This document discusses theories of capital structure and defines key terms. It presents several assumptions of capital structure theories, including that a firm has equity and debt as its only funding sources. It also defines notations used like market values of equity and debt. The net income approach and net operating income approach to capital structure are described. The net income approach states that a firm's value is affected by its debt-equity mix, while the net operating income approach says value depends only on profits. Traditional and Modigliani-Miller theories are also summarized. Modigliani-Miller argues leverage has no effect on value through an arbitrage process and the substitutability of personal and corporate leverage.

1. CAPITAL STRUCTURE
&
THEORIES OF CAPITAL STRUCTURE

2. The theory of Capital structure is closely related to the
firm’s cost of capital. Many debates over whether an
optimal capital Structure exists are found in the
financial literature.
Capital Structure Theories Assumptions
1. There are only two sources of funds i.e., the equity and
the debt, which is having fixed interest.
2. Total assets of the firm are given and there would be
no change in the investment decisions of the firm.
3. The firm has a policy of distributing entire profits
among the shareholders implying that there is no
retained earnings.

3. 4. The operating profits of the firm are given and are
not expected to grow.
5. The business risk complexion of the firm is given and
is constant and is not affected by the financing mix.
6. There is no corporate or personal taxes.

4. Definitions and notations used in capital structure
E = Total market value of the Equity
D = Total market value of the Debt
V = Total market value of the firm I.e, D + E
I = Total Interest Payment
NOP = Net Operating Profit i.e., EBIT
NP = Net Profit or Profit after tax (PAT)
Do = Dividend paid by the company at time 0 (i.e., now)
D1 = Expected dividend at end of year 1
Po = Current market price of the share

5. P1 = Expected market price of the share after 1 year
Kd = After tax cost of debt I.e, I / D
Ke = Cost of Equity I.e, D1 / Po
Ko = Overall cost of capital I.e, WACC
= [D/(D+E)]Kd + [E/(D+E)]Ke
= NOP = EBIT
V V

6. NET INCOME APPROACH
(CAPITAL STRUCTURE MATTERS)
As suggested by Durand, this theory states that there exist a
relationship between capital structure and the value of the
firm.
The firm can affect its value by increasing or decreasing the
debt proportion in the overall financing mix.
ASSUMPTIONS
1) There are no taxes – corporate or personal.
2) Kd is less than Ke.

7. 3) Both Kd and Ke remain constant and increase in financial
leverage has a change in Ko.
As the degree of financial leverage (D/E) increases, Ko
decreases as the proportion of debt increases.
Ke
Kd
Ko
Cost of
capital %
Leverage
(degree)

8. A company’s expected annual net operating income
(EBIT) is Rs. 50,000.The company has Rs. 200,000,
10 % debentures. The equity capitalization(Ke) of the
company is 12.5%.
Net operating Income Rs 50000
Less: Interest on debentures 20000
Earnings available to equity holders, PAT 30000
Equity Capitalization Rate Ke 0.125
Market Value of Equity, E = PAT/Ke 240000
Market Value of Debt 200000
Total Value of the firm, E + D = V 440000
Overall cost of capital, Ko = EBIT/V *100 11.36%
Or 0.10(200000/440000) + 0.125(240000/440000) = 11.36%

9. If firm has raised Debentures to Rs 300000.
Net Operating Income 50000
Less : Interest on debentures 30000
Earnings available to equity holders 20000
Equity Capitalization Rate,Ke 0.125
Market Value of Equity =PAT/Ke 160000
Market Value of Debt,D 300000
Total Value 460000
Ko = 50000 = 10.9%
460000

10. Decrease in Value
Net Operating Income 50000
Less: Interest on Debentures 10000
Earnings available to equity holders 40000
Equity capitalization rate, Ke 0.125
Market Value of Equity, E 320000
Market Value of Debt , D 100000
Total Value of the firm 420000
Ko = 50000 = 11.9%
420000

11. NET OPERATING INCOME APPROACH
• Advocated by David Durand.
• Market Value depends on the Net Operating Income & Business
Risk.
• According to the Net Operating Income approach, the overall
capitalization rate (Ko) & the cost of debt (Kd) remains constant for
all degrees of leverage.
Value of the firm is determined by the equation:
V = EBIT
Ko

12. ASSUMPTIONS
1) The investors see the firm as a whole and thus capitalizes
the total earnings of the firm to find the value of the firm as
a whole.
2) The overall cost of capital, Ko of the firm is constant and
depends upon the business risk which also is assumed to be
unchanged.
3) Kd is also constant.
4) The use of more and more debt in the capital structure
increases the risk of the shareholders and thus results in the
increase in the cost of equity capital i.e., Ke. The increase in
Ke is such as to completely off set the benefits of
employing cheaper debt.

