By Dr. B. Krishna Reddy

Capital
Structure
By Dr. B. Krishna Reddy
Professor and Head_SKIM
Capital Structure
Coverage
Capital Structure concept

Capital Structure planning
Concept of Value of a Firm
Significance of Cost of
Capital (WACC)
Capital Structure theories

Net Income
Net Operating Income
Modigliani-Miller
Traditional Approach
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.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders expectations
(risk & returns) and capital requirements of the firm.
Planning the Capital

Structure Important
Return: ability to generate maximum
returns to the
Considerations
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.
Flexible: altering capital structure without much costs &

delays, to raise funds whenever required.
Capacity: ability to generate profits to pay interest and

principal.
Value of a Firm directly corelated with the maximization of

Value of a firm depends upon earnings of a firm and its
shareholders wealth.
cost of capital (i.e. WACC).
Earnings are a function of investment decisions,

operating efficiencies, & WACC is a function of its
capital structure.
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 cannot affect the total earnings of a

firm (EBIT), but it can affect the residual shareholders
earnings.
An
illustration of
Income
Statement
Capital Structure
Theories
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.
No corporate or personal
taxation.
Investors expect future

profitability of the firm.
Capital Structure Theories

A) Net Income Approach (NI)
Net Income approach proposes that there is a

definite relationship between capital structure and
value of the firm.
The capital structure of a firm influences its cost of

capital (WACC), and thus directly affects the value
of the firm.
NI approach assumptions
o
NI approach assumes that a continuous increase in

debt does not affect the risk perception of investors.
Cost of debt (Kd) is less than cost of equity (Ke) [i.e.

Kd < K e ]
Corporate income taxes do not exist.

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 debtfinanced.

Cost
ke, ko
ke
ko
kd
kd
Debt
As the
proportion of
debt (Kd) in
capital
structure
increases, the
WACC (Ko)
reduces.


B) Net Operating Income
(NOI)
Net Operating Income (NOI) approach is the
exact opposite of the Net Income (NI) approach.
As per NOI approach, value of a firm is not

dependent upon its capital structure.
Assumptions
o
WACC is always constant, and it depends on the

business risk.
Value of the firm is calculated using the overall

cost of capital i.e. the WACC only.
The cost of debt (Kd) is constant.
Corporate income taxes do not exist.

(NOI)
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 (Ke)
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
(NOI)
(Ko) is constant.
Cost
ke
As the
proportion of
debt increases,
(Ke) increases.
No effect on
total cost of
capital (WACC)
ko
kd
Debt

(NOI)

C) Modigliani Miller Model
MM approach supports the NOI approach, i.e. the capital
(MM)
structure (debt-equity mix) has no effect on value of a firm.
Further, the MM model adds a behavioural justification in

favour of the NOI approach (personal leverage)
Assumptions
o
Capital markets are perfect and investors are free to buy,

sell, & switch between securities. Securities are infinitely
divisible.
Investors can borrow without restrictions at par with the

firms.
Investors are rational & informed of risk-return of all

securities
No corporate income tax, and no transaction costs.
100 % dividend payout ratio, i.e. no profits retention

MM
Model proposition
(MM)
o Value
of a firm is independent of the capital

structure.
o Value
of firm is equal to the capitalized value of

operating income (i.e. EBIT) by the appropriate
rate (i.e. WACC).
o Value
of Firm = Mkt. Value of Equity + Mkt. Value
of Debt
= Expected EBIT
Expected WACC

MM
Model proposition
(MM)
o As
per MM, identical firms (except capital

structure) will have the same level of earnings.
o As
per MM approach, if market values of

identical firms are different, arbitrage
process will take place.
o In
this process, investors will switch their

securities between identical firms (from levered
firms to un-levered firms) and receive the same
returns from both firms.

Levered
(MM)Firm
Value of levered firm = Rs. 110,000
Equity Rs. 60,000 + Debt Rs. 50,000
Kd = 6 % , EBIT = Rs. 10,000,
Investor holds 10 % share capital
Un-Levered Firm
Value of un-levered firm = Rs. 100,000 (all
equity)
EBIT = Rs. 10,000 and investor holds 10 % share
capital

Return
from Levered Firm:
(MM)
Investment 10% 110, 000 50 , 000 10% 60, 000 6 , 000
Return 10% 10, 000 6% 50, 000 1, 000 300 700

Alternate Strategy:
1. Sell shares in L: 10% 60,000 6,000
2. Borrow (personal leverage): 10% 50,000 5,000
3. Buy shares in U : 10% 100,000 10,000
Return from Alternate Strategy:
Investment 10,000
Return 10% 10,000 1,000
Less: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Cash available 11,000 10,000 1,000

D) 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 of capital
(Ko) is reduces
initially.
At a point, it
settles
But after this

point, (Ko)
increases, due to
increase in the
cost of equity. (Ke)
Cost
ke
ko
kd
Debt


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Capital

Capital Structure concept

Capital Structure theories

Planning the Capital

shareholders, i.e. maximize EPS and market price per share.

Cost: minimizes the cost of capital (WACC). Debt is cheaper

Risk: insolvency risk associated with high debt component.

Control: avoid dilution of management control, hence debt

Flexible: altering capital structure without much costs &

Capacity: ability to generate profits to pay interest and

Value of a Firm directly corelated with the maximization of

Earnings are a function of investment decisions,

Value of firm is derived by capitalizing the earnings by

Thus, value of a firm varies due to changes in the

Capital structure cannot affect the total earnings of a

Firms use only two sources of

100 % dividend payout ratio, i.e.

Business risk of firm is not

Investors expect future

Capital Structure Theories

Net Income approach proposes that there is a

The capital structure of a firm influences its cost of

NI approach assumes that a continuous increase in

Cost of debt (Kd) is less than cost of equity (Ke) [i.e.

Corporate income taxes do not exist.

Capital Structure Theories

As per NI approach, higher use of debt capital

Earnings (EBIT) being constant and WACC is

Thus, as per NI approach, a firm will have

Capital Structure Theories

Capital Structure Theories

Capital Structure Theories

exact opposite of the Net Income (NI) approach.

As per NOI approach, value of a firm is not

WACC is always constant, and it depends on the

Value of the firm is calculated using the overall

The cost of debt (Kd) is constant.

Corporate income taxes do not exist.

Capital Structure Theories

Capital Structure Theories

Capital Structure Theories

Capital Structure Theories

Further, the MM model adds a behavioural justification in

Capital markets are perfect and investors are free to buy,

Investors can borrow without restrictions at par with the

Investors are rational & informed of risk-return of all

No corporate income tax, and no transaction costs.

100 % dividend payout ratio, i.e. no profits retention

Capital Structure Theories

of a firm is independent of the capital

of firm is equal to the capitalized value of

of Firm = Mkt. Value of Equity + Mkt. Value

Capital Structure Theories

per MM, identical firms (except capital

per MM approach, if market values of

this process, investors will switch their

Capital Structure Theories

Capital Structure Theories