CAPITAL STRUCTURE THEORIES

NET INCOME APPROACH

Capital Structure decision is relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. If therefore the degree of financial leverage as measured by the ratio of debt to equity is increased, the WACC will decline, while the value of the firm as well as the market price of share will increase and vice versa.

Assumptions in net income approach

No taxes. Cost of debt is less than the cost of equity. Use of debt does not change the risk perception of investor.

EXAMPLE

A companys expected annual EBIT is Rs. 100000. The company has Rs 2,50,000, 10% debenture. The cost of equity of the company is 12.5%.

SOLUTION
Net Operating Income (EBIT) Less: Interest on debentures (I) Rs 100,000 25,000 -------------------------75,000 0.125

Earnings available to equity holders (NI) Equity Capitalization Rate (ke)

Market Value of Equity (S) = NI/Ke Market Value of Debt (B)

Total Value of the firm (S+B) = V

6,00,000 2,50,000
----------------------------8,50,000 11.76%

Overall cost of capital = Ko = EBIT/V (%) If debt is increased, S will fall. But V will increase and Ko will reduce

NET OPERATING INCOME APPROACH

The essence of this approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

Assumptions of net operating income

Overall cost of capital is constant Residual value of Equity: Total market value of equity capital = V - B Changes in cost of equity capital: Ke increases with the degree of leveraging.

EXAMPLE

A companys expected annual EBIT is Rs. 100000. The company has Rs 2,50,000, 10% debentures. The cost of equity of the company is 12.5%.

Ke = (EBIT I)/(V B) = Earnings available to equity holders/Total market value of equity shares

SOLUTION
Net Operating Income (EBIT) Overall capitalisation rate (Ko) Rs. 1,00,000 0.125 ------------------------Rs 8,00,000 Rs 2,50,000

Total market value of the firm (V) = EBIT/Ko Total Value of Debt

Total Market Value of Equity(S) = (V B)

Rs 5,50,000

Total MV of firm (V) will be unaffected with increased debt

Ke= EBIT-I/V-B
100000-25000/550000= 13.63%

Ko = kd(b/v) + ke(s/v) = 0.10(250000/800000) + 0.1363(550000/800000)= 12.5%

MM APPROACH
MM approach supports the NOI approach, it means capital structure and cost of capital is irrelevant to value of the firm. Basic Propositions of the MM approach -- The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. -Ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt.

Arbitrage Process

The MM approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other does not.
To understand the process let us have an example

EXAMPLE

Assume there are two firms, L and U, which are identical in all respects except the firm L has 10% Rs 5,00,000 debentures. The EBIT of both the firms are equal, that is, Rs 1,00,000. The equity capitalization rate (Ke) of firm L is higher (16%) than that of firm U (12.5%).
Solution:

Particulars EBIT Less interest Earnings available to ES

Firm L 100000 50000 50000

Firm U 100000 100000

ke Total market value of equity

0.16 312500

0.125 800000

Total market value of debt 500000

Total market value

812500

800000

ko

0.123

0.125

Traditional approach
At optimum capital structure, marginal real cost of debt=marginal real cost of equity Firm can reduce its cost of capital significantly with initial use of leverage

Example
20% debt 80% equity Kd=10% Ke=15%

Solution
Ko=0.10(20/100) +0.15(80/100)= 14%

Increase debt to 50% Kd=11% Ke=16% Ko=13.5% Increase debt to 70% Kd=14% Ke=20% Ko=15.8%

THANK YOU