CAPITAL STRUCTURE

DECISION

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MEANING
Capital

structure is the proportion of debt, preference and

equity shares on a firms balance sheet.

Total capital

Debt capital

Equity capital

Equity share capital

Preference share cap
Retained earnings
Share premium

Term loans
Debentures
Deferred payment liabilities
Other long term debt
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Optimum capital structure

Is

the capital structure at which the weighted average cost of

capital is minimum and thereby maximum value the firm.
The optimum capital structure minimizes the firms overall
cost of capital and maximizes the value of the firm.
Optimum capital structure is also referred as appropriate
capital structure and sound capital structure

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Factors determining capital

structure
Factors

Internal
Cost of capital
Risk factor
Control factor
Objectives
Constitution of the company
Attitude of the management

External
Economic conditions
Interest rates
Policy of lending
Tax policies
Statutory restrictions

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Theories of capital structure

Basic assumptions
1. There are only two sources of funds used by a firm: perpetual
risk less debt and ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100%. that is, the total earnings are
paid out as dividend to the shareholders and there are no
retained earnings.
4. The total assets are given and do not change. The investment
decisions are in other words assumed to be constant.
5. The total financing remains constant. The firm can change its
degree of leverage (capital structure) either by selling shares
and use the proceeds to retire debentures or by raising more
debt and reduce the cost of equity capital.
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Contd
6.
7.

8.
9.

The operating profits (EBIT) are not expected to grow.

All investors are assumed to have same subjective
probability distribution of the future expected EBIT for a
given firm.
Business risk is constant over time and is assumed to be
independent of its capital structure and financial risk.
Perpetual life of the firm.

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Theories of capital
structure
Net Income NI approach
Net

Operating Income NOI approach

Modigliani Miller MM approach
Traditional approach

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Net Income approach

This

approach is given by Durand David

Assumptions: this approach is based on three
assumptions
There are no taxes
Cost of debt is less than the cost of equity
Use of debt does not change the risk perception of the
investor.
According to this approach, the capital structure
decision is relevant to the valuation of the firm.

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Contd
A change

in the capital structure causes a overall change

in the cost of capital and also in the total value of the
firm.
A higher debt content in the capital structure means a
high financial leverage and this results in the decline in
the overall weighted average cost of capital and
therefore there is increase in the value of the firm.
Thus with the cost of debt and the cost of equity being
constant, the increased use of debt (increase in
leverage), will magnify the share holders earnings and,
thereby, the market value of the ordinary shares.

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Contd
NI

Net Income= EBIT-I or earnings available to equity

share holders.
Value of the firm= market value of debt+ market value
of equity.
over all cost of capitalization (ko) = EBIT/V or
(ko) = ki (B/V) + ke (S/V)
Ki= cost of debt
Ke= cost of equity
B= total market value of debt
S= total market value of equity

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Contd
Net

income approach view of capital structure:

Cost of
capital

Cost of equity

Average cost of capital

Cost of debt

Degree of leverage

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Net operating income

approach
This is another theory suggested by Durand
NOI

approach is opposite to NI approach

According to NOI approach value of the firm is
independent of its capital structure it means capital
structure decision is irrelevant to the valuation of the
firm
Any change in leverage will not lead to any change in
the total value of the firm and the market price of the
shares as well as the overall cost of capital is
independent of the degree of leverage

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Assumptions
The

investors see the firm as a whole and thus capitalize

the total earnings of the firm to find the value of the firm
as a whole
The overall cost of capital (ko) of the firm is constant
and depends upon the business risk which also is
assumed to be unchanged
The cost of debt (kd) is also constant
There is no tax
The use of more and more debt in the capital structure
increases the risk of the shareholders and thus results in
the increases in the cost of equity capital (ke)

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Prepositions
NOI

approach is based on the following prepositions:

Overall cost of capital/ capitalization rate (ko) is constant:
this approach argues that the overall capitalization rate of the firm
remains constant for all degrees of leverage. The value of the firm
given the level of EBIT is determined by
V= EBIT/ko
EBIT= earnings before interest and tax
Ko= overall cost of capital or
V=EBIT(1-t) + Bt

ke
B= value of debt
The split of the capitalization between debt and equity is
therefore not significant
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Contd
Residual

value of equity :
The value of equity is the residual value which is
determined by deducting the total value of debt (B) from
the total value of the firm (V)
(S) = V-B
S= value of equity
V= value of firm
B = value of debt

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Contd
Change

in cost of equity capital

The

equity capitalization rate or cost of equity capital

(Ke) increases with the degree of leverage.
The increase in the proportion of debt in the capital
structure relative to equity shares would lead to an
increase in the financial risk to the ordinary
shareholders.
To compensate for the increased risk to the ordinary
shareholders would expect a higher rate of return on
their investment.
The increase in the equity capitalization rate would
match in the increase in debt equity ratio.

