DBB2104 Unit-08

DBB2104: Financial Management Manipal University Jaipur (MUJ)
BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 3
DBB2104
FINANCIAL MANAGEMENT
Unit 8: Capital Structure Theories 1

Unit 8
Capital Structure Theories
Table of Contents
SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1
Introduction
1.1 Learning Objectives
2 Capital Structure Meaning and Definition F1 1
3 Capital Structure Theory 2, 3
3.1 Net Income Approach F2

3.2 Net Operating Income Approach F3
3.3 Traditional Theory of Capital Structure
3.4 Modigliani and Miller Approach
4 Summary
5 Glossary
6 Case Study
7 Terminal Questions
7.1 Answers
8 Suggested Books and E-References

1. INTRODUCTION
Capital structure planning is considered very crucial in financial
STUDY NOTE
decision making since its components are related to each other
Capital structure is
and it also has a relationship with risk, return and value of the
important both for
firm. Basically, there are two forms of capital: equity capital and Fortune 500
companies and for
debt capital small business owners
trying to determine
In order to have sustainable business growth, a balance has to be how much of their
start-up money should
maintained between various funding sources, weighing the pros
come from a bank loan
and cons of each type of capital. The purpose of a finance manager without endangering
the business.
in every organization is to create a capital structure that strives to
attain a balance between risk and reward for the shareholders.
To decide if an investment in a particular business is sound, investors, shareholders, and

analysts will often look at a business’s debt-to-equity ratio.
Working capital, or the cash in hand, a company has is the part of capital structure only.
Working capital is the difference between a business’s assets and liabilities.
More debt than equity means a business has more liability than assets and it will be seen by
the investor as a riskier investment although it may vary from industry to industry. In any
organization capital structure decision is considered to be the most important decision taken
by the management as it has an effect on the risk profile and the profitability of the firm.
The capital structure helps firms to decide how to finance the assets and operations of the
business. A firm can have a combination of debt, equity, and hybrid securities as its source
of finance.
By looking at capital structure one can find out how a firm finance itself. It can choose from
a number of securities: shares, bonds, preferred shares, convertible bonds, etc. Basically,
there are two types of securities, debt and equity, each has its own benefits and drawbacks.
This chapter will give you further insights into important capital structure theories.

1.1 LEARNING OBJECTIVES

After studying this chapter, you will be able to:
❖ Define and distinguish capital structure
❖ Examine critical theories of capital structure
❖ Differentiate between capital structure and financial structure

2. CAPITAL STRUCTURE MEANING AND DEFINITION

Capital structure is defined as the mix of debt and equity that the firm uses in its operations.
Therefore, capital structure means arranging capital from different sources in order to meet
long term funding requirements. The structure comprises of a combination of different
securities. There are many alternative capital structures available for a firm to choose from.
For example, it can use warrants, issue convertible bonds, and arrange lease financing. A firm
can also issue different securities in various combinations to maximize the market value of
the firm.
Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings, and other long-
term sources of funding in the total amount of capital that a firm should raise to run its
business.
Source: https://caknowledge.com/capital-structure-meaning-types/
Fig 1: Capital Structure
Definition
“Capital structure of a company refers to the make-up of its capitalization and it includes all
long-term capital resources viz., loans, reserves, shares and bonds.”—Gerstenberg.
“Capital structure is the combination of debt and equity securities that comprise a firm’s
financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such as debentures, long-
term debts, preference share capital and equity share capital including reserves and sur-
plus.”—I. M. Pandey.
Capital structure, financial structure, and assets structure
People often get confused between the term capital structure and financial structure.
Financial structure includes shareholder’s funds, long term and short-term debt. But capital
structure includes only long-term debt and shareholder’s funds. So, we can say that capital
structure is only one segment in the financial structure of the firm. But some experts in
financial management consider capital structure the same as financial structure.
Capital structure is a part of the financial structure. Capital structure includes only long-term
debt and equity in the total capital. While financial structure includes owner’s equity as well
as long term and short-term liabilities.
The difference between capital structure and financial structure is that the former does not
include short term liabilities.
As far as the term asset structure is concerned, it means a firm’s total assets. In other words,
it will be shown in the assets side of the balance sheet of a company which implies that that
fund has been applied in procuring fixed and current assets.
Asset’s structure = Fixed assets + Current assets.
Calculation

In the absence of market values, book values can be considered.

