The document discusses capital structure and its components. It defines capitalization as the total amount of securities issued by a company, including equity share capital, preference share capital, long-term loans, retained earnings, and capital surplus. Capital structure refers to the proportion of different types of securities that make up the total capitalization. Financial structure includes all financial resources, both short-term and long-term, including current liabilities. The document then discusses various theories of capital structure, including the net income approach, net operating income approach, and traditional approach. It provides examples to illustrate how these approaches analyze the impact of leverage on firm value and cost of capital.

1. Capital Structure,
Capitalization
Capital structure
Financial structure

2. Capitalization Capital structure and
Financial structure
2
Liabilities Rs
Equity share capital 10,00,000
Preference share capital 5,00,000
Long term loans and debenture 2,00,000
Retained earnings 6,00,000
Capital surplus 50,000
Current liabilities 1,50,000
Total 25,00,000
1. Capitalization refers to the total amount of securities issued by a
company.
Equity share capital 10,00,000
Preference share capital 5,00,000
Long term loans and debenture 2,00,000
Capitalization = 17,00,000

3. Continued
II. Capital structure refers to the proportionate amount that makes up
capitalization is computed.
Equity share capital 10,00,000 ---- 58.82%
Preference share capital 5,00,000 ----- 29.41%
Long term loan and debenture 2,00,000 ------ 11.77%
17,00,000 100%
Some authors include retained earnings and surplus also for the purpose
of capital structure:
Equity share capital 10,00,000 ---- 42.55%
Preference share capital 5,00,000 ----- 21.28%
Long term loan and debenture 2,00,000 ------ 8.51%
Retained earnings 6,00,000 -------25.53%
Surplus 50,000 ----- 2.13%
capital structure 23,50,000 100%

4. Continued
Financial structure refers to all the financial resources, short as well
as long term.
Equity share capital 10,00,000 ---- 40%
Preference share capital 5,00,000 ----- 20%
Long term loan and debenture 2,00,000 ------ 8%
Retained earnings 6,00,000 -------24%
Surplus 50,000 ----- 2%
Current liabilities 1,50,000 ----- 6%
Financial structure 25,00,000 -----100%

5. Capital Structure
I. M. Pandey, Financial Management, 9th ed., Vikas. 5
• Capital structure is the mixture of sources of
funds a firm uses (debt, preferred stock, common
stock).
• The amount of debt that a firm uses to finance its
assets is called leverage. A firm with a lot of debt
in its capital structure is said to be highly levered.
A firm with no debt is said to be unlevered.
• Capital structure can be viewed as the
permanent financing the firm represented
primarily by long-term debt, preferred stock, and
common equity but excluding all short term
credit.

6. Patterns of capital structure
I. M. Pandey, Financial Management, 9th ed., Vikas. 6
• Equity Shares only( unlevered firm)
• Equity and preference shares (Levered)
• Equity shares and Debentures (Levered)
• Equity Shares, Preference Shares and Debentures( Levered firm)

7. Determinants of capital
structure
7
• Financial Leverage Growth and stability of
sales
• Cost of capital The profitability of the
organisation
• Reliable cash flows Degree of risk associated with
the enterprise
• Management’s risk aversion attitude
• Availability of different kinds of debt instruments
• Attitude of the promoters towards financial and management
control
• Cost of flotation Legal requirements
• Purpose of financing Period of Finance
• Nature and size of the firm Corporate Tax Rate
• Capital Market Conditions

8. Optimum Capital Structure
( value of the firm and cost of capital)
I. M. Pandey, Financial Management, 9th ed., Vikas. 8
Theories of capital structure:
Net income approach
Net operating income approach
The traditional approach
Modigliani and miller approach

9. Net Income Approach
• Net Income Approach was
presented by Durand. The theory
suggests increasing value of the firm
by decreasing overall cost of capital
which is measured in terms of
Weighted Average Cost of Capital.
This can be done by having higher
proportion of debt, which is a cheaper
source of finance compared to equity

10. I. M. Pandey, Financial Management, 9th ed., Vikas. 10
• Weighted Average Cost of Capital (WACC) is the weighted
average costs of equity and debts where the weights are the
amount of capital raised from each source.
• According to Net Income Approach, change in the financial
leverage of a firm will lead to corresponding change in the
Weighted Average Cost of Capital (WACC) and also the value of
the company. The Net Income Approach suggests that with the
increase in leverage (proportion of debt), the WACC decreases
and the value of a firm increases. On the other hand, if there is a
decrease in the leverage, the WACC increases and thereby the
value of the firm decreases.
• For example, equity-debt mix of 50:50, if the equity-debt mix
changes to 20: 80, it would have a positive impact on value of
the business and thereby increase the value per share.

