CAPITAL STRUCTURE

It represents the mix of

different sources of long term
funds (such as equity shares,
preference shares, long term
loans, retained earnings etc) in
the total capitalization of the
company .
PATTERNS OF CAPITAL STRUCTURE
Capital structure with equity shares
only
Capital structure with both equity
shares and preference shares
Capital structure with equity shares
and debentures
Capital structure with equity shares,
preference shares and debentures
 POINT OF INDIFFERENCE
It refers to the EBIT level at which
EPS remains the same irrespective
of the debt-equity mix. In other
words, at this point, rate of return
on capital employed is equal to the
rate of interest on debt. This is also
known as break-even of EBIT for
alternative financial plans.
 Point of indifference

 X-I1) (1-T) – PD = (X – I2) (1-T) – PD

 S1 S2
X = Point of indifference or Break- even EBIT level.
 I1 = Interest under alternative 1.
 I2 = Interest under alternative 2.
T = Tax rate.
 PD = Preference Dividend.
 S1 = Number of equity shares.
 S2 = Number of equity shares .
 Particulars Rs.
Sales (A) 10,000

(-) Cost of goods sold (B) 4,000

Gross Profit (C = A - B) 6,000

(-) Operating expenses (D) 2,500

Operating Profit (EBIT) (E = C - D) 3,500

An illustration of
(-) Interest (F) 1,000
Income Statement
EBT (G = E - F) 2,500

(-) Tax @ 30% (H) 750

PAT (I = G - H) 1,750

(-) Preference Dividends (J) 750

Profit for Equity Shareholders (K = I - J) 1,000

N o. of Equity Shares (L) 200

Earning per Share (EPS) (K/ L) 5

 OPTIMUM CAPITAL STRUCTURE
A firm should try to maintain an optimum capital
structure with a view to maintain financial stability.
The optimum capital structure is obtained when the
market value per equity share is the maximum. It may,
therefore, be defined as that relationship of debt and
equity securities which maximizes the value of
company’s share in the stock exchange.
There are four major theories:
Net Income (NI) Approach.
Net Operating Income (NOI) Approach.
Modigliani – Miller (MM) Approach.
Traditional Approach.
Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds –
equity & debt.
 No change in investment decisions of
the firm, i.e. no change in total assets.
 100 % dividend payout ratio, i.e. no
retained earnings.
 Business risk of firm is not affected
by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of
the firm.
Net Income (NI) Approach
This approach has been suggested by Durand.
According to this approach, capital structure decision is
relevant to the valuation of the firm. In other words, a
change in the capital structure cause a corresponding
change in the overall cost of capital as well as the total
value of the firm.
Net Income Approach is based on the following three
assumptions:
There are no corporate taxes.
The cost of debt is less than the cost of equity or equity
capitalization rate.
The debt content does not change the risk perception of the
investors
Capital Structure Theories –
A) Net Income Approach (NI)
 As per NI approach, higher use of debt capital will result
in reduction of WACC. As a consequence, value of firm
will be increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value
at a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
 V = S + B.
 V = Value of the firm.
 S = Market value of equity.
 B = Market value of debt.
 S = NI / ke.
 S = Market value of equity.
 NI = Earnings available for equity shareholders.
 Ke = Equity capitalization rate.
Capital Structure Theories –
A) Net Income Approach (NI)
As the proportion of
Cost
debt (Kd) in capital
structure increases,
ke, ko ke
the WACC (Ko)
kd
ko
kd
reduces.

