Capital Structure: By: Anuja Rastogi

Capital Structure
By:
Anuja Rastogi
Capital Structure
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders’ wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
It involves balancing the shareholders’ expectations
(risk & returns) and capital requirements of the firm.
OptiMal Capital StruCture
• The optimal or the best capital structure
implies the most economical and safe ratio
between various types of securities.
• It is that mix of debt and equity which
maximizes the value of the company and
minimizes the cost of capital.
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.
Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
 Value of a firm depends upon earnings of a firm and

its cost of capital (i.e. WACC).
 Value of firm is derived by capitalizing the earnings
by its cost of capital (WACC).
 Value of Firm = Earnings / WACC
 Thus, value of a firm varies due to changes in the
earnings of a company or its cost of capital, or both.
Capital Structure Theories
• Net Income (NI) Theory
• Net Operating Income (NOI) Theory
• Traditional Theory
• Modigliani-Miller (M-M) Theory
• 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.
 There are no corporate taxes.
A) Net Income Approach (NI)
• This theory was propounded by “David Durand” and is also
known as “Fixed ‘Ke’ Theory”.
• According to this theory a firm can increase the value of the
firm and reduce the overall cost of capital by increasing the
proportion of debt in its capital structure to the maximum
possible extent.
• It is due to the fact that debt is, generally a cheaper source of
funds because:
• The benefit of tax as the interest is deductible expense for
income tax purpose.
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.
Net Income Approach (NI)
As the proportion of
Cost
debt (Kd) in capital
ke, ko ke
structure increases,
the WACC (Ko)
ko
kd kd
reduces.
Debt
Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the
exact opposite of the Net Income (NI) approach.
• This theory was propounded by “David Durand”
and is also known as “Irrelevant Theory”.
• According to this theory, the total market value
of the firm (V) is not affected by the change in
the capital structure and the overall cost of
capital (Ko) remains fixed irrespective of the
debt-equity mix.
 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 (K e)
A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (K d )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.
 Cost of capital (Ko)

Cost
ke
is constant.
 As the proportion of
ko debt increases, (Ke)
kd
increases.
Debt
 No effect on total
cost of capital
(WACC)
Traditional Approach
 The NI approach and NOI approach hold extreme
views on the relationship between capital structure,
cost of capital and the value of a firm.
 Traditional approach (‘intermediate approach’) is a
compromise between these two extreme approaches.
 Traditional approach confirms the existence of an
optimal capital structure; where WACC is minimum
and value is the firm is maximum.
 As per this approach, a best possible mix of debt and
equity will maximize the value of the firm.
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.
Cost  Cost of capital (Ko) i

ke
reduces initially.
ko  At a point, it settles
 But after this point,
kd
(Ko) increases, due to
Debt increase in the cost of
equity. (Ke)
Modigliani-Miller Theory
• This theory was propounded by Franco
Modigliani and Merton Miller.
• They have given two approaches
1. In the Absence of Corporate Taxes
2. When Corporate Taxes Exist
Assumptions
o Capital markets are perfect and investors are free

to buy, sell, & switch between securities.
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
In the Absence of Corporate Taxes
• According to this approach the ‘V’ and its ‘Ko’ are
independent of its capital structure.
• The debt-equity mix of the firm is irrelevant in determining
the total value of the firm.
• Because with increased use of debt as a source of finance, ‘Ke’
increases and the advantage of low cost debt is offset equally
by the increased ‘Ke’.
• In the opinion of them, two identical firms in all respect,
except their capital structure, cannot have different market
value or cost of capital due to Arbitrage Process(Buying
security from one market at lower price and selling it in
another market at high price).
When Corporate Taxes Exist
• M-M’s original argument that the ‘V’ and ‘Ko’
remain constant with the increase of debt in
capital structure, does not hold good when
corporate taxes are assumed to exist.
• They recognised that the ‘V’ will increase and
‘Ko’ will decrease with the increase of debt in
capital structure.
• They accepted that the value of levered (VL)
firm will be greater than the value of unlevered
firm (Vu).

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Capital Structure

 Value of a firm depends upon earnings of a firm and

 Cost of capital (Ko)

Cost  Cost of capital (Ko) i

o Capital markets are perfect and investors are free

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