Capital structure is also expressed by the debt to total assets ratio. The financial leverage
ratio or debt to equity ratio of the business can also be used to find the percentage of equity
and percentage of debt.
Example 2: Calculating capital structure when financial leverage ratio is given - the financial
leverage ratio of Indigo Airlines is 2.5. Find its capital structure.
Financial leverage ratio
=2.5
A = 2.5 × (A − L) A = 2.5
A − 2.5 L 2.5
L = 2.5 A − A
2.5 L = 1.5 A
L/A% = 1.5/2.5 = 60%
SELF ASSESSMENT QUESTIONS – 1
1. The capital structure is defined as the mix of ___________and __________ that the firm
uses in its operation.
2. Capital structure does not include short term liabilities but financial structure
includes short-term liabilities or current liabilities. (True/False)
3. Capital structure of a firm is a part of its financial structure.
4. Capital structure consists of long-term debt and ________ fund.

3. CAPITAL STRUCTURE THEORY

There are mainly two ways in which a corporation can finance its business, either through
debt or through equity, although proportion may vary. It is up to a company to choose a
structure which consist half of debt and other half of equity or it can also have more of one
and less of another. The other name of capital structure is financial leverage which means
that a company’s financing mix consists of a proportion of debt or borrowed funds.
Many firms consider debt structuring as it is a cheaper source of finance because interest
payable on a debt is tax deductible. But at the same time, it also has some drawbacks, like the
risk of bankruptcy or increased fixed interest obligations. Different theories have evolved to
find the optimum capital structure so as to maximize the value of a firm. In the following
sections these will be explained.
The important theories are:

1. Net income approach
2. Traditional approach
3. NOI approach
4. MM approach
3.1 Net Income Approach

According to this theory, the value of a firm can be increased if the firm decreases the overall
cost of capital measured in terms of the weighted average cost of capital. This is possible by
choosing a higher proportion of debt in financing since debt financing is cheaper than equity
finance. Weighted average cost of capital (WACC) is the weighted average costs of equity and
debts where the weights are the amount of capital raised from each source.

where:
E = Market value of the firm’s equity
D = Market value of the firm’s debt V=E + D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
Net income approach says that the weighted average cost

STUDY NOTE
of capital (WACC) and company’s value fluctuate with
Net Income Approach was presented
change in financial leverage of a firm. This means that on by Durand which suggests that the
value of the firm can be increased by
increasing the proportion of debt in leverage, the WACC decreasing the overall cost of capital
will decrease and the firm value will increase. At the same (WACC) through higher debt
proportion.
time, if debt proportion decreases in the leverage, the
WACC will increase which would lead to decrease in the value of the firm.
The following example given illustrates it further.
Suppose a firm has equity-debt ratio of 50:50. If it changes this ratio to 20:80, it will bring a
positive change in the business as the value per share of the firm will increase.
Fig 2: Net income approach
Assumptions of net income approach

• Investors will not change their mind with increase in debt proportion.
• Only two sources of finances are there debt and equity. Other sources like preference
• share capital and retained earnings are not there.

• All companies have a uniform dividend payout ratio; it is 1.

