UNIT – III

Meaning of Capital Structure

Capital structure refers to the kinds of securities and
the proportionate amounts that make up
capitalization. It is the mix of different sources of long-
term sources such as equity shares, preference shares,
debentures, long-term loans and retained earnings.
Definition of Capital Structure
According to the definition of Gerestenbeg, “Capital
Structure of a company refers to the composition or
make up of its capitalization and it includes all long-
term capital resources”.
According to the definition of James C. Van Horne,
“The mix of a firm’s permanent long-term financing
represented by debt, preferred stock, and common
stock equity”.
 Objectives of Sound Capital structure
 1. Aims at maximization of shareholders wealth
 2. Cost of financing should be minimum
 3. A balance between Debt & Equity
 4. Take into consideration the control aspect of the
firm
 5. It should be flexible.
FACTORS DETERMINING CAPITAL
STRUCTURE
 Leverage
 Cost of Capital
 Government policy
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firm’s financial
decision which affects the value of the firm and it leads
to change EBIT and market value of the shares. There
is a relationship among the capital structure, cost of
capital and value of the firm. The aim of effective
capital structure is to maximize the value of the firm
and to reduce the cost of capital.
The important theories are:-
 Net Income Approach
 Net Operating Income Approach
 The traditional approach
 The Modigliani and Miller Approach
Net Income (NI) Approach
Net income approach suggested by the Durand.
According to this approach, the capital structure
decision is relevant to the valuation of the firm. In
other words, a change in the capital structure leads to a
corresponding change in the overall cost of capital as
well as the total value of the firm.
Net Income (NI) Approach
According to this approach, use more debt finance to
reduce the overall cost of capital and increase the value
of firm.
Net income approach is based on the following three
important assumptions:
 1. There are no corporate taxes.
 2. The cost debt is less than the cost of equity.
 3. The use of debt does not change the risk perception
of the investor.
 where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the
following formula:
S = NI/Ke
where
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
Format for calculating value of the
firm on the basis of NI approach
Particulars Amount
Net operating income (EBIT) XXX
Less: interest on debenture (i) XXX
Earnings available to equity holder (NI) XXX

Equity capitalization rate (Ke) XXX

Market value of equity (S) XXX

Market value of debt (B) XXX
Total value of the firm (S+B) XXX

Overall cost of capital = Ko = EBIT/V X 100 = XXX%

Exercise 1
(a) A Company expects a net income of Rs. 1,00,000. It
has Rs. 2,50,000, 8% debentures. The equity
capitalization rate of the company is 10%. Calculate
the value of the firm and overall capitalization rate
according to the net income approach (ignoring
income tax).
(b) If the debenture debts are increased to Rs.
4,00,000. What shall be the value of the firm and the
overall capitalization rate?
Solution
(a) Capitalization of the value of the firm
Rs.

Net income 1,00,000

Less: Interest on 8% Debentures of Rs. 2,50,00020,000
Earnings available to equality shareholders 80,000
Equity capitalization rate 10%
= 80,000/10%
Market value of equity = 8,00,000
Market value of debentures = 2,50,000
Value of the firm = 10,50,000
Calculation of Overall capitalization rate (Ko)
Overall cost of capital (Ko) = Earnings/Value of the firm
EBIT/ V
= 1,00,000/10,50,000 ×100
= 9.52%
(b) Calculation of value of the firm if debenture debt is
raised to Rs. 4,00,000.
Net income 1,00,000
Less: Interest on 8% Debentures of Rs. 4,00,000 32,000
Equity Capitalization rate 68,000
10%
Market value of equity = 68,000 × 100/10
= 6,80,000
Market value of Debentures = 4,00,000
Value of firm = 10,80,000
Overall cost of capital =1,00,000/10,80,000 ×10
= 9.26%

Thus, it is evident that with the increase in debt

financing, the value of the firm has increased and the
overall cost of capital has increased.
Net Operating Income (NOI)
Approach
According to this approach, Capital Structure decision is
irrelevant to the valuation of the firm. The market
value of the firm is not at all affected by the capital
structure changes.
According to this approach, the change in capital
structure will not lead to any change in the total value
of the firm and market price of shares as well as the
overall cost of capital.
 NI approach is based on the following important
assumptions :-
 The overall cost of capital remains constant
 There are no corporate taxes
 The market capitalizes the value of the firm as a whole
 The debt capitalization rate is constant.
 The use of less costly debt increases risk of equity
shareholders which result in increases in equity
capitalization rate.
 Value of the firm (V) can be calculated with the help of
the following formula :-
V = EBIT/Ko
Where, V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital

