Capital Structure

Theories
PRESENTED BY MANJUNATH RAMPURE S
UNDER THE GUIDANCE OF MR PRADEEP S S
Introduction
Capital structure theories explain the relationship between cost of capital, capital structure and
value of the firm.
Cost of Capital: Discount rate that is used to determine the present value of the estimated
future cash flows of a project/business.
Operating leverage : Operating leverage exists when the firm has a fixed cost that must be paid
regardless of volume of business.
➢ Example : Fixed Expenses

Financial leverage : Financial leverage exists when the firm has a fixed cost of financing that has
to be paid regardless of profits made.
➢Example : Debt financing
Approaches
1. Net income approach
2. Net operation income approach
3. Modigliani-Miller approach
4. Traditional approach
Assumptions
➢ Sources of funds: only debt and equity
➢ No tax world
➢ 100% pay-out ratio
➢ Total capital remains constant
➢ Constant Business risk
➢ Perpetual succession
Net Income Approach
o Capital structure decision is relevant
o An increase in financial leverage results in
decline of WACC K

Percentag
Ko e
o A decrease in financial leverage results in
increase of WACC Kd

e
o Conclusions:
o Value of firm maximum when WACC is
minimum.
o Suggests maximum possible debt for minimising
WACC

Degree of Leverage
Net Income Approach - Example
COMPANY HAVING DEBT OF 2000000 COMPANY HAVING NO DEBT
Net Operating Income Approach
o Capital structure decisions of the firm are
irrelevant
o Any changes in the financial leverage will not V

Percentag
impact the value of the firm and the market
price of the shares
Ko
o Increase in the use of debt (Which is

e
cheaper) is offset by increase in equity
capitalisation rate.

Degree of Leverage
Net Operating Income Approach - Example
COMPANY HAVING DEBT OF 2000000 COMPANY HAVING NO DEBT
Modigliani-Miller Approach
Additional assumptions:
• Perfect capital markets

• Rational investors

• Firms can be grouped into ‘Equivalent risk classes’

• Taxation ignored
Modigliani-Miller Approach – Ctnd…
Propositions:
K
▪ Total market value is equal to its expected e

Percentag
net operating income divided by the Ko

discount rate appropriate to its risk class

e
Kd
decided by the market.

▪ The expected yield is calculated as per the

equation: Kc = Ko + ( Ko – Kd ) B/S

▪ WACC is independent of financing decisions Degree of Leverage

Problem

Go
Traditional Approach
▪ Financial decisions are relevant
K
▪ Leverage is favourable up to some point and e
then unfavourable
Ko
▪ There is an optimal capital structure which
minimises cost of capital Kd

▪ At optimal capital structure, the marginal cost

of debt and marginal cost of equity are same.
Thank you…☺