13. 5) There is no tax
V = EBIT
Ko
E = V - D
Ke = EBIT – Interest
V - D

14. Ko
Kd
Ke
Cost of
capital %
Leverage (degree)

15. Traditional Approach
A Practical View Point
It takes a mid way between the NI approach (that the
value of the firm can be increased by increasing the
leverage) and the NOI approach (that the value of the
firm is constant irrespective of the degree of financial
leverage).
It states that the value of the firm increases with
increase in financial leverage but up to a certain limit
only.

16. Beyond this limit, the increase in financial leverage
will increase its WACC also & hence the value of the
firm will decline.
The main proposition of this theory is that a firm
should make a judicious use of both the debt and the
equity to achieve a capital structure which may be
called the optimal capital structure.

17. The traditional theory on the relationship between
capital structure and the firm value has three stages:
First stage: Increasing Value
 At this stage Ke either remains constant or rises
slightly with debt.
 The cost of Equity, Ke does not increase fast
enough to offset the advantage of low - cost debt.
 Kd remains constant since the market views the
use of debt as a reasonable policy.
 As a result the WACC or Ko decreases with
increasing leverage & thus the total value of the
firm increases.

18. Second stage: Optimum value
 Once the firm has reached a certain degree of
leverage, increases in leverage has a negligible effect
on WACC.
 Because the increase in the cost of equity due to the
added financial risk just offsets the advantage of low
cost debt.
 Within that range or at the specific point, WACC will
be minimum, & the maximum value of the firm will
be obtained.

19. Third Stage: Declining Value
 Beyond the acceptable limit of leverage, the value
of the firm decreases with leverage as WACC
increases with leverage.
 This happens because investors perceive a high
degree of financial risk and demand a higher
equity capitalization rate, which exceeds the
advantage of low cost debt.

20. Stage 1
Stage 2
Stage 3
kd
ko
ke
leverage
Optimum leverage point
Cost
The cost of capital U- shaped

21. Cost
leverage
ke
ko
kd
Stage 1
Stage 2
Stage 3
Optimum leverage range
The cost of capital saucer shaped

22. The traditional approach is criticized on the point that
the value of the firm is a factor of its profitability
rather than its financial mix.

23. Modigliani-Miller Model : Extension of the NOI approach
Assumptions
1. The capital markets are perfect and complete information is
available to all the investors free of cost.
2. The securities are infinitely divisible.
3. Investors are rational & well informed about the risk return of
all the securities
4. There is no corporate income tax
5. The personal leverage & the corporate leverage are perfect
substitute
Levered firm’s cost of capital, kl = Unlevered firm’s cost
of capital, ku

24. The MM model argues that if two firms are alike in
all respect except that they differ in respect of their
financing pattern & their market value , then the
investors will develop a tendency to sell the shares
of the over valued firm (creating a selling pressure)
and to buy the shares of the under valued firm
(creating a demand pressure).
This buying & selling pressure will continue till the
two firms have same market value.

25. The Arbitrage process
It refers to an undertaking by a person of two related actions or
steps simultaneously in order to derive some benefit
e.g. buying by a speculator in one market and selling the same
at the same time in some other market.
Homemade or Personal Leverage
A substitution of risks that investors may undergo in order to
move from overpriced shares in highly levered firms to those in
unlevered firms by borrowing in personal accounts.
Homemade leverage is a situation where individuals borrowing
on the exact same terms as large firms can duplicate corporate
leverage through purchasing and financing options.

26. ARBITRAGE PROCESS:
It refers to undertaking by a person of two related actions or
steps simultaneously in order to derive some benefit e.g.
buying by a speculator in one market & selling the same at
the same time in some other market or selling one type of
investment & investing the proceed in some other
investment.
The profit or benefit from the arbitrage may be in any form:
increased income from the same level of investment or
same income from lesser investment.

27. Company L (Levered) has 10% debt of Rs 300000 in its
capital structure. Company U (Unlevered) has only
equity. Cost of equity 20%.
L U
EBIT 10,00,000 10,00,000
-Interest 3,00,000 -
Net Profit 7,00,000 10,00,000
Equity Capitalization rate,ke 20% 20%
Value of Equity 35,00,000 50,00,000
Value of Debt 30,00,000 -
Total Value, V 65,00,000 50,00,000
WACC, ko = EBIT/V 15.38% 20%

28. Arbitrage Strategy
1. An investor has a holding of 10% equity in L i.e. Rs 3,50,000.
Income to the investor = Rs 70000(20% of 350000)
2. He disposes of this share & receives Rs 350000.
3. He wants to buy 10% of U i.e. Rs 500000.
4. He borrows 10% of L’s debt @ 10% interest i.e. Rs 300000.
5. He invests Rs 500000 & is left with Rs 150000.
6. By investing Rs 500000 his income is :
Rs 100000 (20% of Rs 500000)
Less: Interest Rs 30000
70000
7. His total income will be greater than Rs 70000 as he will also
invest remaining Rs 150000.

