2. CAPITAL STRUCTURE
• Capital structure is the proportion of debt
and preference and equity shares on a
firm’s balance sheet
• Optimum Capital structure is that at
which the weighted average cost of capital
is minimum and thereby maximum value
of the firm
4. TRADITIONAL APPROACH
• The traditional approach argues that moderate
degree of debt can lower the firm’s overall cost
of capital and thereby, increase the firm value.
The initial increase in the cost of equity is more
than offset by the lower cost of debt. But as debt
increases, shareholders perceive higher risk
and the cost of equity rises until a point is
reached at which the advantage of lower cost of
debt is more than offset by more expensive
equity.
5. NET INCOME APPROACH
• Its relevant to the value of the firm
• Change in financial leverage will lead to
change in overall cost of capital and value of
the firm
• If degree of financial leverage(debt to equity)
increases then overall cost of capital and
market price of share decreases but value of
firm increases
• And vice-versa
6. Assumptions in NI Approach
• No taxes
• Cost of debt < cost of equity (equity
capitalisation rate)
• Use of debt does not change risk
perception of investors
7. Illustration (10%Debentures of Rs.200000)
• EBIT = Rs. 50000
Less: Interest on debentures 20000
Earning available to shareholders(NI) 30000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 240000
Market Value of debt(B) 200000
Total Value of firm(V=S+B) 440000
Overall cost of capital(ko=EBIT/V) 11.36%
8. When Financial leverage increases(10%
Debentures of Rs.300000)
• EBIT = Rs. 50000
Less: Interest on debentures 30000
Earning available to shareholders(NI) 20000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 160000
Market Value of debt(B) 300000
Total Value of firm(V=S+B) 460000
Overall cost of capital(ko=EBIT/V) 10.9%
It clearly shows that with increase in debt, overall cost
of capital decreases but Value of the firm increases.
9. NET OPERATING INCOME
APPROACH
• It is opposite to NI approach
• It states that capital structure decision is
irrelevant
• Any change in leverage will not lead to any
change in value of the firm , market price
of share as well as overall cost of capital
10. Illustration (10%Debt=Rs.200000)
• EBIT Rs. 50000
Overall cost of capital(ko) 0.125
Total Value of the firm(V=EBIT/ko) 400000
Cost of debt (B) 200000
Cost of equity(S=V-B) 200000
Equity Capitalisation rate(ke=EBIT-I ) 0.15%
S
11. When leverage increases (10%debt of
Rs.300000)
• EBIT Rs. 50000
Overall cost of capital(ko) 0.125
Total Value of the firm(V=EBIT/ko) 400000
Cost of debt (B) 300000
Cost of equity(S=V-B) 100000
Equity Capitalisation rate(ke=EBIT-I ) 0.20%
S
This clearly shows that will increase in
financial leverage there is NO effect on
value of firm and overall cost of capital.
12. MODIGLIANI-MILLER(MM)
APPROACH
• It somehow supports NOI approach
• It states that value of the firm must be
constant irrespective of the degree of
leverage
• Even cost of capital as well as market
price of share must be same
• Operational justification for MM hypothesis
is the Arbitrage process
13. • Arbitrage refers to buying an asset or
security in market where price is low and
selling where it is high
• MM approach uses arbitrage process
with reference to valuation of two firms
which are similar in all respects except
leverage
• One will be Levered firm(L) other will be
unlevered firm (U)
• The investors of the firm whose value is
higher will sell their shares instead of
buying of those whose value is lower
14. Illustration
• Particulars L U
EBIT 100000 100000
Less : Interest 50000 ---
Earnings available to
equity shareholders 50000 100000
Equity capitalization rate 0.16 0.125
Market value of share(S) 312500 800000
Market Value of debt(B) 500000 ----
Total Value of firm (V) 812500 800000
Overall cost of capital
(ko=EBIT/V) 0.123 0.125
15. • The illustration clearly shows that Value of
the Firm which employs Debt in capital
structure (L) is more than the Unlevered
firm(U)
