ACKNOWLEDGEMENT

I would like to express my gratitude to all those who gave

me the possibility to complete this project. I want to
thank everybody for their stimulating support.

I am deeply indebted to my teacher Ms. Priyanka Chadda

from the Keshav Mahavidyalaya (University of Delhi)
whose help, stimulating suggestions and encouragement
helped me in all the time of research for and writing of
this project
 CAPITAL STRUCTURE, COST OF CAPITAL AND ITS
VALUATION

Definition:

Capital structure is the proportion of debt and preference

and equity shares on a firm’s balance sheet. Capital
structure refers to the mix or proportion of different
sources of finance (debt and equity) to total
capitalization. A firm should select such a financing-mix
which maximizes its value/the shareholder’s wealth (or
minimizes its overall cost of capital). Such a capital
structure is referred to as the optimum capital structure.

Optimum capital structure is the capital structure at

which the weighted average cost of capital is minimum
and thereby maximum value of the firm.

As a corollary, the capital structure should be examined

from the point of view of its impact on value of the firm. It
can be legitimately expected that if the capital structure
decision affects the total value of the firm, a firm should
select such a financing-mix as will maximize the
shareholders wealth.

CAPITAL STRUCTURE THEORIES:

Capital structure theories explain the theoretical

relationship between capital structure, overall cost of
capital and valuation. The four important theories are:
1. Net income (NI) approach
 2. Net operating income (NOI) approach
3. Modigliani and miller (MM) approach
4. Traditional approach

ASSUMPTIONS:

1. There are only two sources of funds used by a firm:

perpetual riskless debt and ordinary shares.
2. There are no corporate taxes
3. The dividend payout ratio is 100 i.e. the total
earnings are paid out as dividend to the shareholders
and there are no retained earnings.
4. The total assets are given and do not change.
5. The total financing remains constant.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same
subjective probability distribution of the future
expected EBIT for a given firm.
8. Business risk is constant over time and is assumed to
be independent of its capital structure and financial
risk.
9. Perpetual life of the firm.

NET INCOME THEORY:

The capital structure is relevant to the valuation of the

firm.
A change in financial leverage will lead to a
corresponding change in the overall cost of capital and
total value of the firm. If therefore the degree of financial
leverage as measured by the ratio of debt to equity is
increased, the weighted average cost of capital will
decline, while the value of the firm as well as the market
price of ordinary shares will increase. Conversely a
decrease in leverage will cause an increase in the overall
cost of capital and a decline both in the value of the firm
as well as the market price of equity shares.

The NI Approach is based on the following assumptions:

1. There are no taxes.
2. The cost of debt is less than cost of equity.
3. The cost of debt does not change the risk perception
of investors.

Derivation:

B determines the value of debt.

S defines the value of equity.
B+S =V (value of the firm).
B/V is the proportion of debt.
S/V is the proportion of equity.
Cost of debt (kd) =I (1-t)/B
=I/B (since there are no taxes)
B=I/kd
Cost of equity (ke) =D1/P0 + g
The growth rate is zero.
Ke= D1/P0=E1/P0
Since, there are no retained earnings, dividend and
earnings are equal.
ke =total earnings/S
= (EBIT-Interest)/S
= (Net income)/S
S= (EBIT-I)/ Ke
V=B+S
V=I/kd+ (EBIT-I)/ke
Cost of capital (Ko) = kd (B/V) +ke (S/V)
=kd [(I/kd)/V] + ke [{(EBIT-I)/ke}/V]
=I/V + (EBIT-I)/V
= (I+EBIT-I)/V
=EBIT/V
V=EBIT/Ko
When market value of firm increases then cost of capital
has to decrease.