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Contd
Ke

= Ko + (Ko-Ki) (B/S)

Or
Ke= EBIT-I/V-B

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Contd
Cost

of debt
The cost of debt (Ki) has two parts
Explicit cost
Implicit cost hidden cost
Explicit cost is the rate of interest paid by debt.
Implicit cost is the increase in the cost of equity due to
increase in debt.

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Optimal capital structure

The

total value of the firm is unaffected by its capital

structure.
No matter what the degree of leverage is the total value
of the firm remain constant.
The market price of shares will also not change with the
change in debt equity ratio.
There is nothing such as optimum capital structure any
capital is optimum according to NOI approach.

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ke

Cost of
capital

ko

ki

Degree of leverage
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Modigliani Miller Approach

The

M.M thesis relating to the relationship between the

capital structure, cost of capital and valuation is akin to
the NOI approach.

The

NOI approach does not provide operational or

behavioral justification for the irrelevance of the capital
structure.

The

significance of M.M approach lies in the fact that it

provides behavioral justification for constant overall
cost of capital and therefore total value of firm.
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Assumptions
a)
1.
2.
3.
4.
5.

6.

Perfect capital marketSecurities are infinitely divisible

Investors are free to buy/ sell securities
Investors can borrow without restrictions on the same
terms and conditions as the firm can
There are no transactions costs
Information is perfect, that is each investor has same
information which is readily available to him without
cost and
Investors are rational and behave accordingly.

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Contd
b) Given the assumption of perfect information and rationality
all investors have the same expectations of firm net operating
income (EBIT) with which to evaluate the value of a firm
c) Business risk is equal among all the firm within similar
operating environment, that means all the firms can be
divided into equivalent risk class.
The term equivalent/homogeneous risk class means that the
expected earnings have identical risk characteristics and firm
within an industry are assumed to have same risk
characteristics
d) The dividend payout ratio 100%
e) There are no taxes. This assumption is removed later

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Basic prepositions
There

are three basic preposition of M.M approach.

Preposition 1
The overall cost of capital (ko) and the value of the firm
(V) are independent of its capital structure, the ko and V
are constant for all degrees of leverages. the total value
is given by capitalizing the expected stream of operating
earnings at a discount rate appropriate for its risk class.
V=EBIT
ko
V is determined by the assets in which the company
has invested and not how those assets are financed

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Contd
V

Ko %

Degree of leverage (B/V)

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Contd
Preposition

2
The second preposition of M.M approach is that the ke is
equal to the capitalization rate of a pure equity stream
plus a premium for financial risk equal to the difference
between the pure equity capitalization rate (ke) and (ki)
times the ratio of debt to equity.
In other words ke increases in the manner to offset
exactly the use of a less expensive source of funds
represented by debt. Or
The rate of return required by the shareholders increases
linearly as the debt/equity ratio is Increased.
Ke(L) = Ke(u)+[(ke(u)-ki)*D/E]
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Contd
Proposition

3
The cut-off rate for the investment purpose is
completely independent of the way in which an
investment is financed. The cut off rate for investment
will be in all cases the WACC

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MM theory : Arbitrage
Proposition

1:The basic premise of MM approach is that

given the above assumptions the total value of a firm
must be constant irrespective of degree of leverage
(debt-equity ratio) similarly, the cost of capital as well
as the market price of shares must be the same
regardless of the financing-mix.
The operational justification for the MM hypothesis is
the Arbitrage process.

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Arbitrage
The

term arbitrage refers to an act of buying an asset/security

in one market (at lower price) and selling it in another market
(at higher price) to derive benefits from the price differentials
The increase in demand will force up the price of lower
priced goods and increase in supply will force down the price
of the high priced goods.
MM argues that the process of arbitrage will prevent the
different market values for equivalent firms, simply because
of capital structure difference.

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Arbitrage process
The

investor of the firm whose value is

higher(overvalued) will sell their shares and instead buy
the shares of the firm whose value is lower (undervalued)
The behavior of investors will have the effect of
(i) increasing the share prices (value) of the firm whose
shares are being purchased;
(ii) lowering the share prices (value) of the firm whose
shares are being sold .
This will continue till the market prices of both the firms
become identical .

