CAPITAL STRUCTURE

Capital structure is one of the important areas of Finance Function. In this area
it is determined as to what should be the capital Mix. The left side of the
balance sheet indicates the capital areas vis share capital, Reserve and simples,
credit Bal of Profit and loss A/C Bonds/Debentures.

The determination of capital structures firstly aims at deciding whether

the organisation will operate only with the equity capital. In this lose the entire
Net operating income will be income from Equity. The organisation which has
got only one type of capital viz: Equity capital is called unlevered Firm, As and
when Debt will become profit the total capital it will be known as levered Firm.
Higher the probation of Debit in Capital structure higher will be leverage.

Normally debt is cheaper than the Equity therefore, by increasing the

debt the value of the firm goes on increasing so is the risk because higher the
proportion of debt, higher will be the interest component. If the organisations
fail to earn profit the debt herders ……………….be entitled for payment of
interest which will be risky for the firm.

The aim of determination of capital structure is to increase the value of

the firm. There are other theories which stipulate other with Modigliani &
miller is of the opinion that by increasing or decreasing the proposition of debt
is capital structure value of the firm does not champs. By having higher debt
the interest which saves income far increases the value which is offset by the
personal tax and financial distress.

Net operating income approach suppose a firm earns Rs. 10,000/- out of
which is pays Rs. 3000/- as interest their the firm is a levered firm

let ke ( cost of Equity = 107. And Kd (cost of debt:6)

.. Value of equity = discounted value of net income/ cost of Equity
= Rs. 7000/10% =70,000
Value of Debt = Interest /cost of Debt = 3000/6% = 50,000
Value of Firm = value of Equity + Value of Debt
= 70,000 + 50,000
= 1,20,000/-
Firms cost of capital = NOI/value of firm = 10,000/120000= 1/12=0.083 i.e.
8.33%.
Weighted average cost of capital (WACC)
Cost of equity x Equity/total value + cost of Debt x Debt/Total income
Ko = Ke x E/V + Kd d / V

=10% x70,000/ 120000 + 6% x 50,000/120,000

= 7000/120000 + 3000/120000 = 10,000/ 120000 = 8.33%

Now

Ko = Ke E/V + kd D/V

= Ke(KD)/V + Kd D/V

= Ke (1-D/V) + Kd D/V

= Ke – Ke D/V + Kd D/V

= Ke –( Ke-Kd) D/V

From above equation it is clear that with every increase in value of D, value of
D/V will go up since (Ke - Kd) are constant and since ke >Kd and therefore ke –
kd will > 0. Therefore cost of capital will come down. Thus, as with increase in
average the value of the firm will go up.

When D= 0 , Ko = e cost of capital = cost of equity

Now

V= E + D

= NOI – INT/ ke + Interest /Kd

= NOI kd D/ Ke + kd D/ kd

= NOI/ Ke + Kd D /Ke + D kd

= NOI + D + kd/Ke

Value of Firm = NOI/ke + D {1- kd/ke} since ke > kd

Kd/ke < 1

With increase in D the second factor will go up. These the value of Firm will
move up words with increase in value of D. when D=0 value of Firm = NOI / ke
= Discounted value of Net operating income.
EFFECT OF LEVERAGE ON VALUE AND COST OF CAPITAL IN NOI APPROACH

I II III IV V VI
Let % equity 10000 90000 80000 60000 50000 0
capital 0
Debit capital D 10000 20000 40000 50000 100000
Earning (NOI) 10000 10000 10000 10000 10000 10000
Cost of Debit 5 5 5 5 5 5
Kd
Cost of equity 10 10 10 10 10 10
Ke
Interest 0 500 1000 2000 2500 5000
Income to 10000 9500 9000 8000 7500 5000
Equity ………….
(NOI-INT) E/ke
10000 9500/ 9000/10 8000/10 7500/10 5000/10
/10% 10% % % % %
10000 95000 90000 80000 75000 50000
0

Thus as per No. 1 approach value of the firm will be maximum them equity is
NIL and debit is zero because cost of capital will be only 5%. Optimum capital
structure will be at point of minimum WACC

Equity/Total Value F/V 1000/1000 =1

……….

Value of Equity = Net income / cost of Equity = NI/Ke

Value of Debt = Interest / cost of Debt = Interest / Kd

Value of Firm = Net operating Income/WACC = E+D= NOI/Kd

Assumption

1. Replacement of one capital from another

2. Firm value is consistent with share value ……..
3. …. Be merit optimum when cost of capital is minimised.

Factors : Financial issue – Taxes, interest Practical issue- Market, Practices,

Lender’s perspectives, industry norms.

MODIGLIANI MATER MODEL

 It did not agree with traditional ……

 In perfect capital markets without taxes & transaction costs cost of
capital is not diffident upon capital structure.
 Value of the firm is infect dependent upon business risk and earnings of
the firm or the way the assets are financed.
o Two firms of same industry face similar competitions and business
conditions.
o Ka and opportunity cost is same
o Debt will not change the earnings of the firm and business rise therefore
value of levered and unlevered firm will be same.
V= Net operating income /opp. Cost of capital
V= Vt =Vu = NOI/Kd
V= market value of the firm (value of Equity + value of Debt)
NOI = EBIT, Kd= opportunity cost of capital is capitalisation Rate.

Debt holders’ income is interest equity Holders income is Dividend.

V1 = NOI/kd=Ko or Ko=Kt=NOI/Vt
In unlevered frim entire income of the firm is shareholders income
Ko =Ku = NOI / Vu Ka = Expected rate of return on assets.
WACC of two identical …..are levered and one this unlevered will same
and will be equal to opportunity cost of capital Kl=Ko=ka=ku
Infect, when the value of two identical firm differs this the investors
switch over to restore equilibrium in the market. It is done through
personal leverage.
 In this case investment firm covered firm is transferred to
unlevered firm and investment in Debt in levered firm is met with
personal debt
 The sale of levered firm share and purchase of unlevered firms’
share will tend to boost up the price of unlevered firms shares
and decline in he price of levered firm’s share the process will go
till value of e. shares of covered and unlevered firm are same.

Solved Examples:

Radiant Technology has project costing Rs. 15 crore for making high end
microchips on hand. It shall provide the desired capital level of Rs. 4 crore
annually. With a view to decide the desired copied structure the firm compiled
following date with respect to cost of Debt and cost of equity for debt levels
20% to 70% of the cost of project that is reproduced below:

Plan I II III IV V Vi
Debt cost 0% 20 30 40 50 60 70
Amount of Debt 300 450 600 700 900 1050
Cost of Debt (%) 8 8 8 9.50 10 10.5
Cost of Equity (%) 15.5 15.5 16 18 21 250

Examine the best 1 capital structure for Radiant Technology?

Answer: - we shall have to examine the value of Radiant Technology Ltd. at

various levels of debt with enhanced earnings. The level of debt that fives the
maxim value of the firm i.e. value of Equity + value of Debt will be best capital
structure.

Current value of equity = 1500-300=1200 Lakh.

Cost of Equity 15 x 15.5% = 2325 Lakh

Current Level of earning = 400 Lakh