The NI Approach is illustrated by a numerical example:

Example 1: A company’s expected annual net operating

income (EBIT) =Rs.50, 000. The company has Rs.2,
00,000, 10%debentures. The equity capitalization rate
(Ke) is 12.5%

Solution:
Net operating income (EBIT)
=50,000Rs.
Less: interest on debentures (I) =
(20,000)
Earnings available to shareholders (NI)
=30,000Rs
Equity capitalization rate (Ke)
=.125
Market value of equity(S=NI/Ke) =2,
40,000
Market value of debt (B) =2,
00,000
Total value(S+B=V)
=4, 40,000
Overall cost of capital (EBIT/V)
=11.36%

In order to examine the effect of a change in financing-

mix on the firm’s overall cost of capital and its total
value. Let us suppose that the firm has decided to raise
the amount of debentures by Rs. 1, 00,000 and use the
proceeds to retire the equity shares. The K d and K e would
remain unaffected as per the assumptions of the NI
approach. In the new situation the value of the firm will
be as follows:

Net operating income (EBIT)

=50,000Rs.
Less: interest on debentures (I)
= (30,000)
Earnings available to shareholders (NI) =
20,000Rs
Equity capitalization rate (Ke)
=.125
Market value of equity(S=NI/Ke)
=1, 60,000
Market value of debt (B)
=3, 00,000
Total value(S+B=V)
=4, 60,000
Overall cost of capital (EBIT/V)
=10.9%

Thus, the use of additional debt has caused the total

value of the firm to increase the overall cost of capital to
decrease
Now let us suppose that the amount of debt is reduced to
Rs. 1, 00,000 and a fresh issue of equity shares is made
to retire the debentures. Assuming the other facts, the
value of the firm and weighted average cost of capital is
shown below:

Net operating income (EBIT)

=50,000Rs.
Less: interest on debentures (I)
= (10,000)
Earnings available to shareholders (NI)
=40,000Rs
Equity capitalization rate (Ke)
=.125
Market value of equity(S=NI/Ke)
=3, 20,000
Market value of debt (B)
=1, 00,000
Total value(S+B=V)
=4, 20,000
Overall cost of capital (EBIT/V)
=11.9%

We find that the decrease in leverage has increased the

overall cost of capital and has reduced the value of the
firm.

Thus, according to the NI approach, the firm can

increase/decrease its total value (V) and lower/increase
its overall cost of capital (Ko) as it increases/decreases
the degree of leverage.

Graphical representation:
We can graph the relationship between the various
factors (Kd, Ke, and Ko) with the degree of leverage.

The degree of leverage is plotted along the x-axis, while

the percentage rates of Kd, Ke and Ko are on the y axis.
Due to the assumption that Ke and Kd remain unchanged
as the degree of leverage changes, we find that both the
curves are parallel to the x axis. But as the degree of
leverage increases, Ko decreases and approaches the
cost of debt when leverage is 1, i.e. (Ko=Kd). It also
means that there is no equity in the capital structure. This
also means that firm’s overall cost of capital is minimum.
The significant conclusion therefore, of the NI approach is
that the firm can employ 100% debt to maximize its
value.

NET OPERATING INCOME APPROACH:

The approach is diametrically opposite to the NI

approach.
The essence of this approach is that the capital structure
decision of a firm is irrelevant. Any change in leverage
will not lead to any change in the total value of the firm
and the market price of shares as well as the overall cost
of capital is independent of the degree of leverage.

The NOI approach is based on the following propositions:

1.Overall cost of capital/capitalization rate (Ko)
is constant
The NOI approach to valuation argues that the overall
capitalization rate of the firm remains constant, for all
degrees of leverage. the value of the firm is given by the
formula.

V=EBIT/Ko

In other words, the market evaluates the firm as a whole.

The split of the capitalization between debt and equity is,
therefore not significant.

2.Residual value of equity

The value of equity is the residual value which is
determined by deducting the total value of debt (B) from
the total value of the firm (V).
Symbolically, total market value of equity capital (S) =V-
B

3.Changes in cost of equity capital

The equity capitalization rate increases with the degree of
leverage. The increase in the proportion of debt in the
capital structure relative to equity shares would lead to
an increase in the financial risk to the ordinary
shareholders. To compensate for the increased risk, the
shareholders would expect a higher rate of return on their
investments. The increase in the equity capitalization rate
would match the increase in the debt-equity ratio. The Ke
would be =Ko+ (Ko-Kd) [B/S]

4.Cost of debt
The cost of debt has two parts
a) Explicit cost which is represented by the rate of
interest. Irrespective of the degree of leverage, the
firm is assumed to able to borrow at a given rate of
interest. This implies that the increasing proportion of
debt in the financial structure does not affect the
financial risk of the lenders and they do not penalize
the firm by charging higher interest.
b)Implicit or hidden cost
Implicit cost is the increase in cost of equity due to
increase in debt.
As a result, the real cost of debt and the real cost of
equity are the same and equal Ko.