11. I. M. Pandey, Financial Management, 9th ed., Vikas. 11

12. Assumptions of Net Income
Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 12
Net Income Approach makes certain
assumptions which are as follows:
• Increase in debt will not affect the
confidence levels of the investors.
• The cost of debt is less than cost of equity.
• There are no taxes

13. Market Value –NI Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 13
• V=S+D
Where,
V= Total market value of the firm
S=Market value of equity shares
S=Net income/equity capitalization rate(Ke)
D= Market value of Debt
Overall cost of capital or WACC
K o=EBIT/V

14. Example
1. A firm expects a net income of Rs 80,000. it has 8% Rs
2,00,000,debentures. The equity capitalization rate is 10%.
2.If the debt is increased to Rs 3,00,000 what shall be the value of the firm
and overall capitalization rate.
Case 1.
Net income 80,000
Less interest 8% 16,000
Earnings available 64000
Equity capitalization rate (S)= 64000× 100/10 = 6,40,000
Market value of debt is (D) 2,00,000
Value of the firm (S+D) 8,40,000
overall cost OR overall capitalization rate is
EBIT/V 80,000/8,40,000 ×100 = 9.52%

15. Case 2
Net income 80,000
Less interest 24,000
Income available to equity holder 56,000
Equity capitalization rate 10%
Hence market value of equity would be:
56,000 ×100/10% = 5,60,000
Market value of debenture is 3,00,000
Value of the firm 8,60,000
Overall capitalization of firm: 80,000/8,60,000 × 100 = 9.30%

16. Net Operating Income
Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 16
• This theory is opposite to the net income
approach. According to this approach,change in
the capital structure of a company does not affect
the market value of the firm and the overall cost
of capital remains constant irrespective of the
method of financing .
• It implies that the overall cost of capital remains
the same whether the debt equity mix is 50:50,
20:80 or 0:100. So there is nothing optimal
capitals structure and every capital structure is
optimal capital structure.

17. I. M. Pandey, Financial Management, 9th ed., Vikas. 17
• As per this approach, the market value is
dependent on the operating income and the
associated business risk of the firm. Both these
factors cannot be impacted by the financial
leverage. Financial leverage can only impact the
share of income earned by debt holders and
equity holders but cannot impact the operating
incomes of the firm. Therefore, change in debt to
equity ratio cannot make any change in the
value of the firm.

18. Assumption of NOI
I. M. Pandey, Financial Management, 9th ed., Vikas. 18
• The market capitalizes the value of the firm as a whole
• The business risk remains constant at every level of debt equity mix
• There are no corporate taxes.
According to NOI approach, the financing mix is irrelevant and it does not
affect the value of the firm.

19. Value of Firm-NOI Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 19
• V= EBIT/Ko
• V= value of a firm
• EBIT= Earning before interest and Tax
• Ko = Overall cost of capital
• Market value of equity is determined by
deducting the market value of debentures from
value of firm.
• S=V-D
• D= Value of debt

20. Net Operating Income (NOI) Approach
ke
ko
kd
Debt
Cost
20

21. Example
Case 1. firm expects net operating income of Rs 1,00,000 it has 6%
debenture of Rs 5,00,000. overall capitalization rate is 10%
Case 2. when firm increased debt to Rs 7,50,000 .
Find out the value of the firm and equity capitalization rate.
Case 1. Net operating income 1,00,000
overall cost of capital 10%
V –market value of the firm Net operating income(EBIT)
Overall cost of capital (Ko)
100000/10 ×100 = 10,00,000
Market value of firm 10,00,000
Less Market value of debt 5,00,000
Since market value of equity is 5,00,000
Equity capitalization rate (Ke) = EBIT-I/(V-D)
COST OF EQUITY= 1,00,000-30,000
10,00,000-500,000 SINCE = 14%

