 000
40,000*100/12.5
3,20,000
VALUE OF DEBT 2,00,000 3,00,000 1,00,000
VALUE OF FIRM 4,40,000 4,60,000 4,20,000
COST OF CAPITAL EBIT/V
50,000/4,40,000
=11.36%
EBIT/V
50,000/4,60,000
=10.86%
EBIT/V
50,000/4,20,000
=11.9%
MARKET VALUE OF
SHARE
2,40,000/2400
=100
1,60,000/1400
=114.28
3,20,000/3,400
=94.11

9. NET OPERATING INCOME
APPROACH
• This theory was developed by Durand.
• It states that there is no relationship between capital structure,
cost of capital and value of the firm

10. ASSUMPTIONS
• Overall cost of capital remains unchanged
• Total value of firm minus MV of Debt=
MV of equity
Use of debt increases risk of equity thereby increases Ke
Cost of debt remains constant
There are no corporate taxes
There is no optimum capital structure

12. • The total value of firm= EBIT/Ko
• Value of equity= value of firm
minus
value of debt

13. EXAMPLE
Particulars With existing capital
structure
When debt is
increased by
2,00,000
When debt capital is
decreased by
2,00,000
8% debentures 4,00,000 6,00,000 2,00,000
EBIT 1,00,000 1,00,000 1,00,000
Ke 12.5 12.5 12.5
Interest 32,000 48,000 16,000
NO OF SHARES 5,44,000/10
=54,400 SHARES
54,400-(2,00,000/10)
=34,400 SHARES
54,400+20,000
=74,400 SHARES

14. Particulars With existing capital
structure
When debt is increased
by 1,00,000
When debt capital is
decreased by 1,00,000
Value of the firm=
EBIT/Ko
1,00,000/0.125
=8,00,000
1,00,000/0.125
=8,00,000
1,00,000/0.125
=8,00,000
Minus DEBT (4,00,000) (6,00,000) (2,00,000)
VALUE OF EQUITY =4,00,000 =2,00,000 =6,00,000
Cost of equity
EBIT-I*100/E
100,000-32,000
4,00,000
=17%
1,00,000-48,000
2,00,000
=26%
1,00,000-16,000
6,00,000
=14%
NO. OF EQUITYSHARES 4,00,000
10
=40,000 SHARES
40,000-20,000
(2,00,000)
10
= 20,000 shares
40,000+20,000
=60,000 shares
MV per share 4,00,000
40,000
=10 /-
2,00,000
20,000
=10/-
6,00,000
60,000
=10/-

15. TRADITIONAL APPROACH
• this theory was given by Soloman.
• This approach is intermediary between NI approach and NOI
approach
• It is similar to Ni approach in a way that the cost of capital and
value of firm depends on capital structure. But it does not accept
that value of firm will necessarily increase for all degrees of
leverage
• It supports NOI aopproach that , beyond a certain degree of
leverage the over all cost of capital increases, leading to
decrease in the total value of the firm. But differs that overall
cost of capital will remain unchanged for all degrees of
leverage.

16. ASSUMPTIONS
• Rate of interest on debt remains constant for certain period and
then after with an increase in leverage, it increases
• Equity shareholders as well as the debt holders perceive
financial risk and expect premium for the risk undertaken
• Investors risk perception is different at different level of leverage
• There is no corporate tax.

18. MAIN PROPOSITIONS
• Cost of debt (Kd)remains constant upto a certai degree of leverage and
rises thereafter at an increasing rate
• Cost of equity (Ke) remains constant rises slightly upto a certain degree of
leverage andrises sharper thereafter, due to increased perceived risk
• The overall cost of capital (Ko) as a result ofKd and Ke behaves in the
following manner:
• A) stage 1: increasing firm value: decreases upto certain point of degree of
leverage
• B)stage 2: optimum value of firm: remains more or less unchanged for
moderate increase in leverage thereafter
• C) stage 3: decline in firm value: rises sharply beyond certain degree of
leverage

19. • So , it can be concluded that there is a range of capital structure
in which cost of capital(Ko) is minimum and Value of firm is
maximum

20. MODIGLIANI MILLER
APPROACH
(MM HYPOTHESIS)
• This approach is developed by Franco Modigliani and Mertan
Miller (MM).
• This approach is identical to NOI.
• This approach states that total value of the firm is independent
of its capital structure

21. • However, there is basic difference between NOI and MM
• NOI does not provide operational justification
for irrelevance of capital structure whereas
MM states that in the absence of taxes, firm’s
total market value and the overall cost of
capital remains constant to the change of
debt capital proportion in capital structure
•

22. ASSUMPTIONS
• 1. information is available free of cost
• 2. this information is available to all investors
• 3. securities are infinitely divisible
• 4. no transaction cost
• 5. investors are free to buy and sell securities
• 6. dividend payout ratio is 100%
• 7. EBIT is not affected by use of debt

23. BASIC PROPOSITIONS
• Ko and V are independent of capital structure
• Total value of the firm must be constant for all degree of
leverage
• This theory is entirely based on “Arbitrage process”

24. ARBITRAGE PROCESS
• It refers to an act of buying an asset or security in one market at
lower price and selling it in other market at higher price.
• Investors will switch their securities between identical firms
(from levered firm to unlevered firm) and receive the same
returns from both firms

25. EXAMPLE
VALUE OF THE FIRM LEVERED FIRM UNLEVERED FIRM
EQUITY 60,000 1,00,000
DEBT 50,000
TOTAL 1,10,000 1,00,000
Kd 6% -
EBIT 10,000 10,000
Investor holds sharecapital 10% 10%

26. • Return from levered firm
• Investment= 10% of 1,10,000-50,000
= 60,000*10/100=6,000
Return=10%(10000-(6/100*50000) =1000-300=700

27. ALTERNATE STRATEGY
• 1 Sell shares in L=10% of 60,000 = 6000
• 2. borrow (personal leverage)
10% of 50,000=5000
3. Buy shares in U= 10% of 1,00,000=10,000
Return from alternate strategy:
Investment=10,000
Return=10%=1,000
Deduct interest on borrowings= 6% of 5,000=300
Net return=1,000-300 =700
Cash available=11000-10000=1000
Investor shall sell his shares in levered firm and invest in the unlevered firm

28. CRITICISM
• Risk characteristics of individuals and firms are different
• There are different lending and borrowing rates for individuals
and firms
• There are restrictions imposed on institutional investors
• Capital markets are not perfect
• Transaction costs cannot be ignored
• Corporate taxes are an important consideration