CHAPTER 2

THEORY OF CAPITAL STRUCTURE

Introduction
Capital structure is the mix of capital sources of the firm. It is basically the mix of debt and equity. The
composition can be 1:9, 2:8, 5: 5 or any. There are two competing school of thought in capital structure that are
relevance and irrelevance school. Relevance school claims that firms cost of capital can be decreased and firms
value can be maximized by increasing debt in the capital structure. However, irrelevance approach claims that
increase in leverage doesn’t help to reduce cost of capital and increase value of the firm. In other words, firms
value is independent of capital structure.
There are five different theories in capital structure
Relevance School
i. Net Income approach
ii. Traditional approach
iii. MM proposition II (With taxes)
Irrelevance School
i. Net operating Income approach
ii. MM proposition I
Pecking Order Theory
Basic Terms

Cost of Equity (Ke): The cost of equity refers to the financial returns for the investors who invest in the
company. It is percentage return demanded by equity holders.

Cost of Debt (Kd): The cost of debt is the effective interest rate that a company pays on its debts, such as bonds
and loans. The cost of debt can refer to the before-tax cost of debt, which is the company's cost of debt before
taking taxes into account, or the after-tax cost of debt.

Cost of capital/Overall cost of capital/WACC = K d ( B+B S )+ K ( B+S S ) (B= Value of debt, S= Value of equity)
e

Firm Value = Value of debt (B) + Value of equity (S)

Explanation of Theories
Net Income Approach: According to this theory firm can minimize overall cost of capital and maximize firm
value by increasing proportion of debt in the firm.

Here, leverage means debt/equity ratio.

NI approach claims that, both cost of equity & debt remains constant irrespective of debt proportion in capital
structure. And WACC decreases and value of firm increases with the increase in debt.

Net Operating Income Approach (NOI approach): As per this theory firm value is independent of capital
structure. According to this theory firm cannot minimize overall cost of capital and maximize firm value by
increasing proportion of debt in the firm.

NI approach claims that, both cost of equity increases but debt remains constant with the increase in debt
proportion in capital structure. And WACC and value of firm remains constant with the increase in debt.
Traditional approach: This theory claims that by utilizing the mix of debt and equity firm can minimize
WACC and increase value of firm.

Up to certain level of leverage, both cost of debt and equity remains constant. After that certain level both cost
of debt and equity increases. WACC declines with the increase in leverage and reaches minimum at optimal
debt proportion. And firm value is maximum at optimal debt proportion. If debt is further increased firm value
decreases thereafter.

MM approach
Proposition I: The Modigliani-Miller theorem (M&M) states that firm value is independent of its capital
structure. It argues that the combination of debt and equity that a company chooses has no effect on its real
market value.
Proposition II: This proposition says that the financial leverage boosts the value of a firm and reduces WACC.
It is when tax information is available.
Pecking Order Theory: The pecking order theory states that companies prioritize their sources of financing (from
internal financing to equity) and consider equity financing as a last resort. Internal funds are used first, and when they are
depleted, debt is issued. When it is not prudent to issue more debt, equity is issued.

Summary of Capital Structure Theories

Capital Structure Cost of Overall cost
Type Leverage Cost of debt Firm Value
Theories equity of capital

Net Income
Relevance ↑ Constant Constant Decreases Increases (VL>Vu)
Approach

Goes on increasing up to certain

Constant up to Decreases up level, reaches maximum at
Traditional
Relevance ↑ certain level then Increases to certain level optimal leverage, if leverage is
Approach
increases then increases furthermore increased then firm
value decreases thereafter.

Net operating
Irrelevance ↑ Constant Increases Constant Constant (VL=Vu)
Income approach

MM Proposition I
Irrelevance ↑ Constant Increases Constant Constant (VL=Vu)
(Without Taxes)

MM Proposition II Constant with

Relevance ↑ Increases Decreases Increases (VL>Vu)
(With taxes) cheaper debt
List of Formulas
Annual interest expenses( I )
Cost of debt ( K d ) =
Market value of debt(B)

¿
Cost of equity ( K e ) = Earning available¿ equity shareholders(E) Market value of Equity (S)

Net operating Income(NOI )

Cost of Capital ( K 0) =
Market value of firm(V )

Cost of capital ( K 0) = K d ( B+B S )+ K ( B+S S )

e

¿∗B
Cost of equity of Levered firm = K e( L) = K e(U ) + [ K e(U ) - K d
S

EBIT (1−T )
Value of Unlevered firm (V u ¿=
K e(U )

EBIT (1−T )
After Tax WACC=
Vu

WACC for levered firm ( K 0 ¿=K d ( 1−T )∗Debt ∝+ K e∗Equity ∝ ¿

Value of a levered firm (V l )= Value of unlevered firm + PV of debt tax shield (Debt*Tax %)
Problem 2.2: Jyoti Spinning Mill has net operating income (NOI) of Rs 5 million and pays a coupon rate of 10
percent on all debt. Assume that there are no taxes and all debt is issued at par.

a. Under the net income approach, assuming a cost of equity capital of 15 percent, compute the value of the
firm and cost of capital for (i) all equity capital structure (ii) debt of Rs 23 million.

b. Under the net operating income approach, assuming a cost of capital of 12.5 percent, compute the value of
the firm for (i) all equity capital structure and (ii) debt of Rs 23 million.

