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Capital Structure Theories

In this chapter

Net income and net operating income approaches Optimal capital structure Factors affecting capital structure EBIT/EPS and ROI & ROCE Analysis Capital Structure Policies in practice

Capital Structure

Capital structure includes only long term debt and total stockholder investment. Capital Structure = Long Term Debt + Preferred Stock + Net Worth OR Capital Structure = Total Assets Current Liabilities.

Optimal Capital Structure

It is that capital structure at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum. Features:

Profitability solvency Flexibility Conservation control

Determinants / Factors affecting Capital Structure

The benefit of debt. Control Seasonal variations Industry life cycle. Company characteristics Requirement of investors Purpose of finance

Flexibility Industry leverage ratios Degree of competition Agency cost Timing of public issue Period of finance Legal requirements.

Patterns of Capital Structure




Complete equity share capital; Different proportions of equity and preference share capital; Different proportions of equity and debenture (debt) capital an Different proportions of equity, preference and debenture (debt) capital.

EBIT EPS Approach

In this approach, it is analyzed that how sensitive is EPS to the changes in EBIT under different capital structure.

ROI ROE Approach

This approach analyses the relationship between the ROI and ROE for different levels of financial leverage.

Theories of Capital Structure

Net Income Approach Net Operating Income Approach Modigliani and Miller Approach [MM Hypothesis] Traditional Approach.

Assumptions of Capital Structure Theories

Firm uses only two sources of funds: perceptual riskless debt and equity; There are no corporate or income: or personal tax; The dividend payout ratio is 100% [There are no retained earnings]; The firms total assets are given and do not change [Investment decision is assumed to be constant]. The firms total financing remains constant. [Total capital is same, but proportion of debt and equity may be changed]; The firms operating profits (EBIT) are not expected to grow; The business risk is remained constant and is independent of capital structure and financial risk; All investors have the same subject probability distribution of the expected EBIT for a given firm; and The firm has perpetual life;

Definitions used in Capital Structure

E = Total Market Value of Equity. D = Total Market Value of Debt. V = Total Market Value of the Firm. I = Annual Interest payment. NI = Net Income. NOI = Net Operating Income. Ee = Earning Available to Equity Shareholder.

Net Income Approach

A change in the proportion in capital structure will lead to a corresponding change in Ko and V. Assumptions:
(i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the perception of investors. (iv) Cost of debt and cost of equity remains constant;


Net Income Approach

Formula used for NI Approach

Net Income [NI] = EBIT Debenture Interest. Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D] Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke] Cost of Capital [Ko] = EBIT / V * 100

Net Operating Income Approach

There is no relation between capital structure and Ko and V. Assumptions:

(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. (ii) The market capitalises the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity; (iii) The market value of equity is residue [i.e., Total value of the firm minus market value of debt) (iv) The use of debt funds increases the received risk of equity investors, there by ke increases (v) The debt advantage is set off exactly by increase in cost of equity. (vi) Cost of debt (Ki) remains constant (vii) There are no corporate taxes.

Net Operating Income Approach

Formula used for NOI Approach

Value of the Firm [V] = EBIT / Ko Market Value of Equity [E] = V D Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT I / V - D

MM Hypothesis

This approach was developed by Prof. Franco Modigliani and Mertan Miller. According to this approach, total value of the firm is independent of its capital structure.

a. b. c. d.

f. g.


Information is available at free of cost The same information is available for all investors Securities are infinitely divisible Investors are free to buy or sell securities There is no transaction cost There are no bankruptcy costs Investors can borrow without restrictions as the same terms on which a firm can borrow Dividend payout ratio is 100 percent EBIT is not affected by the use of debt

I. Ko and V are independent of capital structure II. Ke = to capitalisation rate of the pure equity plus a premium for financial risk. Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt) III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.

MM Approach [Proposition I] arbitrage Progress:

Refers to an act of buying an asset or security in one market at lower price and selling it is an other market at higher price. Steps in working out Arbitrage Process: Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return). Step 2: Calculation of Savings in Investment by moving from levered firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm. Step 3: Calculation of Increased Income, by investing total funds available.

Limitations of MM Approach

Investors cannot borrow on the same terms and conditions of a firm Personal leverage is not substitute for corporate leverage Existence of transaction cost Institutional restriction on personal leverage Asymmetric information Existence of corporate tax

Traditional Approach

This approach was given by Soloman. This approach is the midway between NI Approach and NOI Approach. Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital

Main Prepositions
1. The pretax cost of debt (Ki) remains more or less constant up to a certain degree of leverage and /but rises thereafter of an increasing rate 2. The cost of equity capital (Ke) remains more or less constant rises slightly up to a certain degree of leverage and rises sharper there after, due to increased perceived risk. 3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I increasing firm value]; (b) Remains more or less unchanged for moderate increase in leverage thereafter [stage II optimum value of firm], and

(c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].