5.Optimum capital structure

The total value of the firm is unaffected by its capital
structure. No matter what the degree of leverage is, the
total value of the firm will remain constant. The market
price of shares will also not change with the change in
debt-equity ratio. Any capital structure is optimum,
according to the NOI approach.

The effect of NOI approach on the value of the firm and

market price share is numerically illustrated below:

Numerical example:

Assuming operating income= Rs. 50000, 10%

outstanding debt= Rs2, 00, 000 and overall cost of
capital is 12.5%

Solution:
EBIT =
Rs.50, 000
Ko (capitalization rate) =
0.125
Total market value (V=EBIT/Ko) =
Rs.4, 00,000 Total value of debt (B)
= Rs.2, 00,000 Mkt. value of equity(S=V-B)
= Rs.2, 00,000
Equity capitalization rate [Ke= {(EBIT -I)/ (V-B)}] =
0.15
= (50,000-20,000)/ (2, 00,000)

In order to examine the effect of leverage, let us assume

that the firm increases the amount of debt from 2, 00,000
to 3, 00,000 and uses the proceeds of the debt to
repurchase equity shares. The value of the firm would
remain unchanged at Rs. 4, 00,000, but the equity
capitalization rate becomes 20%

Net operating income (EBIT)

= Rs.50, 000
Ko (capitalization rate) =
0.125
Total market value (V=EBIT/Ko) = Rs.4,
00,000
Total value of debt (B) =
Rs.3, 00,000
Mkt. value of equity(S=V-B) =
Rs.1, 00,000
Equity capitalization rate (Ke) = 0.20
= (EBIT - I)/ (V - B)
= (50,000-30,000)/ (1, 00,000)

Let us further suppose that the debt get reduced to Rs.1,

00,000 by issuing fresh equity capital of the same
amount. The value of the firm would remain unchanged
at Rs. 4, 00,000 and the equity capitalization rate
becomes 13.3%.

EBIT =
Rs.50, 000
Ko (capitalization rate) = 0.125
Total market value (v=EBIT/Ko) = Rs.4,
00,000 Total value of debt (B)
= Rs.100, 000
Mkt. value of equity(S=V-B) = Rs.3,
00,000
Equity capitalization rate (Ke) =
0.133
= (EBIT - I)/ (V - B)
 = (50,000-10,000)/ (2, 00,000)

The significant feature is that the equity capitalization

rate increases with the increase in the degree of
leverage. It has gone up from 15% to 20% with the
increase in leverage from 0.5 to 0.75. the equity
capitalization rate decreases with the decrease in the
degree of leverage. It has come down from 15% to
13.33% with the decrease in leverage from 0.5 to 0.25.
Thus, we note that there is no change in the market price
due to change in leverage.

Graphical representation:
We have portrayed the relationship between the leverage
and the various costs. Due to the assumption that Ko and
Kd remain unchanged as the degree of leverage changes,
we find both the curves are parallel to x axis. But as the
degree of leverage increases the Ke increases
continuously.

MODIGLIANI-MILLER (MM) APPROACH:

The MM proposition supports the NOI approach relating to

the independence of the cost of capital of the degree of
leverage at any level of debt-equity ratio.

It provides behavioral justification for constant overall

cost of capital and therefore total value of the firm,
weighted average cost of capital doesn’t change with a
change in the proportion of debt to equity in the capital
structure.
In other words, MM approach maintains that the weighted
average (overall) does not change with a change in the
proportion of debt to the equity in capital structure (or
degree of leverage). They offer operational justification
for this and are not content with merely stating the
proposition.

BASIC PROPOSITIONS:

1. Ko (overall cost of capital) and V are independent of

its capital structure. The Ko and V are constant for all
degrees of leverage. The total value is given by
capitalizing the expected stream of operating
 earnings at a discount rate appropriate for its risk
class.