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Contd
The

use of debt by the investor for arbitrage is called as

Home Made or Personal leverage

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Limitations or Criticism of
MM approach
Risk

perception
Convenience
Cost
Institutional restrictions
Double leverage
Transaction cost
Taxes

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Risk perception
In

the first place, the risk perceptions of personal and

corporate leverage are different.
The risk exposure to investor is greater with personal
leverage than with corporate leverage.
The liability of an investor is limited in corporate
enterprise. The risk to which he is exposed is limited to
his relative holdings in the company
The liability of an individual borrower is, on the other
hand, unlimited as even his personal property is liable to
be used for payment to the creditors.
The risk to the investor with personal borrowings is
higher.
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Convenience
Apart

from higher risk exposure the investor would find

the personal leverage inconvenient.
This is so because with corporate leverage the
formalities and procedures involved in borrowing are to
be observed by the firms.
In case of personal leverage these will be the
responsibility of the investor borrower.

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Cost
Another

constraint on the perfect substitutability of personal

and corporate leverage and, hence, the effectiveness of the
arbitrage process is the relatively high cost of borrowing with
personal leverage.
As a general rule, large borrowers with high credit standing
can borrow at a lower rate of interest compared to borrowers
who are small and do not enjoy high credit standing.
For this reason it is reasonable to assume that a firm can
obtain a loan at a cost lower than what a individual investor
would have to pay
As a result of higher interest charges, the advantage of
personal leverage would disappear and the MM assumption
of corporate and personal leverage being perfect substitutes
would be a doubtful validity
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Institutional restrictions
Yet

another problem with the MM hypothesis is that

institutional restrictions stand in the way of smooth
operation of the arbitrage process.
Several institutional investors such as insurance
companies, mutual funds, commercial bank and so on
are not allowed to engage in personal leverage.
Thus switching the option from the unlevered to levered
firm may not apply to all investors and, to that extent,
personal leverage is an imperfect substitute for corporate
leverage.

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Double leverage
A related

dimension is that in certain situations, the

arbitrage process may not actually work.
For instance, when an investor has already borrowed
funds while investing in shares of an unlevered firm.
If the value of that is more than that of a levered firm,
the arbitrage process will require selling securities of the
overvalued firm (unlevered) and purchasing the
securities of undervalued firm(levered).
Thus, an investor would have double leverage both in
personal portfolio as well as in the firms portfolio.
The MM assumption will not hold true in such a
situation.
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Transaction cost
Transaction

cost would effect arbitrage process.

The effect of transaction/flotation cost is that the
investor would receive net proceeds from the sale of
securities which will be lower than the investment
holding in the levered/unlevered firm, to the extent of
brokerage fees and other costs.
He would therefore have to invest a large amount in the
shares of the unlevered/levered firm, than his present
investment, to earn the same returns.
This implies that the arbitrage process will be hampered
and will not be effective.

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Taxes
Finally

if the corporate taxes are taken into account, the

MM Approach will fail to explain the relationship
between financing decision(capital structure) and the
value of the firm
MM themselves are aware of it and in fact, recognized
it.

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Corporate Taxes in MM
Approach
MM

agrees that the value of firm will increase and cost

of capital will decline with leverage, if corporate taxes
are introduced in the exercise.
Since the interest on debt is tax deductible the effective
cost of borrowing is less than the contractual rate of
interest.
Debt, thus, provide a benefit to the firm because of tax
deductibility of interest payments
Therefore a levered firm would have greater market
value than the unlevered firm

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Contd
Specifically, MM

states that the value of the levered

firm would exceed that of the unlevered firm by an
amount equal to the levered firms debt multiplied by
the tax rate.
Symbolically,
V(l) = V(u) + Bt
V(u) = EBIT(1-t)
Ke
Where V(l)= value of levered firm
Vu = value of unlevered firm
B= amount of debt and
t = tax rate
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Contd
Since

the value of the levered firm is more than that of

the unlevered firm, it is implied that the over all cost of
capital of the former would be lower than that of the
later.
The implication of MM analysis in this case is that a
firm can lower its cost of capital continually with
increased leverage. However, the extensive use of debt
financing would expose business to high probabilities of
default. Therefore an excessive use of debt may cause
rise in the cost of capital and therefore reduce value of
the firm.

