Presentation topic on capital Structure

1. Theory of Capital Structure

2. Capital Structure
Capital structure can be defined as the
mix of owned capital and borrowed
capital
Maximization of shareholders’ wealth is
prime objective of a financial manager.

3. Capitalization and Capital Structure
Capitalization refers to the total amount of
long-term funds employed by the firm.
Capital structure signifies the kinds of
securities and their proportion in the total
capitalization of a firm.

4. Financial structure and capital structure.
 Financial structure is different from capital structure.It means
the composition of the entire liabilities side of the balance sheet.
 It shows the way in which the firm’s assets are financed.
Financial structure includes long-term as well as short-term
sources of finance.
 Capital structure signifies the proportion of long-term sources
of finance in the capitalization of the firm.
 It is represented by shareholders’ funds and long-term loans.
Capital structure is a part of the financial structure.

5. Forms of pattern of Capital
Structure:
The capital structure of a new company generally includes
the following:
a) Equity shares
b) Preference shares
c) Debentures or Bonds
d) Long-term loans

6. Theories of Capital Structure
The four major theories of approaches
which explain the relationship between capital
structure, cost of capital and valuation of firm are:
1. Net Income (NI) Approach
2. Net Operating Income (NOI) Approach
3. The Traditional Approach
4. Modigliani-Miller (MM) Approach

7. Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds –
equity & debt.
 No change in investment decisions of
the firm, i.e. no change in total assets.
 100 % dividend payout ratio, i.e. no
retained earnings.
 Business risk of firm is not affected by
the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of
the firm.

8. Capital Structure Theories –
A) Net Income Approach (NI)
Relationship between capital structure and
value of the firm.
 Its cost of capital (WACC), and thus directly affects the value of
the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]
o Corporate income taxes do not exist.

11. EBIT = 100,000
Less: Interest cost
(10% of 300,000)
= 30,000
Earnings (since
tax is assumed to
be absent)
= 70,000
Shareholders’
Earnings
= 70,000
Market value of
Equity
(70,000/14%)
= 500,000
Market value of
Debt
= 300,000
Total Market
value
= 800,000
Overall cost of
capital
=
EBIT/(Total value
of the firm)
= 100,000/800,000
= 12.5%
Calculating the value of a company
(EBIT) = 100,000
Less: Interest cost (10% of
400,000)
= 40,000
Earnings (since tax is assumed to
be absent)
= 60,000
Shareholders’ Earnings = 60,000
Market value of Equity
(60,000/14%)
= 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
Overall cost of capital =
EBIT/(Total value of
the firm)
= 100,000/828,570
= 12% (approx)
Now, assume that the proportion of debt
increases from 300,000 to 400,000, and
everything else remains the same.

12. As observed, in the case of the Net Income Approach, with an increase in debt
proportion, the total market value of the company increases, and the cost of capital
decreases. The reason for this conclusion is the assumption of the NI approach that
irrespective of debt financing in capital structure, the cost of equity will remain the
same. Further, the cost of debt is always lower than the cost of equity, so with the
increase in debt finance, WACC reduces, and the firm’s value increases.

13. Capital Structure Theories –
B) Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact opposite of
the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent upon
its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.

14. Capital Structure Theories –
B) Net Operating Income (NOI)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained due
to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not affect
the value of the firm.

16. (EBIT) = 100,000
WACC = 12.5%
Market value of
the company
= EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 300,000
Total Equity =
Total market
value – total debt
= 800,000-300,000
= 500,000
Shareholders’
earnings
=
EBIT-interest on
debt
=
100,000-10% of
300,000
= 70,000
Cost of equity = 70,000/500,000
= 14%
(EBIT) = 100,000
WACC = 12.5%
Market value of
the company
= EBIT/WACC
= 100,000/12.5%
= 800,000
Total Debt = 400,000
Total Equity =
Total market
value – total debt
= 800,000-400,000
= 400,000
Shareholders’
earnings
=
EBIT-interest on
debt
=
100,000-10% of
400,000
= 60,000
Cost of equity = 60,000/400,000
= 15%
Now, assume that the proportion of debt increases
from 300,000 to 400,000, and everything else
remains the same.
As observed, in the case of the Net Operating
Income approach, with the increase in debt
proportion, the total market value of the
company remains unchanged, but the cost of
equity increases.

17. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 MODIGLIANI- MILLER explain the relationship between
capital structure, cost of capital and value of the firm under two
conditions:
1. When there is no corporate taxes
2. When there is corporate taxes

18. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
WHEN THERE IS NO CORPORATE TAXES
 The MODIGLIANI- MILLER Approach is identical to NOI
approach when there are no corporate taxes.
 MODIGLIANI- MILLER argue that in the absence of taxes, the
cost of capital and value of the firmare not affected by capital
structure or debt-equity mix.

19. Modigliani – Miller Model (MM) Assumption
The MM hypothesis is based on the following
assumption
There is perfect market. It implies that
(a). Investors are free to buy
and sell securities:
(b). they can borrow freely
on the same term as the firms do;
(c). Investors act in a rational
manner.

20. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
There are no corporate taxes.
There are no transaction costs.
The payout is 100 per cent. That is, all
the earnings are distributed to
shareholders.
Firms can be grouped into
homogeneous risk classes.

21. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
2. When there are corporate taxes:
Modigliani an Miller have recognized that capital structure
would affect the cost of capital an value of the firm, when there
are corporate taxes.
If a firm uses debt in its capital structure, the cost of capital will
decline an market value will increases. This is because of the
deductibility of interest charges for computation of tax

22. Modigliani – Miller Model……
 According to the M-M approach, the value of an unlevered
firm (Which does not use debt ) can be calculated as
follows.
 Value of unlevered firm, Vu = EBIT/ Ke (1-T)
Where EBIT = Earnings Before Interest an Taxes
T = Tax rate Ke = Cost of equity
VL = Vu = (T x D)
Value of levered firm = Value of unlevered firm = (Tax
rate x Debt)

23. Criticism of MM Approach
1. Markets are not perfect
2. Higher interest for individuals
3. Personal leverage is no substitute for corporate
leverage
4. Transaction costs
5.Corporate taxes

24. Capital Structure Theories –
D) Traditional Approach
 The NI approach and NOI approach hold extreme views on the
relationship between capital structure, cost of capital and the value
of a firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches.
 Traditional approach confirms the existence of an optimal capital
structure; where WACC is minimum and value is the firm is
maximum.
 As per this approach, a best possible mix of debt and equity will
maximize the value of the firm.

25. Capital Structure Theories –
D) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings (since
Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases and
it tends to stabilize. Further increase in borrowings will not affect
WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to higher
debt, WACC increases & value of firm decreases.