2. Ke is equal to the capitalization rate of a pure equity

stream plus a premium for financial risk equal to the
difference between the pure equity capitalization
rate (Ke) and K times the ratio of debt to equity. Ke
increases in a manner to offset exactly the use of a
less expensive source of funds represented by debt.

3. The cut-off rate for investment purposes is

completely independent of the way in which an
investment is financed.

ASSUMPTIONS:

1. Perfect capital markets: the implication of a perfect

capital market is that
a) Securities are infinitely divisible
b)Investors are free to buy/sell securities.
c) Investors can borrow without restrictions on the
same terms and conditions as firms can.
d)There are no transaction costs
e) Information is perfect i.e. each investor has the
same information which is readily available to
him without cost.
f) Investors are rational and behave accordingly.
2. Expectations regarding EBIT are same for all
investors.
3. Dividend payout ratio is 100%.
4. There are no taxes.
 5. Business risk is equal among all firms with similar
operating environment. That means all firms can be
divided into ‘equivalent risk classes or
‘homogeneous risk classes. The term equivalent risk
class means that the expected earnings have
identical risk characteristics. Firms within an industry
are assumed to have the same risk categories. The
categorization of firms into equivalent risk class is on
the basis of the industry group to which the firm
belongs.

The Operational justification is the arbitrage

process. The term ‘Arbitrage’ implies buying a security
in a market where price is low and selling where it is
high. It is a balancing operation. The essence of the
arbitrage process is the purchase of securities/assets
whose prices are lower and sale of securities whose
prices are higher in related markets which are
temporarily out of equilibrium. The investors of the firm
whose value is higher will sell their shares and instead
buy shares of the firm whose value is lower. Investors
would be able to earn the same return at lower outlay
with the same perceived risk. This will continue till the
market prices of two identical firms become identical.
Thus the switching operation derives the total value of
two homogeneous firms in all respects, except the debt
equity ratio, together. The arbitrage process, as already
indicated, ensures to the investor the same return at
lower outlay as he was getting by investing in the firm
whose total value was higher and yet, his risk is not
increased. This is so because the investors would borrow
in the proportion of the degree of leverage present in the
firm. The use of debt by the investor for arbitrage is
called as homemade or personal leverage. Homemade
leverage can replicate the firm’s capital structure,
thereby causing investors to be indifferent to it. The
essence is that the investors are able to substitute
personal leverage or homemade leverage for corporate
leverage, i.e. the use of debt by the firm itself.

EXAMPLE:

Assume there are two firms, L and U, which are identical

in all respects except that the firm L has 10 % Rs. 5,
00,000 debentures. The earnings before interest and
taxes (EBIT) of both the firms are equal, that is, Rs. 1,
00,000. The equity capitalization rate (Ke) of firm L is
higher (16%) than that of firm U (12.5%).

Particulars L U
EBIT Rs.1,00,000 Rs.1,00,000
-interest Rs.50,000 -
Earnings Rs.50,000 Rs.1,00,000
available to
equity holders
Ke .16 .125
S Rs.3,12,500 Rs.8,00,000
B Rs.5,00,000 -
V Rs.8,12,500 Rs.8,00,000
EBIT/V=Ko .123 .125
B/S=debt-equity 1.6 -
ratio
The modus operandi of the arbitrage process is as
follows-
Suppose an investor, Mr. X, hold 10% of the outstanding
shares of the levered firm (L). His holdings amount to Rs.
31,250 (i.e. 0.1 * Rs. 3, 12,500) and his share in the
earnings that belong to the equity shareholders would be
Rs. 5,000 (0.1 * Rs. 50,000)
He will sell his holdings in firm L and invest in the
unlevered (U) firm. Since, firm U has no debt in its capital
structure, the financial risk to Mr. X would be less than in
firm L. to reach the level of financial risk of firm L, he will
borrow additional funds equal to his proportionate share
in the levered firm’s debt on his personal account. That
is, he will substitute personal leverage for corporate
leverage. In other words, instead of the firm using debt,
Mr. X will borrow money. The effect, in essence, of this is
that he is able to introduce leverage in the capital
structure of the the unlevered firm by borrowing on his
personal account. Mr. X in our example will borrow Rs.
50,000 at 10% rate of interest. His proportionate holding
(10%) in the unlevered firm will amount to Rs. 80,000 on
which he will receive a dividend income of Rs. 10,000.
Out of this income, he will pay Rs. 5,000 as interest on
his personal borrowings. He will be left with Rs. 5,000
that is the same amount he was getting from the levered
firm (L). But his investment outlay in firm U is less as
compared with that in firm L. at the same time, his risk is
identical in both the situations.

