CAPITAL

STRUCTURE
THEORIES
 CAPITAL STRUCTURE
Capital structure is the proportion of debt
and preference and equity shares on a
firms balance sheet
Optimum Capital structure is that at
which the weighted average cost of capital
is minimum and thereby maximum value
of the firm
TRADITIONAL APPROACH
The traditional approach argues that moderate
degree of debt can lower the firms overall cost
of capital and thereby, increase the firm value.
The initial increase in the cost of equity is more
than offset by the lower cost of debt. But as debt
increases, shareholders perceive higher risk
and the cost of equity rises until a point is
reached at which the advantage of lower cost of
debt is more than offset by more expensive
equity.
NET INCOME APPROACH
Its relevant to the value of the firm
Change in financial leverage will lead to
change in overall cost of capital and value of
the firm
If degree of financial leverage(debt to equity)
increases then overall cost of capital and
market price of share decreases but value of
firm increases
And vice-versa
Assumptions in NI Approach
No taxes
Cost of debt < cost of equity (equity
capitalisation rate)
Use of debt does not change risk
perception of investors
Illustration (10%Debentures of Rs.200000)
EBIT = Rs. 50000
Less: Interest on debentures 20000
Earning available to shareholders(NI) 30000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 240000
Market Value of debt(B) 200000
Total Value of firm(V=S+B) 440000
Overall cost of capital(ko=EBIT/V) 11.36%
When Financial leverage increases(10%
Debentures of Rs.300000)
EBIT = Rs. 50000
Less: Interest on debentures 30000
Earning available to shareholders(NI) 20000
Equity capitalisation rate(ke) 0.125
Market value of equity(S)=(NI/ke) 160000
Market Value of debt(B) 300000
Total Value of firm(V=S+B) 460000
Overall cost of capital(ko=EBIT/V) 10.9%

It clearly shows that with increase in debt, overall cost

of capital decreases but Value of the firm increases.
 NET OPERATING INCOME
APPROACH
It is opposite to NI approach
It states that capital structure decision is
irrelevant
Any change in leverage will not lead to
any change in value of the firm , market
price of share as well as overall cost of
capital
Illustration (10%Debt=Rs.200000)

EBIT Rs. 50000

Overall cost of capital(ko) 0.125
Total Value of the firm(V=EBIT/ko) 400000
Cost of debt (B) 200000
Cost of equity(S=V-B) 200000
Equity Capitalisation rate(ke=EBIT-I ) 0.15%
S
 When leverage increases (10%debt of
Rs.300000)
EBIT Rs. 50000
Overall cost of capital(ko) 0.125
Total Value of the firm(V=EBIT/ko) 400000
Cost of debt (B) 300000
Cost of equity(S=V-B) 100000
Equity Capitalisation rate(ke=EBIT-I ) 0.20%
S
This clearly shows that will increase in
financial leverage there is NO effect on
value of firm and overall cost of capital.
 MODIGLIANI-MILLER(MM)
APPROACH
It somehow supports NOI approach
It states that value of the firm must be
constant irrespective of the degree of
leverage
Even cost of capital as well as market
price of share must be same
Operational justification for MM hypothesis
is the Arbitrage process
 Arbitrage refers to buying an asset or
security in market where price is low and
selling where it is high
MM approach uses arbitrage process with
reference to valuation of two firms which
are similar in all respects except leverage
One will be Levered firm(L) other will be
unlevered firm (U)
The investors of the firm whose value is
higher will sell their shares instead of
buying of those whose value is lower
Illustration
Particulars L U
EBIT 100000 100000
Less : Interest 50000 ---
Earnings available to
equity shareholders 50000 100000
Equity capitalization rate 0.16 0.125
Market value of share(S) 312500 800000
Market Value of debt(B) 500000 ----
Total Value of firm (V) 812500 800000
Overall cost of capital
(ko=EBIT/V) 0.123 0.125
 The illustration clearly shows that Value of
the Firm which employs Debt in capital
structure (L) is more than the Unlevered
firm(U)
THANK
YOU!!!