Capital Structure

Capital Structure concept

Capital Structure planning
Concept of Value of a Firm
Significance of Cost of
Capital (WACC)
Capital Structure
Coverage
Capital Structure theories
Net Income
Net Operating Income
Modigliani-Miller
Traditional Approach
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders expectations
(risk & returns) and capital requirements of the firm.
Capital Structure
Planning the Capital Structure
Important Considerations
Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
Risk: insolvency risk associated with high debt component.
Control: avoid dilution of management control, hence debt
preferred to new equity shares.
Flexible: altering capital structure without much costs & delays,
to raise funds whenever required.
Capacity: ability to generate profits to pay interest and principal.
Value of a firm depends upon earnings of a firm and its
cost of capital (i.e. WACC).
Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
Value of firm is derived by capitalizing the earnings by its
cost of capital (WACC). Value of Firm = Earnings / WACC
Thus, value of a firm varies due to changes in the earnings
of a company or its cost of capital, or both.
Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders earnings.
Value of a Firm directly co-related with
the maximization of shareholders wealth.
Factors Determining Capital Structure
- Trading on Equity- The word equity denotes the ownership of the
company. Trading on equity means taking advantage of equity share
capital to borrowed funds on reasonable basis. It refers to additional
profits that equity shareholders earn because of issuance of debentures
and preference shares. It is based on the thought that if the rate of
dividend on preference capital and the rate of interest on borrowed
capital is lower than the general rate of companys earnings, equity
shareholders are at advantage which means a company should go for a
judicious blend of preference shares, equity shares as well as debentures.
Trading on equity becomes more important when expectations of
shareholders are high.

Factors Determining Capital Structure
- Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting
rights in a concern as compared to the preference shareholders and debenture
holders. Preference shareholders have reasonably less voting rights while
debenture holders have no voting rights. If the companys management policies
are such that they want to retain their voting rights in their hands, the capital
structure consists of debenture holders and loans rather than equity shares.
- Flexibility of financial plan- In an enterprise, the capital structure should be
such that there is both contractions as well as relaxation in plans. Debentures and
loans can be refunded back as the time requires. While equity capital cannot be
refunded at any point which provides rigidity to plans. Therefore, in order to
make the capital structure flexible, the company should go for issue of debentures
and other loans.

Factors Determining Capital Structure
- Choice of investors- The companys policy generally is to have different
categories of investors for securities. Therefore, a capital structure should give
enough choice to all kind of investors to invest. Bold and adventurous investors
generally go for equity shares and loans and debentures are generally raised
keeping into mind conscious investors.
- Capital market condition- In the lifetime of the company, the market price of
the shares has got an important influence. During the depression period, the
companys capital structure generally consists of debentures and loans. While in
period of boom and inflation, the companys capital should consist of share
capital generally equity shares.

Factors Determining Capital Structure

- Period of financing- When company wants to raise finance for short period, it
goes for loans from banks and other institutions; while for long period it goes for
issue of shares and debentures.

- Cost of financing- In a capital structure, the company has to look to the factor of
cost when securities are raised. It is seen that debentures at the time of profit
earning of company prove to be a cheaper source of finance as compared to
equity shares where equity shareholders demand an extra share in profits.

Factors Determining Capital Structure
- Stability of sales- An established business which has a growing market and high
sales turnover, the company is in position to meet fixed commitments. Interest on
debentures has to be paid regardless of profit. Therefore, when sales are high,
thereby the profits are high and company is in better position to meet such fixed
commitments like interest on debentures and dividends on preference shares. If
company is having unstable sales, then the company is not in position to meet
fixed obligations. So, equity capital proves to be safe in such cases.
- Sizes of a company- Small size business firms capital structure generally consists
of loans from banks and retained profits. While on the other hand, big companies
having goodwill, stability and an established profit can easily go for issuance of
shares and debentures as well as loans and borrowings from financial institutions.
The bigger the size, the wider is total capitalization.

Particulars Rs.
Sales (A) 10,000
(-) Cost of goods sold (B) 4,000
Gross Profit (C = A - B) 6,000
(-) Operating expenses (D) 2,500
Operating Profit (EBIT) (E = C - D) 3,500
(-) Interest (F) 1,000
EBT (G = E - F) 2,500
(-) Tax @ 30% (H) 750
PAT (I = G - H) 1,750
(-) Preference Dividends (J) 750
Profit for Equity Shareholders (K = I - J) 1,000
No. of Equity Shares (L) 200
Earning per Share (EPS) (K/L) 5
An illustration of
Income Statement
ASSUMPTIONS
Firms use only two sources of funds
equity & debt.
No change in investment decisions of
the firm, i.e. no change in total assets.
100 % dividend payout ratio, i.e. no
retained earnings.
Business risk of firm is not affected by
the financing mix.
No corporate or personal taxation.
This assumption is removed later.
Investors expect future profitability of
the firm.
Capital Structure Theories
Capital Structure Theories
A) Net Income Approach (NI)
Net Income approach (By Durand) proposes that there is a
definite relationship between capital structure and value of
the firm.
The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
NI approach assumptions
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (K
d
) is less than cost of equity (K
e
) [i.e. K
d
< K
e
]
o Corporate income taxes do not exist.