• There is no flotation cost, transaction cost, or corporate dividend tax.
• Capital market is perfect, which means that information about all companies is avail-
able to all investors and there are no chances of overpricing or underpricing of security.
Further, it means that all investors are rational. So, all investors want to maximize their
return with the minimization of risk.
• All sources of finance are for infinity. There are no redeemable sources of finance.
Calculation procedure
# Particulars Amount
A EBIT XXX
B Less: Interest cost (Debt X Interest rate) (XX)
C EAT (Tax is assumed to be absent) XXX
D Shareholders earnings (C = D) XXX
E Market value of equity shares (D/Cost of Equity) XX
F Market value of debt XX
G Total market value of firm (E + F) XXX
H Overall cost of capital in percentage (A/G*100) XX%
Example: Consider a fictitious company with the figures (all figures in Rupees).
Earnings before interest tax (EBIT) = 1,00,000

Bonds (Debt part) = 3,00,000
Cost of bonds issued (Debt) = 10%
Cost of equity = 14%
Calculating the value of a company
EBIT = 1,00,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings (since tax is assumed to be = 70,000
absent)
Shareholders’ earnings = 70,000
Market value of equity (70,000/14%) = 5,00,000

The market value of debt = 3,00,000

Total market value = 8,00,000
EBIT/(Total value of
The overall cost of capital = firm)
1,00,000/8,00,000
12.5%
Now, assume that the proportion of debt increases from 3,00,000 to 4,00,000, and everything
else remains the same.
EBIT = 1,00,000
Less: Interest cost (10% of 4,00,000) = 40,000
Earnings (since tax is assumed to be = 60,000
absent)
Shareholders’ earnings = 60,000
Market value of equity (60,000/14%) = 4,28,570 (approx.)
The market value of debt = 4,00,000
Total market value = 8,28,570
EBIT/(Total value of firm)
The overall cost of capital = 1,00,000/8,28,570
12.% (approx.)
It is clear from the above illustration that in net income approach, as the debt proportion
increases, the overall market value of the company will also increase resulting in decreased
cost of capital. As debt is a cheaper source of finance than equity, increase in debt finance
will reduce WACC and the value of firm will increase.

5. According to the net income approach, the value of a firm can be increased by
decreasing the ________ through higher debt proportion.
6. Weighted average cost of capital (WACC) is the weighted average cost of _______
and debts where the weights are the amount of capital raised from each source.
3.2 Net Operating Income Approach

According to the net operating income approach, value of a
STUDY NOTE
firm is unaffected by any change in debt proportion in the
Net operating income approach
capital structure of the firm. The assumption behind this is suggests that the value of a firm is
dependent on the operating income
that with the increase in debt proportion there is a and the associated business risks.
Change in the leverage (debt) fails
simultaneous increase in the required rate of return by the
to affect the value of the firm.
equity shareholders. Debt financing has its own risks,
mainly bankruptcy. Therefore, as the risk increases, expectations of equity shareholders also
increase.
While financing their businesses, companies choose to have a mix ratio of debt and equity in
their capital structure. The other name of debt ratio in capital structure is financial leverage.
Companies have a choice here; they can choose to have more debt or more equity while
financing their assets. The paramount aim of a company is to maximize profits and its market
value. At last, only the relationship between the capital structure and value of a firm matters
to a company.
There is a difference of opinion in this matter, some believe that an increase in the debt
component will increase the value of a firm, while the others are of the opinion that it will
also increase risk at the same time. Various theories have been given to establish the
relationship between financial leverage, weighted average cost of capital and the total value
of the firm. One among them is the net operating income approach.
This theory was given by Durand and is also known as the traditional approach and it is
completely different from the net income approach. As per this theory, change in debt of the

firm will not bring about any change in the total value of the firm. Moreover, it says that no
relationship exists between capital structure decision, WACC, and the total value of a
company. In other words, we can say that they are independent of each other.
It further says that the market value of a firm depends on its operating income and the
related business risk of the firm. Financial leverage does not affect any of the above
mentioned fac- tors; it can only affect the income of debt holders and equity holders but does
not have any impact on the operating income of the firm. For this reason, it can be concluded
that any change in the debt-to-equity ratio does not impact the value of the firm.
Fig 3: Net operating income
As a company increases its debt component, the related risk also simultaneously increases
which causes the equity shareholders to expect a higher return. So, when a company
increases its financial leverage, the cost of equity also increases with it.
A.
B. Assumptions of net operating income approach