22. • CASE 2
Equity capitalization rate (Ke) = EBIT- I/V-D
EBIT- I = 1,00,000- 45000 = 55,000
V-D= S= 10,00,000- 7,50,000 =
2,50,000
COST OF EQUITY =55,000/2,50,000 × 100 =
22%

23. Traditional Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 23
• The traditional approach is also known as
intermediate approach, is a compromise between
two extremes of net income approach and NOI
approach.
• Stage-1 The value of the firm can be increased initially or
cost of capital can be decreased by using more debt as
the debt is a cheaper source of funds than equity. Thus,
optimum capital structure can be reached by a proper
debt –equity mix.
• Stage 2: Beyond a particular point, the cost of equity
increase because increased debt increases the financial
risk of the equity shareholders. The advantage of
cheaper debt at this point of capital structure is offset by
increased cost of equity.

24. I. M. Pandey, Financial Management, 9th ed., Vikas. 24
• Stage 3: At this stage, when the increased cost
of equity cannot be offset by the advantage of
low-cost debt.So, overall cost of capital,
increases or rise beyond a certain point.Even
the cost of debt may increase at this stage due to
increased financial risk.

25. Net operating income Rs 2,00,000, total investment Rs 20,00,000
equity capitalization rate 10% if firm uses debt, 11% if firm uses Rs
4,00,000 debt at 5% and 13% if firm uses Rs 6,00,000 debt at 6%
particulars No Debt Debt 4,00,000 Debt 6,00,000
Net operating income
Less interest
Earnings available to equity
holders
Equity capitalization rate
Market value of shares
Market value of debt
Market value of firm
Average cost of capital
2,00,000
Nil
2,00,000
10%
2,00,000×100/10
20,00,000
-------
20,00,000
2,00,000/20,00,000
×100 =
10%
2,00,000
20,000
1,80,000
11%
2,00,000 ×100/11
16,36,363
+4,00,000
20,36,363
2,00,000/20,36,36
3×100 =
9.8%
2,00,000
36,000
1,64,000
13%
2,00,000×100/13
12,61,538
+6,00,000
18,61,538
2,00,000/186153
8 ×100=
10.7%

26. 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.
ke
ko
kd
Debt
Cost
I. M. Pandey, Financial Management, 9th ed., Vikas. 26

27. MM Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 27
• MM approach has two version –MM I & MM II
• Assumptions
– There are no corporate taxes
– There is a perfect market
– Investor act rationally
– The expected earnings of all firms have identical risk characteristics
– The cut off point of investment in a firm is capitalization rate.
– Risk to investors depends upon the random fluctuations of expected
earnings.
– All earnings are distributed to the shareholders.

28. MM Approach
I. M. Pandey, Financial Management, 9th ed., Vikas. 28
• This approach was devised by Modigliani and
Miller during 1950s. The fundamentals of
Modigliani and Miller Approach resemble to that
of Net Operating Income Approach. Modigliani
and Miller advocates capital structure irrelevancy
theory. This suggests that the valuation of a firm
is irrelevant to the capital structure of a company.
Whether a firm is highly leveraged or has lower
debt component in the financing mix, it has no
bearing on the value of a firm

29. I. M. Pandey, Financial Management, 9th ed., Vikas. 29
• Modigliani and Miller Approach further states that
the market value of a firm is affected by its future
growth prospect apart from the risk involved in
the investment. The theory stated that value of
the firm is not dependent on the choice of capital
structure or financing decision of the firm. If a
company has high growth prospect, its market
value is higher and hence its stock prices would
be high. If investors do not see attractive growth
prospects in a firm, the market value of that firm
would not be that great.

