Capital Structure Theories

 Net Income Theory

 Net Operating Income Theory
 Modigliani-Miller (MM) Theory
 Traditional Approach
Net Income Approach
 According to the NI approach, capital structure is
relevant as it affects the k0 and V of the firm.
 The core of this approach is that as the ratio of less
expensive source of funds (i.e., debt) increases in the
capital structure, the k0 decreases and V of the firm
increases.
 With a judicious mixture of debt and equity, a firm can
evolve an optimum capital structure at which the k0
would be the lowest, the V of the firm the highest and
the market price per share the maximum.
Assumptions
 There are no taxes
 Cost of debt is lesser than the cost of
equity
 Use of debt does not change the risk
perception of investors.
 Due to change in leverage cost of debt
and equity will not change.
Try Yourself (4)
 A company’s expected annual net operating income (EBIT) is Rs. 50,000.
The company has Rs 2,00,000, 10% debentures. The equity capitalization
rate (ke) of the company is 12.5 per cent. Calculate value of firm and
WACC (Ko).

Case A:
 Let us suppose that the firm has decided to raise the amount of debenture
by Rs. 1,00,000 and use the proceeds to retire the equity shares. The ki and
ke would remain unaffected as per the assumptions of the NI Approach

Case B:
 Let us suppose that the amount of debt has been reduced by Rs 1,00,000
to Rs 1,00,000 and a fresh issue of equity shares is made to retire the
debentures.
Net Operating Income Approach
 The NOI approach is diametrically opposite to the NI
approach. The essence of this approach is that capital
structure decision of a corporate does not affect its
cost of capital and valuation, and, hence, irrelevant.
 NOI argues that Overall cost of capital remain constant
for all degree of leverage
Residual value of equity
 Value of equity is residual value of equity
which is determined by deducting the
total value of debt from the total value of
firm.
 S =V - B
Changes in the cost of equity
 The cost of equity increase with the
degree of leverage.
 The increase in proportion of debt will
leads to increase in financial risk to equity
shareholders.
 To compensate for the increased risk the
shareholders would expect a higher rate
of return on their investment.
Cost of Debt
(a) Explicit Cost: which is represented by
the rate of interest, irrespective of the
degree of leverage, the firm is assumed
to be able to borrow at a given rate of
interest.
(b) Implicit Cost: which is increase in cost
of equity due to increase in debt.
Optimum Capital Structure
 The total value of firm is unaffected by its
capital structure.
 The market price of share will also not
change.
 There is noting such as an optimum
capital structure.
Try Yourself (5)
 A company’s expected annual net operating income (EBIT) is Rs. 50,000.
The company has Rs 2,00,000, 10% debentures. The overall capitalization
rate (ko) of the company is 12.5 per cent. Calculate value of firm and
equity capitalization rate (Ke).

Case A:
 Let us suppose that the firm has decided to raise the amount of debenture
by Rs. 1,00,000 and use the proceeds to retire the equity shares. The ki and
kO would remain unaffected as per the assumptions of the NOI Approach

Case B:
 Let us suppose that the amount of debt has been reduced by Rs 1,00,000
to Rs 1,00,000 and a fresh issue of equity shares is made to retire the
debentures.
Traditional Approach
 The crux of the traditional view relating
to leverage and valuation is that through
judicious use of debt-equity proportions,
a firm can increase its total value and
thereby reduce its overall cost of capital.
 The rational behind this view is that debt
is relatively cheaper source of funds as
compared to ordinary shares.
Try Yourself (6)
 Assume a firm has EBIT of Rs.40000. The firm has 10% debentures of Rs.100000 and its current
equity capitalization rate is 16%. Calculate the current value of firm and its overall cost of
capital.

Case A:
 Let us suppose that the firm is considering increasing its leverage by issuing additional Rs.50000
debentures and using the proceeds to retire the amount of equity. As firm increase leverage,
cost of debt would rise to 11% and cost of equity to 17%. Calculate the value of firm and cost of
capital

Case B:
 Let us suppose that the firm is considering increasing its leverage by issuing
additional Rs.100000 debentures and using the proceeds to retire the
amount of equity. As firm increase leverage, cost of debt would rise to
12.5% and cost of equity to 20%. Calculate the value of firm and cost of
capital
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.
 The MM approach maintains that the
WACC does not change with a change
in the proportion of debt to equity in
the capital structure (or degree of
leverage)
Basic Propositions
Proposition 1:
The overall cost of capital (Ko) and the
value of firm (V) are independent of its
capital structure. The Ko and V are
constant for all degree of leverage.
Proposition II
 As the company increases its use of debt
financing, the cost of equity rises.
 The net effect of the increased use of a
cheaper sources of capital and the rising
cost of equity is that there is no change in
the company’s overall cost of capital
Arbitrage Process
 Implies buying a security in a market
where price is low and selling where it is
high.
Try Yourself (7)
 The two companies, U and L, belongs to an equivalent
risk class. These two firms are identical in every
respect except that U company in unlevered while
company L has 10% debentures of Rs.30 lakhs. The
other information are as follows:
 EBIT Rs. 750000 for both firms
 Equity capitalization rate 15% for firm U and 20% for
firm L.
 Assume an investor owns 10% equity shares of
company L. Show the arbitrage process and the
amount by which he could reduce his outlay through
the use of leverage.
Try Yourself (8)
 The two companies, X and Y, belongs to an equivalent
risk class. These two firms are identical in every
respect except that X company in unlevered while
company Y has 10% debentures of Rs.5 lakhs. The
other information are as follows:
 EBIT Rs. 750000 for both firms
 Equity capitalization rate 12.5% for firm X and 14%
for firm Y.
 Assume an investor owns 10% equity shares of
company overvalued firm. Show the arbitrage process
and the amount by which he could reduce his outlay
through the use of leverage.