1. The overall capitalization rate remains constant irrespective of the degree of
leverage.
2. Value of equity is the difference between the total firm value and the value of debt.
3. WACC (Weightage average cost of capital) remains constant; and with the increase in
debt, the cost of equity also increases.
C. Example

D. Consider a fictitious company with the following figures (all figures are in Rupees).
Earnings before interest tax (EBIT) = 1,00,000

Bonds (Debt part) = 3,00,000
Cost of bonds issued (Debt) = 10%
WACC = 12.5%
Calculating the value of the company:
EBIT = 1,00,000
WACC = 12.5%
Market value of the company = EBIT/WACC
= 1,00,000/12.5%
= 8,00,000
Total debt = 3,00,000
Total equity = Total market value – total debt
= 8,00,000 – 3,00,000
= 5,00,000
Shareholders’ earnings = EBIT – interest on debt
= 1,00,000 – 10% of 3,00,000
= 70,000
Cost of equity = 70,000/5,00,000
= 14 %
Now assume that the proportion of debt increases from 3,00,000 to 4,00,000 and everything
else remains the same.
(EBIT) = 1,00,000
WACC = 12.5%
The market value of the company = EBIT/WACC
= 1,00,000/12.5%
= 8,00,000
Total debt = 4,00,000
Total equity = Total market value –
total debt
= 8,00,000 – 4,00,000
= 4,00,000

= EBIT – Interest on
debt
= 1,00,000 – 10% of
4,00,000
= 60,000
= 60,000/4,00,000
= 15%
So, on the basis of above illustration, we can say that, in the net operating income approach,
with the increase in debt proportion, market value of the company remains unaffected, but
the cost of equity increases.
3.3 Traditional Theory of Capital Structure

The traditional theory of capital structure says that for an optimal capital structure to exist,
the weighted average cost of capital (WACC) must be at a minimum level while the market
value of the assets or company is at the maximum level. An optimal capital structure is also
regarded as an optimal debt to equity ratio in this traditional theory. The traditional theory
of capital structure maintains that the capital structure of a company (a mix of debt and
equity capital) is an important metric in gauging the value of the company. However, an
optimal structure of capital exists when the overall cost of capital of the firm is reduced and
the market value of the firm or its assets maximized.
According to the traditional theory of capital structure, the optimal capital structure will
increase to a certain level before it remains constant and eventually begins to decrease. An
increase or a decline on the optimal structure of capital affects the value of a firm. Hence,
when the overall cost of capital is reduced down to a specific level of debt, the optimal capital
structure exists to increase the value of a company.
The fundamental concepts of this theory are given below:

a) The cost of debt capital Kd, remains constant more or less up to a certain level and
thereafter rises.
b) The cost of equity capital Ke, remains constant more or less, or rises gradually up to a
certain level and thereafter increases rapidly.

c) The average cost of capital Kw, decreases up to a certain level, remains unchanged more
or less, and thereafter rises after attaining a certain level.
7. An optimal capital structure is also regarded as an optimal debt to equity ratio in

_______ theory.
8. The traditional theory maintains that a mix of _____ is an important metric
in gauging the value of the company.
Example
Consider a fictitious company with the following data.
Particulars Case 1 Case 2 Case 3 Case 4 Case 5