The effect of arbitrage process is summarized below:

(A)Mr. X’s position in firm L with 10% equity holding
a) Investment outlay Rs.
31,250
 b) Dividend income
5,000

(B)Mr. X’s position in firm U with 10% equity holding

a) Total funds available
(Own funds, Rs. 31,250 + borrowed funds, Rs.50, 000)
81,250
b)Investment outlay
(Own funds, Rs. 30000+borrowed funds, Rs. 50000)
80,000
c) Dividend income:
Total income (0.1*100000)
Rs. 10,000
Less: interest payable on borrowed funds
(5,000)
5,000
(C)Mr. X’s position in firm U if he invests the total funds
available
a) Investment costs
Rs.81,250
b) Total income
10,156
c) Dividend income (net)(Rs. 10,156- Rs. 5,000)
Rs. 5,156

It is thus, clear that X will be better off by selling his

securities in the levered firm and buying the shares of the
unlevered firm. With identical risk characteristics of the
two firms, he gets the same income with lower
investment outlay in the unlevered firm.

Arbitrage process-reverse direction:

According to the MM hypothesis, since debt financing has
no advantage, it has no disadvantage either. In other
words, just as the total value of a levered firm cannot be
more than that of an unlevered firm. This is so because
the arbitrage process will set in and depress the value of
the unlevered firm and increase the market price and
thereby, the total value of the levered firm. The arbitrage
would thus operate in the reverse direction. Here the
investors will dispose of their holdings in the unlevered
and obtain the same return by acquiring proportionate
share in the equity capital and the debt of the levered
firm at a lower outlay without any increase in the risk.

Example: assume that the equity capitalization rate is

20% in the case of the unlevered firm (L), instead of the
assumed 16%.

PARTICULARS L U

EBIT Rs.1,00,000 Rs.1,00,000

-Interest Rs.50,000 -
Income to Rs.50,000 Rs.1,00,000
equity share
holders

Ke .2 .125
S Rs.2,50,000 Rs.8,00,000
B Rs.5,00,000 -
V Rs.7,50,000 Rs.8,00,000
Ko .133 .125
B/S 2 0

The modus operandi of the arbitrage process is as

follows-
Suppose an investor, Mr. Y, hold 10% of the outstanding
shares of the unlevered firm (U). He earns Rs. 10,000
(0.1*1, 00,000).
He will sell his holdings in firm U and invest in the levered
(L) firm. He can purchase 10% of firm L’s debt at a cost of
Rs. 50,000 which will provide Rs. 5,000 interest and 10%
of L’s equity at a cost of Rs. 25,000 with an expected
income of Rs. 5,000 (0.1*50,000). The purchase of a 10%
claim against the levered firm’s income costs Mr. Y only
Rs. 75,000, yielding the same expected income of Rs.
10,000 from the equity shares of the unlevered firm. He
would prefer the levered firm’s securities as the outlay is
lower. It is summarized below:

Effect of reverse arbitrage:

(A)Mr. Y’s current position in firm U with 10% equity

holding

Investment outlay Rs.

80,000
Dividend income 5,000

(B) Mr. Y sells his holdings in firm U and purchases 10% of

the levered firm’s equity and debentures

Investment Income
Debt Rs. 50,000 Rs.
5,000
Equity 25,000
5,000
Total 75,000
10,000
Y would prefer this situation to previous one as he is able
to earn the same amount of income with a smaller outlay.

(C)He invests the entire sum of Rs. 80,000 in firm L.

Investment Income
Debt Rs. 53,333
Rs. 5,333
Equity 26,667
5,333
Total 80,000
10,666
He augments the income by Rs. 666

Thus, MM approach shows that the value of a levered firm

can neither be greater nor smaller than that of an
unlevered firm; the two must be equal. There is neither
an advantage nor disadvantage in using debt in the
capital structure. The principle involved is simply that
investors are able to reconstitute their former position by
offsetting changes in corporate leverage with personal
leverage. As a result the investment opportunities
available to them are not altered by changes in the
capital structure of the firm.

