UNIT-4

CAPITAL STRUCTURE AND

VALUATION

CAPITAL STRUCTURE
Capital Structure Theories
Net Income Approach
Net Operating Income (NOI)
Approach
Modigliani-Miller (MM) Approach
Traditional Approach
Solve Problems

Capital Structure

Capital structure is the proportion of debt and

preference and equity shares on a firms
balance sheet.
Optimum capital structure is the capital
structure at which the weighted average cost of
capital is minimum and thereby maximum value
of the firm.

Capital structure theories explain the theoretical

relationship between
capital structure,
overall cost of capital (k0) and
valuation (V).

The four important theories are

1)

2)

Net income (NI) approach,

Net operating income (NOI)
approach,

3) Modigliani and
approach and

Miller

4) Traditional approach.

(MM)

Net Income Approach

According to the NI approach, capital structure is
relevant as it affects the k0 and V of the firm.
The core of this approach is that as the ratio of less
expensive source of funds (i.e., debt) increases in the
capital structure, the k0 decreases and V of the firm
increases.
With a judicious mixture of debt and equity, a firm can
evolve an optimum capital structure at which the k0
would be the lowest, the V of the firm the highest and
the market price per share the maximum.

Basic assumptions

There are no taxes on companies.

The cost of debt is less than the cost of
equities.
A change in the ratio of debts to equity
does not affect the degree of risk that
the investors bear. In other words
whatever may be the ratio of debts to
equity, the cost of debts as also the cost
of equity capital remain constant.

Ke, ki and k0 (%)

ke
15.0
k0

10.0

ki
5.0
X
0

0.5
Degree of Leverage (B/V)

Figure 1: Leverage and Cost of Capital (NI Approach)

1.0

Net Operating Income (NOI)

Approach
The NOI approach is diametrically opposite to the NI
approach. The essence of this approach is that capital
structure decision of a corporate does not affect its cost of
capital and valuation, and, hence, irrelevant.
The NOI Approach
propositions.

is

based

on

the

following

Overall Cost of Capital/Capitalisation Rate (k0) is Constant

The NOI Approach to valuation argues that the overall capitalisation
rate of the firm remains constant, for all degrees of leverage. The
value of the firm, given the level of EBIT, is
V = (EBIT/ko)

. Due to the assumption that k0 and ki remain unchanged as the degree of

leverage changes, we find that both the curves are parallel to the x-axis. But as
the degree of leverage increases, the ke increases continuously.

Y
25.0

Ke, ki and k0 (%)

20.0
ke
15.0
k0

10.0

ki
5.0
X
0

0.5

1.0

Degree of Leverage (B/V)

Figure 2: Leverage and Cost of Capital (NOI Approach)

Modigliani-Miller (MM)
Approach
Modigliani and Miller (MM) concur with NOI and
provide a behavioural justification for the
irrelevance of capital structure. They maintain
that the cost of capital and the value of the firm
do not change with a change in leverage.

Traditional Approach
The traditional approach is mid-way between the two
extreme (the NI and NOI) approaches.
The crux of this approach is that through a judicious
combination of debt and equity, a firm can increase its
value (V) and reduce its cost of capital (k0) upto a
point.
However, beyond that point, the use of additional debt
will increase the financial risk of the investors as well
as of the lenders and as a result will cause a rise in
the k0. At such a point, the capital structure is
optimum. In other words, at the optimum capital
structure the marginal real cost of debt (both implicit
Tata McGraw-Hill
and
explicit) will be equal to the real cost
of Company
equity.
Publishing
19-12
Limited, Financial
Management

The traditional view on leverage is commonly referred to as one of U

shaped cost of capital curve (as shown in Fig. 5). In such a situation, the
degree of leverage is optimum at a point at which the rising marginal cost
of borrowing is equal to the average overall cost of capital. For this
purpose, marginal cost of a unit of debt capital consists of two parts: (i) the
increase in total interest payable on debt; (ii) the amount of extra net
earnings required to restore the value of equity component to what it
would have been under the pre-existing capitalisation rate before the debt
is increased.

Ke, ki and k0 (%)

ke
k0
ki

x
Degree of Leverage (B/V)

Figure 5: Leverage and Cost of Capital (Traditional Approach)

SOLVE PROBLEMS