Weight of debt 10% 30% 50% 70% 90%
Weight of equity 90% 70% 50% 30% 10%
Cost of debt 10% 11% 12% 14% 16%
Cost of equity 17% 18% 19% 21% 23%
WACC 16.3% 15.9% 15.5% 16.1% 16.7%
It is clear from the above example that with the increase in financial leverage of the
company, the debt increases from 10% to 50% and there is a decrease in equity from 90%
to 50% (case 1 to 3). As can be seen from the table, there is also an increase in cost of debt
and equity because of the company’s higher exposure to risk. The WACC decreased from
16.3% to 15.5%.
It can also be observed from the table, that as the financial leverage of the company increases,
the overall cost of capital decreases simultaneously. The reason behind this is that debt is a
cheaper source of finance as interest on debt is tax deductible.
When a company increases its financial leverage further, there is an increase in debt from
50% to 90% and a reduction in equity from 50% to 10% (Case 3 to 5). There is also a
further increase in cost of debt and equity. The new WACC is increased from 15.5% to

16.7%. So, it can be revealed that as the financial leverage of the company increases, the
overall cost of capital also increases.
The above exercise shows that initially increasing the debt reduces WACC but only to a
certain level. After that level is crossed, a further increase in the debt level increases WACC
and reduces the market value of the company.
3.4 Modigliani and Miller Approach

This theory is considered to be the most important theory
STUDY NOTE
in corporate finance. It was developed by the economists,
The theory stated that the value
Modigliani and Miller in 1958. The main idea behind this of a firm is not depended on the
choice of capital structure or its
theory is that overall value of a company is unaffected by its financing decision. On the contrary,
it is affected by its operating
capital structure. income apart from the risk involved
in the investment. This approach
This theory has two versions: was devised by Modigliani and
Miller during the 1950s. It
• The M&M theorem or capital structure irrelevance resembles the net operating income
approach.
theorem
• M& M theorem in the real world
Capital structure irrelevance theorem

This first version of M&M theorem is based on the assumption that the market is perfectly
efficient. In other word companies operating in such markets do not pay any taxes, there are
no transaction costs or bankruptcy costs, and all investors have access to the same
information which means that information is perfectly symmetrical.
Assumptions made by the Modigliani and Miller approach

• There are no taxes.
• Transaction cost for buying and selling securities as well as the bankruptcy cost is nil.
• There is symmetry of information.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
• There is no corporate dividend tax.
1. Proposition 1 (M&M I):

2. VL = VU
Where:
VU = Value of unleveraged firm (Equity financed)
VL = Value of leveraged firm (Debt and equity financed)
It proposed that a company’s value is unaffected by its capital structure as it is calculated by

the present value of future cash flows. Also, it is assumed in perfectly efficient markets that
companies do not pay any taxes therefore companies do not receive any benefits from tax
deductible interest payments.
3. Proposition 2 (M &M I)
Where:
rE = Cost of levered equity
ra = Cost of unlevered equity
rD =Cost of debt
D/E = Debt-to-equity ratio
As per the second preposition, a company’s cost of equity and a company’s leverage level are
directly proportional to each other. There will be an increase in related risk and therefore
investors may demand a higher return due to the additional risk.
M&M theorem in the real world

The second version of M&M approach is exactly opposite to the first version as it was
developed after considering real world situations. In this theory, it is assumed that a
company pays taxes and bears other costs as well, like transaction and bankruptcy costs.
Also, there is no symmetry of information.
Proposition 1 (M&M II):

VL = VU + Tc × D
Where:

Tc = Tax rate
D = Debt
As a result of tax-deductible interest payment, value of a levered company increases. There

is a positive effect on a company’s cash flows because of tax deductible interest payments.
Value of the company is determined by the present value of the future cash flows, this led to
an increase in the value of the levered company.
Proposition 2 (M&M II):
It states that the cost of equity and leverage level directly proportional to each other.
Example
Company A and B are two similar businesses with similar business risks. Company A is
unleveraged whereas Company B is leveraged with Rs. 2,00,000 debenture @ 5% interest
rates. Both companies earn Rs. 50,000 before-tax income. The after-tax capitalization rate is
10% and the corporate tax rate is 40%. Calculate the market value of the two firms.
Solution
Firm A Firm B
Net operating income 50,000 50,000
Interest on debenture - 10,000
Profit before taxes 50,000 40,000
Taxes (40%) 20,000 16,000
Profit after taxes 30,000 24,000
After-tax capitalization rate 10% 10%
Total market value of the equity (S) 3,00,000 2,40,000
Market value of debt (B) - 2,00,000
Total value (V) 3,00,000 4,40,000

