Lecture Notes on Capital Structure :

The relationship among Capital structure Cost of capital and Value of Firm had always
been one of the most debated issue in financial management.

Basic Formulae for Value of Firm = EBIT/ Ko

In this chapter we have to find an answer to the following question:

Whether Capital Structure decision is relevant to the firm’s Value or Not ?

To answer this question there are several opinions /approaches having different opinion
and justification for their opinion.

Broadly speaking, there are four Approaches to capital structure and they can be grouped
into two categories; the one which says that capital structure decision is relevant to the
firm’s value and the other which says that capital structure decision is not relevant to the
firm’s value.

Relevant to the Firm’s Value Not Relevant to the Firm’s Value

1. Net Income Approach ( NI) 1. Net Operating Income Approach ( NOI)
2. Traditional Approach 2. Modigliani & Miller Approach (MM Approach)
(With and Without Taxes)

1. Net Income Approach : As per this approach , capital structure decision is

relevant to the firm’s Value. It says that any change in capital structure will bring
change in overall cost of capital (Ko) and value of the firm.

Assumptions : NI Approach is based on following assumptions :

1. No Tax is there.
2. Cost of Debt ( Kd) is less than cost of equity ( Ke).
3. Use of Debt have no impact on risk perception of investors.

Formulae given by the NI Approach :

1) V= E+D
Where V= Value of Firm
E= Market Value of Equity
D= Market Value of Debt

2) Market Value of Equity (E) = Net Income Available to Equity Share holders/ Ke
3) Market Value of Debt (D) = Interest/Kd

4) Ko = EBIT / V
 2. Net Operating Income Approach ( NOI) : This approach is entirely opposite to
NI Approach. It believes that value of firm is not affected by capital structure
changes. According to it the advantage of debt is affected by the increase in equity
capitalization rate.

Assumptions : NOI Approach is based on following assumptions :

1. There are no corporate Taxes
2. The debt equity mix does not affect the overall cost of capital.
3. The increase in debt changes the risk perception of shareholders.
4. Cost of Debt is Constant.

Formulae given by the NOI Approach :

1. Value of Firm = EBIT / Ko

2. Value of Equity (E) = V – D

3. Rate of Equity Capitalization ( Ke) = EBIT- Interest/ V- D

3) Traditional Approach :

It is a compromise between NI and NOI approach. It states that cost of capital decreases
within reasonable limit of debt and then increases with the leverage. This approach
believes that through a proper use of debt-equity proportions ,a firms can increase its total
value and result by reduce its overall cost of capital.

It believes that there is no optimum capital structure but it can be at an optimum level in a
range.

Note : Formulae used in NI approach is used for Traditional Approach as well.

4) Modigliani & Miller Approach ( MM Approach) :

This approach supports NOI approach relating to cost of capital and degree of
leverage. It maintains that the WACC is not affected with the proportion of debt to
equity on the capital structure.
MM approach offers behavioral justification for this statement (through Arbitrage
process).
Following three proposals are given under MM approach :
(i) Overall cost of Capital (Ko) and Value of enterprise are independent of its
capital structure. Ko and V are constant for different degrees of leverage.
 (ii) Ke increases in a manner to offset the use of sources of funds represented by
the less expensive means of debt.
(iii) The Cut-off rate is independent of the way in which investment is financed.

Assumptions: Followings are the assumptions :

1. There are perfect capital markets. (Means investors are free to buy and sell
securities).
2. Individuals can borrow at the same terms & conditions as firms can.
3. All investors have same expectations and awareness to the value of firm.
4. Dividend payout ratio is 100%.
5. There are no taxes.
6. Business risk is equal among all firms with similar operating environment.
7. There are no transaction costs. Every investor has the freedom to switch from one
firm to another without any restrictions or costs of making the change.

Formulae: This approach justifies its opinion by the way of Arbitrage & Reverse
Arbitrage process.

Note : The process of shifting from one firm to another will continue till value of
both the firms becomes equal.

MM –II ( Introduction of Corporate Taxes into the MM Approach )

MM Approach, at a later stage introduced with the effects of Tax in two identical firms.
These two firms are similar in all aspects, except that one firm is levered and the other is
unlevered to find out the advantage of Debt.

According to it Value of firm will increase and cost of capital will decrease (leverage) with
the introduction of taxes. Since the Interest is tax deductible. Levered firm will have
greater value.

Formulae:

1. VU = EBIT ( 1 - t) / Ko
2. VL = VU + Dt
Where VU = Value of Unlevered Firm

VL = Value of Levered Firm

D = Debt, t= Tax Rate

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