30. MM Proposition Without
Taxes
• EBIT 24,00,000,
• Kd = 8% Debt having the value of Rs 1 crore
• Ke = 12%
• 1. Determines the market value of firm.
• 2. determines the value of equity.
• 3. determine the firms leverage cost of equity
Market value of the firm
V = EBIT/Ke 24,00,000/.12 = 2 Crore
Market value of equity
S = V-D Means 2Cr -1Cr = 1Crore
Firms leverage cost of equity: Ke +(Ke –Kd)
12% +(12%-8%) = 16%

31. MM Approach Without Tax: Proposition I
• Proposition 1: With the
above assumptions of “no
taxes”, the capital structure
does not influence the
valuation of a firm. In other
words, leveraging the
company does not increase
the market value of the
company.
I. M. Pandey, Financial Management, 9th ed., Vikas. 31

32. MM with Corporate Taxes
32
The real world is somewhat different from that
created for the purposes of MM's original 1958
model. One of the most significant differences is
that individuals and companies do have to pay
taxes.
MM corrected for this assumption in their 1963
version of the model – this changes the analysis
dramatically. Most tax regimes permit companies
to offset the interest paid on debt against taxable
profit. The effect of this is a tax saving which
reduces the cost of debt capital.

33. I. M. Pandey, Financial Management, 9th ed., Vikas. 33
The introduction of taxation brings an additional
advantage to using debt capital: it reduces the
tax bill. Now value rises as debt is added to the
capital structure because of the tax benefits (or
tax shield).
The WACC declines for each unit increase in debt
so long as the firm has taxable profits. This
argument can be taken to its logical extreme,
such that WACC is at its lowest and corporate
value at its highest when the capital of the
company is almost entirely made up of debt.

34. When the corporate taxes are assumed to be
exist.
• Firms EBIT is Rs 1,00,000
• Expected return is 12.5%
• Find out the total value of the firm according to MM Approach .
value of the firm = EBIT/Cost of capital (Ko)
V = 1,00,000/12.5% = 8,00,000
Now there two X and Y same identical firms except use of debt in their
financing Mix. Y using the 5% debenture Rs 1,00,000 both firms have
same EBIT Rs 25000, equity capitalization rate is 10%, tax rate is 50%.
Since market value of firm X which does not uses the debt :
Vu = EBIT/Ko (1-t) (Vu = value of
unlevered firm)
25,000/10 (0.5) = 1,25,000
Market value of firms Y which uses debt of Rs 1,00,000
Vl = VU + td ( Vl = value of
levered firm)
= 1,25,000 + 0.5×1,00,000 = Rs 1,75,000

35. 35
 Value of Unlevered Firm:
(Vu)= EBIT / Ko (1-t)
Where
EBIT= Earning before interest and tax
Ko = Overall Cost of Capital
 Value of levered Firm:
(VL)= Vu + tD
Where
VL = Value of levered Firm
t = rate of tax
D = Quantum of Debt used in the mix

36. MM with Taxes
I. M. Pandey, Financial Management, 9th ed., Vikas. 36
•

37. Financial Distress
37
• Financial distress arises when a firm is not
able to meet its obligations to debt-holders.
• For a given level of debt, financial distress
occurs because of the business (operating)
risk with higher business risk, the probability
of financial distress becomes greater.
Determinants of business risk are:
– Operating leverage (fixed and variable costs)
– Cyclical variations
– Intensity of competition
– Price fluctuations
– Firm size and diversification
– Stages in the industry life cycle

38. Consequences of Financial Distress
I. M. Pandey, Financial Management, 9th ed., Vikas. 38
–Bankruptcy costs
–Indirect costs
• Investing in risky projects.
• Reluctance to undertake profitable projects.
• Premature liquidation.
• Short-term orientation.

39. Suggested Readings
• Chandra, Prasanna “Financial Management”, Tata McGraw
Hill, New Delhi
• James C Van Horne, Financial Management, Prentice-Hall,
New Delhi
• Khan M.Y. & Jain P.K, Financial Management, Tata McGraw
Hill, New Delhi
• Pandey I.M “Financial Management”, Vikas Publishing
House, New Delhi
• Reference Material –
• Maheshwari S.N. “Principles of Financial Management”,
Sultan Chand & Sons, New Delhi
• Kulkarni P.V. “Financial Management”, Himalaya Publishing
House, Mumbai