Debt
Capital Structure Theories –
A) Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10% Kd = 6%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000

Ke 10% 10% 10%

Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)

Value of D ebt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%

(EBIT / Value) * 100
Capital Structure Theories –
B) Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent
upon its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
 Net Operating Income (NOI) Approach

 This approach has also been suggested by Durand. This is just

opposite of Net Income Approach. According to this approach, the
market value of the firm is not at all affected by the capital
structure changes. The market value of the firm is ascertained by
capitalizing the net operating income at the overall cost of capital
(k), which is considered to be constant.
 Assumptions:
 The overall cost of capital (k) remains constant for all the degrees of debt
– equity mix or leverage.
 The market capitalizes the value of the firm as a whole and, therefore,
the split between debt and equity is not relevant.
 The use of debt having low cost increases the risk of equity shareholders,
this result in increase in equity capitalization rate. Thus, the advantage of
debt is set off exactly by increase in the equity capitalization rate.
 There are no corporate taxes.
Capital Structure Theories –
B) Net Operating Income (NOI)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the
capital structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity
capitalization rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.
Capital Structure Theories –
B) Net Operating Income (NOI)
 Cost of capital (Ko)
Cost is constant.
ke
 As the proportion
of debt increases,
ko

kd
(Ke) increases.
 No effect on total
Debt cost of capital
(WACC)
 V = EBIT / k.
 Where,
 V = Value of firm.
 K = overall cost of capital.
 EBIT = Earnings before interest and tax.
Capital Structure Theories –
B) Net Operating Income (NOI)
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%

Capital Structure Theories –
C) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, &
switch between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
 Modigliani – Miller (MM) approach
 This approach is similar to the Net Operating
Income (NOI) Approach. In other words,
according to this approach, the value of firm is
independent of its capital structure. However
there is a basic difference between the two. The
NOI approach is purely definitional or
conceptual. It does not provide operational
justification for irrelevance of the capital
structure in the valuation of the firm.
Basic Propositions: The following are the
three basic propositions of MM approach:
The overall cost of capital (k) and the value
of the firm (V) are independent of the capital
structure.
The cost of equity (ke) is equal to
capitalization rate of a pure equity stream
plus a premium for the financial risk.
The cut off rate for investment purpose is
completely independent of the way in which
an investment is financed.
Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition –
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate (i.e.
WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC
The MM approach is subject to the
following assumptions:
Capital Markets are perfect.
The firm can be classified into homogeneous
group classes. All the firms within the same class
will have the same degree of business risk.
All investors have the same expectation of a
firm’s net operating income with which to evaluate
the value of any firm.
The dividend payout ratio is 100%.
There are no corporate taxes.
 Arbitrage Process
 The “arbitrage process” is the operational
justification of MM hypothesis. The term arbitrage
refers to an act of buying an asset or security in one
market having low price and selling it in another
market at a higher price.

 The consequence of such action is that the market

prices of the securities of the two firms exactly
similar in all respects except in their capital
structures cannot for long remain different in
different markets. Thus arbitrage process restores
equilibrium of value of securities.
Capital Structure Theories –
C) Modigliani – Miller Model (MM)
Levered Firm
• Value of levered firm = Rs. 110,000
• Equity Rs. 60,000 + Debt Rs. 50,000
• Kd = 6 % , EBIT = Rs. 10,000,
• Investor holds 10 % share capital

Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all equity)
• EBIT = Rs. 10,000 and investor holds 10 % share capital
Capital Structure Theories –
C) Modigliani – Miller Model (MM)
Return from Levered Firm:
Investment  10%  110, 000  50 , 000   10%  60, 000   6 , 000
Return  10% 10, 000   6%  50, 000    1, 000  300  700
Alternate Strategy:
1. Sell shares in L: 10%  60,000  6,000
2. Borrow (personal leverage): 10%  50,000  5,000
3. Buy shares in U : 10%  100,000  10,000
Return from Alternate Strategy:
Investment  10,000
Return  10%  10,000  1,000
Less: Interest on personal borrowing  6%  5,000  300
Net return  1,000  300  700
Cash available  11,000  10,000  1,000
Limitations of MM hypothesis
Rates of interest are the not the same for
the individuals and the firms.
Homemade leverage is not perfect
substitute for corporate leverage.
Transaction costs involved.
Corporate tax frustrate MM hypothesis
Institutional restrictions.
Capital Structure Theories –
D) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk (financial risk) and hence Ke increases. Kd also rises due
to higher debt, WACC increases & value of firm decreases.
Capital Structure Theories –
D) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk (financial risk) and hence Ke increases. Kd also rises due
to higher debt, WACC increases & value of firm decreases.
Capital Structure Theories –
D) Traditional Approach
 Cost of capital (Ko) Cost