4. SUMMARY
• Theories of capital structure argue about the use of debt in the capital mix and its
resulting impact on the value of a firm; dividend theories argue about the policy of
dividend payment and retention and its resulting impact on the value of the firm.
• These theories have been divided into two categories: theories of relevance and
theories of irrelevance.
• All the theories are bound by certain assumptions which are subject to criticism.
• Application of these theories would be possible if all the assumptions are realized.
• Practically, at the time of formulation of investment and financing policies in the
industry, these capital structures and dividend theories provide guidance.
5. GLOSSARY
Capital Structure: Capital Structure is the proportion of all types of long-term capital.
Financial structure is the proportion of all types of long-term and short-term capital.
EBIT: Earnings before Interest and taxes.
EPS: Earning per share.
NI approach: Net income approach says more usage of debt will enhance the value of the
firm.
NOI approach: Net operating income approach.
WACC: Weighted average cost of capital.
Cost of equity: The cost of equity is the return a company requires to decide if an investment
meets capital return requirements.
Debt: Debt is something, usually money, borrowed by one party from another. Debt is used
by many corporations and individuals to make large purchases that they could not afford
under normal circumstances. A debt arrangement gives the borrowing party permission to
borrow money under the condition that it is to be paid back at a later date, usually with
interest.
Cost of capital: Cost of capital is the required return necessary to make a capital budgeting
project, such as building a new factory, worthwhile.
Cost of debt: The cost of debt is the effective interest rate a company pays on its debts

Equity: A security or investment representing ownership in a corporation. Equity is often

used interchangeably with stock. Compare to a bond, which represents a loan to a borrower.
5. CASE STUDY
“A business that doesn’t grow dies”, says Mr. Shah, the owner of Shah Marble Ltd. with a
grand success having a capital base of Rs. 80 crores in just 36 months. Within a short span of
time, the company could generate a cash flow which not only covered
fixed cash payment obligations but also create a sufficient buffer. The company is on the
growth path and a new breed of consumers are eager to buy the Italian marble sold by Shah
Marble Ltd. To meet the increasing demand, Mr. Shah decided to expand his business by
acquiring a mine. This required an investment of Rs. 120 crores. To seek advice in this
matter, he called his financial advisor, Mr. Seth who advised him a judicious mix of equity
(40%) and debt (60%). Mr. Seth also suggested to him to take a loan from a financial
institution as the cost of raising funds from financial institutions is low. Though this will
increase financial risk, it will also increase the return to equity shareholders. He also
apprised him that the issue of debt will not dilute the control of equity shareholders. At the
same time, the interest on a loan is a tax-deductible expense for computation of tax liability.
After due deliberations with Mr. Seth, Mr. Shah decided to raise funds from a financial
institution.
1. Identify and explain the concept of financial management as advised by Mr. Seth in the
above situation.

7. TERMINAL QUESTIONS
SHORT ANSWER QUESTIONS
Q1. What is a firm’s capital structure? How is it different from financial structure?
Q2. Under the traditional approach to capital structure, what happens to the cost of debt and
cost of equity as the firm’s financial leverage increases?
LONG ANSWER QUESTIONS

Q1. Mehta company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has
Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%.
Compute the value of the firm.
7.1 ANSWERS
SELF ASSESSMENT QUESTIONS
1. Debt and Equity
2. True
3. True
4. Shareholder’s fund
5. The overall cost of capital (WACC)
6. Equity
7. Traditional
8. Debt and equity
TERMINAL QUESTIONS
SHORT ANSWER QUESTIONS
Answer 1: Capital structure refers to the proportions or combinations of equity share
capital, preference share capital, debentures, long-term loans, retained earnings, and other
long-term sources of funds in the total amount of capital which a firm should raise to run its
business. Capital structure is different from the financial structure. It is a part of the financial
structure. Capital structure refers to the proportion of long-term debt and equity in the total
capital of a company. On the other hand, financial structure refers to the net worth or owners’
equity and all liabilities (long-term as well as short-term).