Problem 2.3: Given the following information of firm

Debt Interest rate Ke EBIT

0 0 15% 200,000
100,000 10% 15% 200,000
200,000 10% 15% 200,000
300,000 10% 16% 200,000
400,000 12% 18% 200,000
500,000 14% 20% 200,000
600,000 16% 24% 200,000

Calculate: a) Value of firm b) WACC c) At which structure firms value is maximum

Problem 2.4: U Company and L Company are identical in every respect except that U is unlevered while L has
Rs 10 million of 5 percent bonds outstanding. Assume that
(1) all of the MM assumptions are met,
(2) the tax rate is 40 percent,
(3) EBIT is Rs 2 million,
(4) the equity capitalization rate for U Company is 10 percent, and
(5) the coupon rate is equal to the risk free rate, i.e., 5 percent.

What value would MM estimate for each firm?

Problem 2.5: Company U and Company L are identical in every respect except that U is unlevered while L has
Rs 10 million of 5 percent bonds outstanding. Assume that
(1) all of the MM assumptions are met,
(2) there are no corporate and personal taxes,
(3) EBIT is Rs 2 million, and
(4) the cost of equity to Company U is 10 percent.
When there is no tax MM assumes same value for levered and unlevered firm.

a. What value would MM estimate for unlevered firm? (20 m)

b. What is the Ks(Ke) for Company U? For Company L? (Cost of Equity for levered: 15%)
c. Find the value of a levered firm? (20 m)
d. What is the weighted average cost of capital for Company U? For Company L? (WACC levered: 10%)
e. Recalculate part (a) to (d) assuming 40 percent tax rate. (Value of Unlevered firm: 12 m, Value of Levered
firm: 16 m, Ke levered firm: 15%, WACC unlevered: 10%, WACC levered: 7.5 %)

Problem 2.6

Sahara Company currently has EBIT of Rs 25,000 and is all-equity financed. EBIT is expected to stay at this
level indefinitely. The firm pays corporate taxes equal to 35 percent of taxable income. The discount rate for the
firm's projects is 10 percent.

a. What is the market value of the firm?

b. Now assume the firm issues Rs 50,000 of debt paying interest of 6 percent per year, using the proceeds to
retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus
equity)?
c. Recalculate your answer to (b) under the following assumptions. The debt issue raises the possibility of
bankruptcy. The firm has a 30 percent chance of going to bankruptcy after 3 years. If it does go to bankruptcy, it
will incur bankruptcy costs of Rs 200,000. The discount rate is 10 percent. Should the firm issue the debt?
Problem 2.7: Sunflower Oil Company has Rs 1 million in earnings before interest and taxes. Currently it is all
equity financed. It may issue Rs 3 million in perpetual debt at 15 percent interest to repurchase stock, thereby
recapitalizing the corporation. There are no personal taxes.

a. If the corporate tax rate is 40 percent, what is the income to all security holders (1) if the company remains all
equity financed? (2) if it is recapitalized?
b. What is the present value of the debt tax shield?
c. The required return on equity for the company's stock is 20 percent while it remains all equity financed. What
is the value of the firm? What is the value if it is recapitalized?

Problem 2.8: Bhandari Wine Company is presently family owned and has no debt. The Bhandari family is
considering going public by selling some of their stock in the company. Investment bankers tell them the total
market value of the company is Rs 10 million if no debt is employed. In addition to selling stock, the family
wishes to consider issuing debt that, for computational purposes, would be perpetual. The debt then would be
used to purchase stock, so the size of the company would stay the same. Based on various valuation studies, the
net tax advantage of debt is estimated at 22 percent of the amount borrowed when both corporate and personal
taxes are taken into account. The investment banker has estimated the following present values of bankruptcy
costs associated with various levels of debt:

Debt (in Millions) Present Value of Bankruptcy Costs

Rs 1 0
2 Rs 50,000
3 100,000
4 200,000
5 400,000
6 700,000
7 1,100,000
8 1,600,000

Given this information, what amount of debt should the family choose?

Problem 2.9: MK Company is trying to determine an appropriate capital structure. It knows that as its
leverage increases, its cost of borrowing will eventually increase, as will the required rate of return on its
common stock. The company has made the following estimates for various leverage ratios:

Debt + Interest rate on Required rate of return on equity (Bankruptcy

Equity borrowings Costs)
0.1 8% 10.5
0.2 8.5 11
0.3 9 11.5
0.4 9 12.25
0.5 10 13.25
0.6 12.5 14.25
0.7 12.5 16
0.8 15 18
Questions: a. At a tax rate of 50 percent, what is the weighted average cost of capital of the company at various
leverage ratios in the absence of bankruptcy and agency costs? What is the optimal capital structure?

b. With bankruptcy and agency costs, what is the optimal capital structure?

Problem 2.10: Sukam Company is an unlevered firm that has constant expected operating earnings (EBIT) of
Rs 2 million per year. The company's tax rate is 40 percent, its cost of equity is 10 percent and its market value
is Rs 12 million. Management is considering the use of debt that would cost the firm 8 percent regardless of the
amount used. The firm's analysts have estimated, as an approximation, that the present value of any future
financial distress costs is Rs 8 million, and that the probability of distress would increase with leverage
according to the following schedule:

Value of debt Probability of financial distress

Rs 0 0.00%
2,500,000 2.50%
5,000,000 5.00%
7,500,000 10.00%
10,000,000 25.00%
12,500,000 50.00%
15,000,000 75.00%

a. According to the MM with corporate taxes model, what is the optimal level of debt?
b. What is the optimal capital structure when financial distress costs are included?
c. Assume that the firm's unleveraged cost of equity is 8 percent. What is the firm's optimal capital structure
including financial distress costs?