is reduces initially. ke

 At a point, it settles ko

 But after this point,

(Ko) increases, due kd

to increase in the
cost of equity. (Ke) Debt
 Traditional Approach
Net Income (NI) and Net Operating Income (NOI)
Approach represents two extremes. According to
NI approach, the debt content in the capital
structure affects both the overall cost of capital
and total valuation of the firm while NOI
approach suggests that the capital structure is
totally irrelevant so far as the total valuation of
the firm is concerned.
Capital Structure Theories –
D) Traditional Approach
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case II

Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
FEATURES OF AN APPROPRIATE CAPITAL
STRUCTURE
Profitability.  
Solvency.
 Flexibility.
Conservatism.
 Control.
Planning the Capital Structure
Important Considerations –
 Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs & delays,
to raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.
 FACTORS DETERMINING CAPITAL STRUCTURE

 Trading on equity
 Retaining Control
 Nature of enterprise
 Legal requirements.
 Purpose of financing.
 Period of finance.
 Market sentiments.
 Requirement of investors.
 Size of the company.
 Government policy.
 Provision for the future
 CAPITAL GEARING
• The term "capital gearing" or "leverage" normally refers to the proportion

of relationship between equity share capital including reserves and

surpluses to preference share capital and other fixed interest bearing

funds or loans.

• It is the proportion between the fixed interest or dividend bearing funds

and non fixed interest or dividend bearing funds.

• Equity share capital includes equity share capital and all reserves and

surpluses items that belong to shareholders. Fixed interest bearing funds

includes debentures, preference share capital and other long-term loans.

 Financial Risk Sales

Operating (–) Variable costs

• Debt causes financial
Leverage Contribution
risk !
(–) Fixed costs

EBIT / Profit
• The use of debt
(–) Interest expense
financing is referred to
Financial EBT
as financial leverage.
Leverage (–) Taxes

EAT
• Financial leverage
(-) Preference dividend
measures Financial
Earnings available for
risk. equity Shareholders
 LEVERAGES
The dictionary meaning of the term leverage
refers to "an increased means for accomplishing
some purpose".
James Home has defined leverage as "the
employment of an asset or funds for which the
firm pays a fixed cost or fixed return”
Types of leverage
Operating Leverage
Financial Leverage.
Composite leverage
 Operating Leverage
The operating leverage may be defined as
the tendency of the operating to vary
disproportionately with sales. It is said to
exist when the firm has to pay fixed cost
regardless of volume of output or sales.
OL = CONRIBUTION
EBIT
Degree of operating leverage =Percentage change in profits
Percentage change in sales
 Financial Leverage
The financial leverage may be defined as the
tendency of the residual income to vary
disproportionately with operating profit. It
indicates the change that takes place in the
taxable income as a result of change in the
operating income.
F L = EBIT
EBT
degree of financial leverage (DFL)
Percentage change in taxable income
Percentage change in the operating income
 COMPOSITE LEVERAGE
 Operating leverage measure percentage change in
operating profit due to percentage changes in sales.
It explains the degree of operating risk.
 Composite leverage = Operative leverage x Financial
leverage.
OR
CONTRIBUTION
EBT
 SIGNIFICANCE OF OPERATING AND
FINANCIAL LEVERAGES
 Theoperating leverage and the financial leverage are
the quantitative tools used by the financial experts to
measure the return to the owners .
 Thefinancial leverage is considered to be superior
these two tools.
A firm cannot go indefinitely in raising the debt
content the total capital structure of the company.
A company should try to have a balance of the two
leverage because they have got tremendous
acceleration or deceleration effect on EBIT and EPS.