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Traditional approach
In

the earlier discussions we have seen that the net

income approach (NI) as well as net operating income
approach(NOI) represent two extremes as regards the
theoretical relationship between the capital structure, the
weighted average cost of capital and value of the firm.
While the NI Approach takes the position that the use of
debt in the capital structure will always affect the overall
cost of capital and the total valuation, the NOI approach
argues that capital structure is totally irrelevant.
The MM Approach supports the NOI approach. But the
assumptions of MM approach are of doubtful vaidity.

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Contd
The

traditional approach is the midway between the NI

and NOI approaches.
It partakes of some features of both these approaches.
It is also known as Intermediate approach.
It resembles or agrees with the NI approach in arguing
that cost of capital and total value of the firm are not
independent of the capital structure. But it dose not
agree with the view that the value of firm will
necessarily increase at all degrees of leverage

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Contd
It

shares a feature with NOI approach also that beyond a

certain degree of leverage, the overall cost increases
leading to decrease in the total value of the firm. And it
differs with NOI approach in that it dose not argue that
the weighted average cost of capital is constant for all
degrees of leverage.

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Contd
The

crux of traditional view relating to leverage and

valuation is that through judicious use of debt-equity
proportions, a firm can increase its total value and there
by reduce its over all cost of capital.
The rationale behind this view is that debt is relatively
cheaper source of funds as compared to ordinary shares.
With a change in the leverage, that is , using more debt
in place of equity, a relatively cheaper source of fund
replaces a source of fund which has relatively higher
cost. This obviously causes a decline in the over all cost
of capital.

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Contd
If

the debt-equity ratio is raised further, the firm would

become financially more risky to the investors who will
penalize the firm by demanding a higher equity
capitalization rate (ke). But the increase in ke may not be
so high to neutralize the benefit of using cheaper debt.
If, however, the debt is increased further two things are
likely to happen:
(i) owing to increased financial risk ke will record a
substantial rise ;
(ii) the firm would become very risky to creditors who
also would be compensated by a higher return such that
ki will rise
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Contd
The

use of debt beyond a certain point will, therefore,

have the effect of raising the weighted average cost of
capital and conversely reducing the total value of the
firm.
Thus up to a point the use of debt will favorably affect
the value of the firm; beyond that point use of debt will
adversely affect the value of the firm. At that level of
debt-equity ratio, the capital structure is an optimal capital
structure.

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Contd
At

the optimal capital structure, the marginal real cost of

debt, defined to include both implicit and explicit, will
be equal to the real cost of equity. For a debt equity ratio
before that level, the marginal real cost of debt would be
less than that of equity capital, while beyond that level
of leverage, the marginal real cost of debt would exceed
that of the equity.

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Over all cost of capital and

optimum leverage

Cost of equity Ke
WACC

Cost of
capital
Cost of debt Ki

Optimum level of capital

Degree of leverage
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Overall cost of capital and

value of the firm
Market
value

Value of firm
Value of equity
Value of debt
Optimum level of capital
Degree of leverage
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EBIT-EPS analysis
Keeping

in mind the primary objective of financial

management of maximizing the market value of the
firm, the EBIT-EPS analysis should be considered
logically as the first step in the direction of designing a
firms capital structure.
EBIT-EPS analysis shows the impact of various
financing alternatives on EPS at various levels of EBIT.

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Contd
This

analysis is useful for two reasons

The EPS is the measure of firms performance given the
P/E ratio, the larger the EPS the larger would be the
value of the firm
The EBIT-EPS analysis information can be extremely
useful to finance manager in arriving at an appropriate
financing decision.

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Contd
In

general, the relationship between EBIT and EPS is as

follows
EPS= (EBIT-I) (1-t)
N
Where EPS= earning pre share
EBIT= earnings before interest and tax
I= interest
t= tax
N= number of equity shares

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Break even EBIT level or

Indifferent point
The

breakeven EBIT for two alternative financing plans

is the level of EBIT for which the EPS is the same under
both the financing plans.
(EBIT-I) (1-t) = (EBIT-I) (1-t)

N
N

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Contd
EPS

EBIT
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Financial breakeven
It

is the minimum level of EBIT needed to satisfy all

fixed financial charges i.e. interest and preference
dividends.
It denotes the level of EBIT for which the firms EPS just
equals to zero.
If EBIT is less than financial break even point, then EPS
will be negative
But if the expected level of EBIT exceeds than that of
break even point more fixed costs financing instruments
can be inducted in the capital structure otherwise the use
of equity will be preferred.

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ROI-ROE
ROI=

EBIT/D+E
ROE= (EBIT-I) (1-t)/E
Mathematical relationship
ROE= (ROI+ (ROI-r)D/E) (1-t)

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