This document discusses capital structure and theories of capital structure. It provides definitions of key terms like capital structure, leverage, and theories proposed by David Durand, Ezra Solomon, and Modigliani-Miller. The net income approach and net operating income approach are explained. The document also discusses the rationale for acceptance of leverage initially and then the reality check. Examples of DLF Ltd.'s capital structure and its challenges due to extensive borrowing are provided.

1. Capital Structure
-B.V.Raghunandan
Post-Graduate Department of Commerce,
Government First Grade College, Hebri
April 6, 2014

2. Capital Structure
• It is the mixture or combination of debt and
equity used by a corporate in financing its
long-term operations
• As debt and equity have different cost of
servicing, the composition has an effect on
the profitability and ultimately on the
valuation of a corporate

3. Leverage
• Leverage: Having debt in the
capital structure of a
company
• In 1950s and 60s, it was
considered to be a magical
act through comparison of
leveraged company and a
non-leveraged company
• Effect was considered for
profitable companies and
non-profitable companies
were ignored

4. Theories of Capital Structure
• Theories of capital structure dealt with the presence of
debt in the long-term capital structure of a firm and its
impact on cost of capital, profitability and valuation of
the firm wit the objective determining the optimum
capital structure
• Theories are:
1) Net Income Approach-David Duran
2) Net Operating Income Approach-David Duran
3) Traditional Approach-Ezra Solomon
4) Modigliani-Miller Theories

5. I Net Income Approach
• Propounded by David Durand in 1952
• The presence of debt and its increase reduces the
weighted average cost of capital of the firm as
cost of debt is less than cost of equity
• Thus, an increase in debt component of the
capital structure leads to better valuation of the
firm
• There is a direct relation between degree of
financial leverage and the valuation of the firm

6. II Net Operating Income Approach
• Also propounded by David Durand
• Directly opposite to Net Income Approach
• Increase in debt increases debt-equity ration forcing
the lenders to charge a higher rate of interest
• Thus, cost of debt will be equal to cost of debt
which is equal to weighted average cost of capital
• Thus, change in financial leverage does not change
the cost of capital or valuation of the firm
• Known as Irrelevance Theory

7. III Traditional Approach
• Asserted by Ezra Solomon
• Resolves the contradiction
between NI and NOI
• Upto a certain level, increase in
debt will increase the benefit of
financial leverage leading to
weighted average cost of capital
and higher valuation of the firm
• After that, a higher debt-equity
ratio will result in a higher rates of
interest neutralising the benefit of
leverage
Prof. Ezra Solomon

8. Franco Modigliani
• Italian Economist
• Naturalised American
• Professor at Graduate
School of Industrial
Administration of
Carnegie Mellon
University in 1958
• Joined Merton Miller in
advocating Modigliani-
Miller Theorem on
Corporate Finance

9. Merton Miller
• Graduate from
Harvard School
• Joined as
Asst.Professor at
London School of
Economics
• A ground-breaking
work called,”Merton
Miller on Derivatives”
• Nobel Laureate

10. IV Modigliani-Miller Theory
• they compiled a paper on ‘The Cost of Capital,
Corporate Finance and the Theory of
Investment’,
• They based their theory on NOI Approach
• They objected to the traditional view of
finding an optimal capital structure
• The weighted cost of capital does not change
with increase in debt
• Hence, no change in leverage or valuation of
firm

11. Rationale for Acceptance
• High corporate taxes caused reduced tax incidence as interest
on debt was a business expense
• Promoters’ Control was not diluted as debt did not carry
voting rights
• Equity form of finance like venture capital emerged later
• The concept of risk management also emerged later

12. Reality Check
• During a long gestation period of heavy industries and
infrastructure projects, it becomes toxic
• For the industry having a huge capital cost and huge running
expenses like civil aviation, it is devastating
• When unexpected risks exist, the tables will turn very quickly
• Prolonged trade cycles like mining and metal industries

13. Warning
• Sharia held debt to be a sin
• Shakespeare maintained, "never a lender nor a borrower be”
and also depicted the cruelest aspect through the character
of Shylock in Merchant of Venice
• Financial Management considered both equity and debt to be
the components of capital structure
• Never considered the repayment programme, cautions,
warning signals etc as an important exercise

14. A Carefree World
• Corporates did not learn the lesson
leading to the development of art
and science of bankruptcy
• Individuals and families were
encouraged to overborrow like
housing finance, consumer finance,
finance for hospital bills, student
loans
• Questionable methods employed for
recovery including foreclosure
• Credit card booms
• Empty houses and homeless
population

15. Revival of Equity Culture
• A more mature and developed primary market and stock market
• Reduced corporate tax rates
• Emergence of venture capital and private equity fund
• Contribution of HNI and Angel Investors
• A Systematic Risk Management and Popularity of debt-free capital structure
• Basel Norms for Banks

16. Rationale for Equity Shares
• No need to pay dividend in the absence
of profit
• Even in the presence of profit, a growth
oriented company does not declare
dividend
• No need to pay dividend during
gestation period
• Large body of investors to share the
losses
• Equity shares are the cheapest source
of finance
• Shareholder Loyalty for other projects
and group companies
• Huge funds can be raised through IPOs
and FPOs
• Share Premium as another cheap
source of finance
• Listed companies having access to
cheaper foreign funds

17. The Fallen Empire-DLF Limited
• 1946-Chaudhry Ragvendra
Singh promoted
• Developer of residential
and other complexes in
Delhi until 1957
• 1957-Delhi Development
Authority banned private
developers
• It went out to Gurgaon in
Haryana to develop a city

18. IPO Details of DLF Ltd.
• 2007-IPO made
• 17.5 crore shares of Rs.2 through book-building
• Cut-off Price Rs.525
• Face Value of Shares: Rs.35 crore
• Share Premium: Rs.9,152.5 crore
• Share Price went upto Rs.1000 in 2008

19. Falling Down from Grace
• Forays into Capital
Intensive expansion
• Hospitality Industry
• Wind and other power
business
• Extensive Borrowings
• Debt: Rs.19000 crores
• Questionable Trade
Practices

20. Correlation between Interest and Profit of DLF Ltd.(Figures in
Rs.Crore)
Year Sales Interest Profit
2007-08 14433 310 7,847
2008-09 10,035 555 4,497
2009-10 7,423 1,110 1,709
2010-11 9,560 1,706 1,638
2011-12 9,629 2,246 1,169
2012-13 7,773 2,314 663
2013-14 8,298 2,463 582

21. Alternative
• FPO at the cut-off price of IPO could have
brought in a huge amount of cost-free funds
• It would have saved the interest
• More meaningful diversification
• Taking care of quality of building in Gurgaon
and maintaining the customer relation

22. THANK YOU