Graphical representation:
The MM approach maintains that the weighted average
cost of capital does not change, with a change in the
proportion of debt to equity in the capital structure.

LIMITATIONS of MM APPROACH:

1. RISK PERCEPTION:

In the first place, the risk perceptions of personal and

corporate leverage are different. If home-made leverage
and corporate leverage are perfect substitutes, as the MM
approach assumes, the risk to which an investor is
exposed, must be identical irrespective of whether the
firm has borrowed (corporate leverage) or the investor
himself borrows proportionate to his share in the firm’s
debt. If not, they cannot be perfect substitutes and
consequently the arbitrage process will not be effective.
The risk exposure to the investor is greater with personal
leverage than corporate leverage. The liability of an
investor is limited in corporate enterprises in the sense
that is liable to the extent of his proportionate
shareholdings in case the company is forced to go in to
liquidation. The risk, to which he is exposed, therefore, is
limited to his relative holding. The liability of an individual
borrower is, on the other hand, unlimited as even his
personal property is liable to used for the payment to the
creditors. The risk to the investor with personal
borrowings is higher.

2. CONVINIENCE:

The investors would find it investor-borrower in case of

personal leverage. That corporate leverage is more
convenient to the investor means that the investors
would prefer the personal leverage inconvenient. This is
so because with corporate leverage the formalities and
procedures involved in borrowing are to be observed by
the firms while these will be the responsibility of them
rather than to do the job themselves. The perfect
substitutability of the two leverages is thus open to
question.

3. COST:

Another constraint on the perfect substitutability of

personal and corporate leverage and hence, the
effectiveness of the arbitrage cost is the relatively high
cost of borrowing with the personal leverage. Lending
costs are not uniform for all categories of borrowers.
Large borrowers with high credit standing can borrow at a
lower rate of interest compared to borrowers who are
small and do not enjoy high credit standing. Therefore, it
is reasonable to assume that a firm can obtain a loan at a
cost lower than what the individual investor would have
to pay. As a result of higher interest charges, the
advantage of personal leverage would largely disappear
and the MM assumption of personal and corporate
leverage being perfect substitutes would be of doubtful
validity.

4. INSTITUTIONAL RESTRICTIONS:

Institutional restrictions stand in the way of smooth

operations of the arbitrage process. Several institutional
investors such as insurance companies, mutual funds,
commercial banks and so on are not allowed to engage in
personal leverage. Thus, switching the option from the
unlevered to the levered firm may not apply to investors
and, to that extent, personal leverage is an imperfect
substitute for corporate leverage.

5. DOUBLE LEVERAGES:

Double leverage includes leverage both in personal

portfolio as well as in the firm’s portfolio. For instance,
when an investor has already borrowed funds while
investing in the shares of the unlevered firm. If the value
of the firm is more than that of the levered firm, the
arbitrage process would require selling the securities of
the overvalued firm and purchasing securities of the
levered firm.

6. TRANSACTION COSTS:

Transaction costs would affect the arbitrage process. The

effect of transaction/floatation cost is that the investor
would receive net proceeds from the sale of securities
which will be lower than his investment holding in the
levered/unlevered firm, to the extent of the brokerage fee
and other costs. He would therefore, have to invest a
larger amount in the shares of the levered/unlevered firm,
than his present investment, to earn the same return.

7. TAXES:

Finally, if corporate taxes are taken into account, MM

approach would fail to explain the relationship between
financing decision and value of the firm.

TRADITIONAL APPROACH:

The traditional approach is midway between the two

extreme (NI and NOI) approaches. While the NI approach
takes the position that the use of debt in the capital
structure will always affect the overall cost of capital and
the total valuation, the NOI approach argues that the
capital structure is totally irrelevant. Traditional approach
partakes some features from both these approaches. It is
also known as the intermediate approach. It resembles
the NI approach in arguing that cost of capital and total
value of the firm are independent of the capital structure.
But it does not subscribe to the view that value of a firm
will necessarily increase for all degrees of leverage. In
one respect it shares a feature with the NOI approach that
beyond a certain degree of leverage, the overall cost
increases leading to decrease in the total value of the
firm. But it differs from the NOI approach in that it does
not argue that the weighted average cost of capital is
constant for all degrees of leverages.