Capital Structure Theories
A) Net Income Approach (NI)
As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Earnings (EBIT) being constant and Ko (Weighted average cost
of capital) is reduced, the value of a firm will always increase.
Thus, as per NI approach, a firm will have maximum value at a
point where WACC is minimum, i.e. when the firm is almost
debt-financed.

Capital Structure Theories
A) Net Income Approach (NI)
According to net income approach, the value of the firm and the value
of equity are determined as given below:
Value of Firm (V) = S + B
Where, S= Market value of Equity
B= Market Value of Debt
Market Value of Equity (S) = NI/Ke
Where, NI = Net income available for equity shareholders
Ke = Equity capitalisation rate
Overall capitalisation rate(Ko) = EBIT/V
Where, EBIT= Earnings before interest & tax
V= Value of firm


Capital Structure Theories
A) Net Income Approach (NI)
ke
ko
kd
Debt
Cost
kd
ke, ko
As the proportion of
debt (K
d
) in capital
structure increases,
the WACC (K
o
)
reduces.
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Kd = 6%
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000
Ke 10% 10% 10%
Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)
Value of Debt 500,000 700,000 200,000
Total Value of Firm 2,200,000 2,280,000 2,080,000
WACC 9.09% 8.77% 9.62%
(EBIT / Value) * 100
Capital Structure Theories
A) Net Income Approach (NI)
Capital Structure Theories
B) Net Operating Income (NOI)
Net Operating Income (NOI) approach is the exact opposite
of the Net Income (NI) approach.
As per NOI approach, value of a firm is not dependent upon
its capital structure.
Assumptions
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (K
d
) is constant.
o Corporate income taxes do not exist.
Capital Structure Theories
B) Net Operating Income (NOI)
NOI propositions (i.e. school of thought)
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (K
e
)

A higher cost of equity (K
e
) nullifies the advantages gained
due to cheaper cost of debt (K
d
)

In other words, the finance mix is irrelevant and does not
affect the value of the firm.
Capital Structure Theories
B) Net Operating Income (NOI)
The NOI approach believes that the market value of the firm as a whole for a
given risk complexions. Thus for a given value of EBIT, the value of the firms
remains the same irrespective of the capital compositions, and instead depends
on the overall cost of capital.
Value of Firm (V) = EBIT/Ko
Where, EBIT = Earnings before interest and tax
Ko = Overall Cost of capital
Value of Equity (S) = V B
Where, V = Value of firm
B = Value of debt
Equity capitalisation rate(Ke) = (EBIT-I)/(V-B)
Where, V = Value of firm EBIT= Earnings before interest & tax
B = Value of debt I= Interest

Capital Structure Theories
B) Net Operating Income (NOI)
Cost of capital (K
o
)
is constant.
As the proportion
of debt increases,
(K
e
) increases.
No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%
Value of the firm 2,000,000 2,000,000 2,000,000
Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000
Interest @ 6 % 18,000 24,000 30,000
EBT (EBIT - interest) 182,000 176,000 170,000
Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
Capital Structure Theories
B) Net Operating Income (NOI)
Capital Structure Theories
C) Modigliani Miller Model (MM)
According to Modigilani & Miller cost of capital is
independent of capital structure and there is no optimal
value. According to them, under competitive conditions and
perfect markets, the choices between equity financing and
borrowing does not affect firms market value because the
individual investor can alter investment to any mix of debt
and equity the investor desires. MM argues that a companys
WACC remains unchanged at all levels of gearing, implying
that no optimal capital structure exist for a particular
company.
Assumptions
1. The MM theory is based on the following assumptions:
1. The capital market is assumed to be perfect. It means that
both investors and individuals can borrow unlimited amounts at the
same rate of interest. There are no limits of borrowing.
2. The investors are free to sell and buy securities and are well
informed about the risk and return involved in different securities.
All securities are infinitely divisible.
3. There are no transaction costs. There are no brokerage or other
transaction cost.
4. The debt is less expensive than equity. Increase in debt will increase
the financial risk of the firm and expectations of equity holders will
be more. Thus the average cost of capital will remain constant for
all levels of leverage.




5. There is no benefit of debt financing other than reduction in corporate
income taxes due to tax shield of interest payments of debt.
6. Interest rates are equal between borrowing and lending for firms as well
as individuals.
7. The firms investments and cash flows are assumed to be constant.
9. The stock market is perfectly competitive.
10. The investors are rational and expect other investors to behave
rationally.
11. The dividend payout ratio is 100% i.e. there are no retained earnings.








