Theories of Capital Structure

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By: Anika Chandra Bilal Ahmad Dar Uzma Manzoor Dar Utkarsh Singh Sissodia

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Capital Structure theories

Net Income Approach Operating Income Approach Miller Approach Approach

Net

Modigliani Traditional

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Net Income approach

This This

approach is given by Durand David approach is based on three assumptions:

There are no taxes Cost of debt is less than the cost of equity Use of debt does not change the risk perception of the investor. to this approach, the capital structure decision is relevant to the valuation of the firm.

According

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Contd
A

change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. higher debt content in the capital structure means a high financial leverage and this results in the decline in the overall weighted average cost of capital and therefore there is increase in the value of the firm. with the cost of debt and the cost of equity being constant, the increased use of debt (increase in leverage), will magnify the share holders earnings and, thereby, the market value of the ordinary shares.

Thus,

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V = (S+B)
V S B

= value of the firm = Value of the equity = Value of the debt is no taxes

Assumptions
There

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NIA

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Example
A

companys expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000 @ 10% debentures. The equity capitalization rate (ke) 12.5%.

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Example Rs.
Net Operating Income (EBIT) 50000 (Less) Interest on 20000 PBT ( no tax so) PAT (NI) 30000 Ke Value of equity (S) [ NI/Ke) 240000 0.125

Net Operating Income (EBIT) (Less) Interest on PBT ( no tax so) PAT (NI) Ke Value of equity (S) [ NI/Ke) Value of debt (B) Value of the firm [S+B]

Suppose, the company raises the debt by 100000 i.e., Rs.300000

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50000

30000 20000 0.125 160000 300000 460000 10.9%

Overall cost of capital Ko = EBIT/V

Thus, the Ko differs when the Debt differs.

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Net Operating Income Approach

This NOI

is another theory suggested by Durand approach is opposite to NI approach

According

to NOI approach value of the firm is independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage

Any

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Assumptions
The

investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchanged cost of debt (kd) is also constant is no tax

The

The The

There

use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke)

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Example
A

companys expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000 @ 10% debentures. The Overall cost of capitalization rate (ko) 12.5%.

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Example
Net Operating Income (EBIT) Overall cost of capital (Ko)

Rs.
50000 0.125 400000 200000 200000

Value of the firm [ EBIT/ Ko ] Value of the debt (B) Value of the equity (S) = V-B Ke = Eps / Value of Equity shares Eps = EBIT I = 50000 20000 = 30000/200000 = Ko = K [B/V ]+ Ke [S/V]

0.15

=0.10 [ 200000/400000]+ .15 [200000/400000] = 0.125

Suppose, the company raise debt by 100000 i.e.., Rs.300000 Rs. Net Operating Income (EBIT)
50000 Overall cost of capital (Ko) 0.125 Value of the firm [ EBIT/ Ko ] 400000 Value of the debt (B) 300000 Value of the equity (S) = V-B 100000 Ke = Eps / Value of Equity shares Eps = EBIT I = 50000 30000 =

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