The crux of this approach is that through a judicious

combination of debt and equity, a firm can increase its
value and reduce its cost of capital (Ko) up to a point.
However, beyond that point, the use of additional debt
will increase the financial risk of the investors as well as
of the lenders and as a result will cause a rise in the Ko.
At such a point, the capital structure is optimum. In other
words, at the optimum capital structure the marginal real
cost of debt wiz; be equal to the real cost of equity.

At the optimum capital structure, the marginal real cost

of debt, defined to include both implicit and explicit, will
be equal to the real cost of equity. For a debt equity ratio
before that level, the marginal real cost of debt would be
less than that of equity capital, while beyond that level of
leverage, the marginal real cost of debt would exceed
that of equity.

Example:

Assuming a firm has EBIT=Rs. 40,000, 10% debentures

of Rs. 1, 00,000 and current Ke=16%. The current value
of the firm and its overall cost of capital is as follows:

EBIT
=Rs.40, 000
Less: Interest on debentures (I)
(10,000)
Earnings available to share holders (NI)
30, 000
Ke
0.16
Mkt. value of equity(S)
Rs.1, 87,500
Mkt. value of debt (B)
1, 00,000
Total value(S+B=V)
2, 87,500
Overall cost of capital (EBIT/V)
0.139
Debt/equity ratio (B/S)
0.53

Assuming the firm issues additional Rs. 50,000

debentures which increases the Ke to 17%.

EBIT
=Rs.40, 000
-Interest on debentures (I) =
(16,500)
Earnings available to share holders (NI)
=Rs.23, 500
Ke
=0.17
Mkt. value of equity(S) =1,
38,325
Mkt. value of debt (B)
=1, 50,000
Total value(S+B=V) =2,
88,235
Overall cost of capital (EBIT/V)
=0.138
Debt/equity ratio (B/S) =1.08

Assuming the firm issues more additional Rs. 50,000

debentures which increases the Ke to 20%.

EBIT
=Rs.40, 000
-Interest on debentures (I) =
(25,000)
Earnings available to share holders (NI)
=Rs.15, 000
Ke
=0.2
Mkt. value of equity(S) =
75,000
Mkt. value of debt (B) =2,
00,000
Total value(S+B=V) =2,
75,000
Overall cost of capital (EBIT/V)
=0.145
Debt/equity ratio (B/S) =2.67

During the first phase, increasing leverage increases the

total valuation of the firm and lowers the overall cost of
capital. As the proportion of debt in the capital structure
increases, the cost of equity begins to rise as a reflection
of the increased financial risk. But it does not rise fast
enough to offset the advantage of using the cheaper
source of debt capital. Likewise, for most of the range of
this phase, the cost of debt (Kd) either remains constant
or rises to a very small extent because the proportion of
debt by the lender is considered to be within safe limits.
Therefore, they are prepared to lend to the firm at almost
the same rate of interest.

After a certain degree of leverage is reached, further

moderate increases in leverage have little or no effect on
total market value. During the middle range, the changes
brought in equity capitalization rate and debt
capitalization rate balance each other. As a result, the
values of V and Ko remain almost constant.

Beyond a certain critical point, further increases in debt

proportions are not considered desirable. They increase
financial risks so much that both Ko and Kd start rising
rapidly causing Ko to rise and V to fall.

Graphical representation:
The Ko curve is a shallow saucer with a horizontal section
over the middle ranges of leverage. The firm should not
go to the left or to the right of the saucer part of the
curve. The traditional view on leverage is commonly
referred to as one of the U shaped cost of capital curve.
In such a situation, the degree of leverage is optimum at
a point at which the rising marginal cost of borrowing is
equal to the average overall cost of capital.

Thus, according to the traditional approach the cost of

capital of a firm is dependent on the capital structure of
the firm and there is an optimum capital structure in
which the firm’s Ko is minimum and its V is maximum.