29. Arbitrage in reverse direction
L’s Capital Structure = Rs 450000 ((Debt)300000+(Equity)150000)
UL’s Capital Structure = Rs 500000
1. An investor has 10% of UL’s share ie. Rs 500000.
2. Sell Rs 500000
3. Buy 10% of equity of L i.e. Rs 150000 & 10% debt Rs
300000.
4. Income on above securities: 10% of 700000 =70000
10% of 300000= 30000
100000
Investment of Rs 450000 led to an income of Rs 100000
whereas in L also he was earning Rs 100000 at an
investment of Rs 500000.

30. Critical evaluation of MM model
Non substitutability of personal and corporate
leverages
• Risk Perception
• Convenience
• Cost
• Institutional Restrictions
• Transaction Costs
• Taxes

31. Chapter-10
Optimum Capital
Structure

32. Capital Structure: It refers to the mix of long-term
sources of funds, such as debentures, long-term debt,
preference share capital & equity share capital including
reserves & surpluses.
The financial manager should plan an optimum capital
structure of his company.
There are significant variations among industries &
among individual companies within an industry in terms
of capital structure.
Number of factors determine the capital structure.

33. A sound or appropriate capital should have the following
features:
Profitability
Solvency
Flexibility
Capacity
Control

34. Optimum Capital Structure Models:
1. Operating & Financial Leverage Model
2. Cost of capital & valuation model for
determining the impact of debt on the
shareholders value.
3. Cash flow models governing the capital
structure decisions

35. Limitations of EPS as a financing decision:
~ EPS is one of the most widely used measures of the
company’s performance.
~ Too much emphasis is given EPS.
~ EPS does not consider risk.
~ Ignores the variability about the expected value of EPS.
~ Investors in valuing the shares of the company consider
both expected value & variability.

36. EPS Variability
The EPS variability resulting from the use of financial
leverage is called financial risk. Financial risk is added
with the use of debt as :
a) Increased Variability in the Shareholders Earnings.
b) The threat of insolvency.
A firm can avoid risk altogether if it does not employ
debt in the capital structure.
But EPS wont be maximized.
Due to increase in debt, the expected EPS will
continue to increase, but the value of the company will
fall due to increase in financial distress.

37. EPS does not consider the long-term perspectives of
financing decisions. It fails to deal with the risk-return
trade-off.
A long-term view of the effects of financing decisions will
lead to a criterion of wealth maximization rather than
EPS maximization.
EPS should be used as performance criterion rather than
decision criterion.
Long term view of the effect of the alternative financial
plans on the value of the shares should be taken.

38. Operating Conditions:
Variability of EPS depends on the growth & stable of
sales.
Magnitude of the EPS variability with sales will depend
on the degrees of operating & financial leverages
employed by the company.
High growth firms can afford to have high degree of
leverage as they can meet fixed commitments easily.

39. Cost of Capital & Valuation Model
The cost of a source of finance is the minimum return
expected by its suppliers.
The expected return depends on the degree of risk
assumed by investors.
Debt is the cheapest source of the finance & equity the
most expensive.
Pecking-Order Hypothesis:

40. The profitable firms have lower debt ratios because they
have lower targets & they use internal sources of finance
as it is cheaper than equity.
An equity issue indicates that the share price is
overvalued.
The management avoids signaling adverse information
about their companies.

41. Trade-off Theory
• This theory studies the following costs:
~ Costs of Financial Distress:
Financial Distress arise when a firm is not able to meet
its obligations to debt holders. When the higher business
risk & higher debt, the probability of financial distress
becomes greater.
Costs of Financial Distress are of two types: Direct Costs
of financial distress include Costs of Insolvency.
Indirect Costs:
~ Employees ~ Customers ~ Suppliers ~ Investors
~ Shareholders ~ Managers

42. Agency Costs:
There may exist a conflict of interest among
shareholders, debt- holders & management. These
conflicts give rise to agency problems, which involve
agency costs. Agency costs have their influence on a
firm’s capital structure.
• Shareholders-Debt holders conflict
• Shareholders-Managers conflict
• Monitoring & agency costs

43. Cash Flow Model
Components of Cash Flows:
1. Operating Cash Flows: Operations of the firm
2. Non-Operating Cash Flows: Capital Expenditure &
Working Capital changes
3. Financial Flows: Interests, Dividends,etc