NI = EBIT – Interest on Debenture

Value of Equity = Value of Firm – Value of Debt

Ke = NI/ Value of Equity

Exercise 1
XYZ expects a net operating income of Rs. 2,00,000. It
has 8,00,000, 6% debentures. The overall
capitalization rate is 10%. Calculate the value of the
firm and the equity capitalization rate (Cost of Equity)
according to the net operating income approach.
If the debentures debt is increased to Rs. 10,00,000.
What will be the effect on volume of the firm and the
equity capitalization rate?
Solution
Net operating income = Rs. 2,00,000
Overall cost of capital = 10%

Market value of the firm (V) =EBIT/Ko

= 2,00,000×100/10
= Rs. 20,00,000

Market value of the firm =Rs. 20,00,000

Less: market value of Debentures = Rs. 8,00,000
Value of equity = 12,00,000

Equity capitalization rate (or) cost of equity (Ke)

Ke =EBIT – I/ V-D
= NI/Value of Equity
 Where,
V = value of the firm
D = value of the debt capital
Ke = NI/Market Value of Equity
(2,00,000 – 48,000/20,00,000-8,00,000) ×100
Ke = 12.67%

If the debentures debt is increased to Rs. 10,00,000, the

value of the firm shall remain changed to Rs. 20,00,000.
The equity capitalization rate will increase as follows:
Ke =EBIT- I/V – D *100
=( 2,00,000 – 60,000/20,00,000-10,00,000) ×100
=(1,40,000/10,00,000 )×100
Ke = 14%.
Traditional Approach
According to the traditional approach, mix of debt
and equity capital can increase the value of the firm by
reducing overall cost of capital up to certain level of
debt.
Traditional approach states that the Ko decreases only
within the responsible limit of financial leverage and
when reaching the minimum level, it starts increasing
with financial leverage.
Assumptions
Capital structure theories are based on certain assumption
to analysis in a single and convenient manner:
• There are only two sources of funds used by a firm; debt and
shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
 2cr Debt :-
1. NI = Net Op. In. – Interest
= 7500000 – 10% of 2cr.(20,00,000) = 5500000
 Ke = 18%
2. Market Value of Equity = NI/Ke
= 5500000/ 18% = 3,05,55,555
3. Value of Firm = Equity + Debt
= 3,05,55,555 + 2,00,00,000 = 5,05,55,555
4. Ko = EBIT/V X 100 = 75,00,000/5,05,55,555 X 100 = 14.8%
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing
decision of a firm does not affect the market value of a
firm in a perfect capital market. In other words MM
approach maintains that the average cost of capital
does not change with change in the debt weighted
equity mix or capital structures of the firm.
 Modigliani and Miller approach is based on the
following important assumptions:
• There is a perfect capital market.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.
Value of the Unlevered firm can be calculated with the
help of the following formula:
EBIT/Ko
Where
EBIT = Earnings before interest and tax
Ko = Overall cost of capital

Vu = 8,00,000/ 10% = 80,00,000

 Value of the Levered firm can be calculated with the
help of the following formula:
Vl = Vu + t*D

Where
Vu = Value of Unlevered firm
t = Tax rate
D = Amount of debt capital

= 80,00,000 + 50% x 50,00,000 = 1,05,00,000

Exercise 1
ABC Ltd., needs Rs. 30,00,000 for the installation of a new
factory. The new factory expects to yield annual earnings
before interest and tax (EBIT) of Rs.5,00,000. In choosing a
financial plan, ABC Ltd., has an objective of maximizing
earnings per share (EPS). The company proposes to issuing
ordinary shares and raising debit of Rs. 3,00,000 and Rs.
10,00,000 of Rs. 15,00,000. The current market price per
share is Rs. 250 and is expected to drop to Rs. 200 if the
funds are borrowed in excess of Rs. 12,00,000. Funds can be
raised at the following rates.
 –up to Rs. 3,00,000 at 8%
 –over Rs. 3,00,000 to Rs. 15,000,00 at 10%
 –over Rs. 15,00,000 at 15%
 Assuming a tax rate of 50% advise the company.
Exercise 2
Compute the market value of the firm, value of shares and
the average cost of capital from the following information.
Net operating income Rs. 1,00,000
Total investment Rs. 5,00,000
Equity capitalization Rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs. 25,000 debentures 11%
(c) If the firm uses Rs. 4,00,000 debentures 13%
Assume that Rs. 5,00,000 debentures can be raised at 6%
rate of interest whereas Rs. 4,00,000 debentures can be
raised at 7% rate of interest.