Answer 2: In the traditional approach to capital structure, the cost of debt capital Kd,
remains constant more or less up to a certain level and thereafter rises. The cost of equity
capital, Ke, remains constant more or less, or rises gradually up to a certain level and
thereafter increases rapidly.
LONG ANSWER QUESTIONS

Answer 1:
Net income Rs 2,00,000
Less: Interest on 10% debenture of Rs 5,00,000 Rs 50,000
Earnings available to equity shareholders Rs 1,50,000
Market capitalization rate 12.5%
Market value of the equity(S) = 1,50,000*12.5% Rs 12,00,000
Market value of debenture (D) Rs 5,00,000
Value of the firm (S+D) Rs 17,00,000

8. SUGGESTED BOOKS AND E-REFERENCES

BOOKS
• Srivastava R.M. (2003), Financial Management and Pragati Himalaya Publishing
Housing Mumbai.
• Pandey, I.M., (1993), Financial Management.
REFERENCES
• A., & Olokoyo, F. O. (2015). An empirical analysis of capital structure on performance
of firms in the petroleum industry in Nigeria. Journal of Accounting and Auditing:
Research & Practice, 1-9
• Alves, P. F. P., & Ferreira, M. A. (2011). Capital structure and law around the world.
Journal of Multinational Financial Management, 21(3), 119-150.

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DBB2104: Financial Management Manipal University Jaipur (MUJ)

Unit 8: Capital Structure Theories 1

SL Topic Fig No / Table SAQ / Page No

3.1 Net Income Approach F2

Unit 8: Capital Structure Theories 2

To decide if an investment in a particular business is sound, investors, shareholders, and

Unit 8: Capital Structure Theories 3

1.1 LEARNING OBJECTIVES

Unit 8: Capital Structure Theories 4

2. CAPITAL STRUCTURE MEANING AND DEFINITION

Unit 8: Capital Structure Theories 5

Capital structure, financial structure, and assets structure

Asset’s structure = Fixed assets + Current assets.

Unit 8: Capital Structure Theories 6

In the absence of market values, book values can be considered.

leverage ratio of Indigo Airlines is 2.5. Find its capital structure.

Financial leverage ratio

SELF ASSESSMENT QUESTIONS – 1

Unit 8: Capital Structure Theories 7

3. CAPITAL STRUCTURE THEORY

The important theories are:

3.1 Net Income Approach

Unit 8: Capital Structure Theories 8

Net income approach says that the weighted average cost

The following example given illustrates it further.

Fig 2: Net income approach

Assumptions of net income approach

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• All companies have a uniform dividend payout ratio; it is 1.

Earnings before interest tax (EBIT) = 1,00,000

Calculating the value of a company

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The market value of debt = 3,00,000

else remains the same.

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SELF ASSESSMENT QUESTIONS – 2

3.2 Net Operating Income Approach

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Fig 3: Net operating income

B. Assumptions of net operating income approach

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Earnings before interest tax (EBIT) = 1,00,000

Calculating the value of the company:

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3.3 Traditional Theory of Capital Structure

The fundamental concepts of this theory are given below:

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SELF ASSESSMENT QUESTIONS – 3

7. An optimal capital structure is also regarded as an optimal debt to equity ratio in

Consider a fictitious company with the following data.

Particulars Case 1 Case 2 Case 3 Case 4 Case 5

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3.4 Modigliani and Miller Approach

Capital structure irrelevance theorem

Assumptions made by the Modigliani and Miller approach

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It proposed that a company’s value is unaffected by its capital structure as it is calculated by

M&M theorem in the real world

Proposition 1 (M&M II):

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