Capital Structure Theories
C) Modigliani Miller Model (MM)
MM Model proposition
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC
MM Theory : No Taxation
The debt is less expensive than equity. An increase in debt will
increase the required rate of return on equity. With the increase in
the level of debt, there will be higher level of interest payments
affecting the cash flows of company. Then equity shareholders
demand for more returns. The increase in cost of equity is just
enough to offset the benefit of low cost debt, and consequently
average cost of capital is constant for all levels of leverage.


There are three basic propositions of
MM approach:

Propositions I : The overall cost of capital (ko) and the value of the
firm (V) are independent of its capital structure..The Ko and V are
constant at all degrees of leverage. The total value is given by
capitalizing the expected stream of operating earning s at a discount
rate appropriate for its risk class.
WACC is independent of the debt/equity ratio and equal to
the cost of capital which the firm would have with no gearing in
its capital structure.

- Proposition 2
This asserts that the rate of return required by shareholders increases
linearly as the D/E ratio increases i.e. the cost of equity increases
exactly in line with any increase in gearing to precisely offset any
benefits conferred by the use of apparently cheap debt. MM went on
arguing that the expected return on the equity of a geared company is
equal to the return on equity stream plus a risk premium dependent on
the capital structure.

- Proposition 3
MM theorys third proposition asserts that the cut off rate for new
investment will in all cases be average cost of capital and will be
unaffected by the type of security used to finance the investment. The
cut off rate for investment purposes is completely independent of the
way in which an investment is financed. This implies a complete
separation of investment and financing decisions of the firm.

Capital Structure Theories
C) Modigliani Miller Model (MM)
MM Model proposition
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, arbitrage process will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.
MM Model without taxes (In Brief)
- The firms capital structure is irrelevant.
- The WACC is the same no matter what mixture of debt and equity is
used to finance the firm., and
- Cost of Equity (Ke) = Ko +(Ko-Kd)D/E. It implies that cost of equity
rises as the firm increases use of debt.
MM Theory : With Taxation
- The value of levered firm is equal to the value of unlevered firm + the
present value of the interest tax shield i.e.,
Vl = Vu+D(t)
So debt financing is advantageous and it increases the value of firm.
- The WACC of the firm decreases, as the firm relies more and more on
debt financing.
- The cost of equity, Ke= Ko+(Ko-Kd)(D/E)(1-t)
Where Ko is the WACC of the unlevered firm.


Capital Structure Theories
C) Modigliani Miller Model (MM)
Levered Firm
Value of levered firm = Rs. 110,000
Equity Rs. 60,000 + Debt Rs. 50,000
K
d
= 6 % , EBIT = Rs. 10,000,
Investor holds 10 % share capital

Un-Levered Firm
Value of un-levered firm = Rs. 100,000 (all equity)
EBIT = Rs. 10,000 and investor holds 10 % share capital
Capital Structure Theories
C) Modigliani Miller Model (MM)
( ) ( )
( )
Return from Levered Firm:
10 110, 000 50 000 10% 60, 000 6 000
10% 10, 000 6% 50, 000 1, 000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
= = =
= = = (

=
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
=
=
=
= =
= =
= =
sh available 11,000 10,000 1,000 = =
Capital Structure Theories
D) Traditional Approach
The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
Traditional approach (intermediate approach) is a compromise
between these two extreme approaches.
Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
Capital Structure Theories
D) Traditional Approach
The approach works in 3 stages
1) Value of the firm increases with an increase in borrowings
(since K
d
< K
e
). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders
risk (financial risk) and hence K
e
increases. K
d
also rises due
to higher debt, WACC increases & value of firm decreases.
Capital Structure Theories
D) Traditional Approach
ke
ko
kd
Debt
Cost
Cost of capital (K
o
)
is reduces initially.
At a point, it settles
But after this point,
(K
o
) increases, due
to increase in the
cost of equity. (K
e
)
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
Capital Structure Theories
D) Traditional Approach

1.A firm is expected to generate net operating earnings of Rs.20,00,000
which market capitalizes at that rate ke, at 20%. Assume that it has Rs.
25,00,000 in debt at 16% interest, given this information, calculate value
of firm using NI Approach.

2. Assuming no taxes and given the earning before interest and
taxes(EBIT), Interest (I), at 10% and equity capitalization rate (K),
below, calculate the total market value of each firm Using NI Approach:


Firms EBIT I K
X 2,00,000 20,000 12%
Y 3,00,000 60,000 16%
Z 5,00,000 2,00,000 15%
W 6,00,000 2,40,000 18%
Also determine the weighted average cost of capital for each firm.

3. (a) A company expects a net income of Rs.80,000. It has Rs. 2,00,000 ,
8% Debentures. The equity capitalization rate of the company is 10%.
Calculate the value of the firm and overall capitalization rate according
to Net Income Approach (ignoring tax).
(b) If the debenture debt is increases to Rs. 3,00,000, what shall be the
value of firm.

4. The operating income of a firm is Rs. 50,000. The cost of debt is 10%.
Outstanding debt is Rs. 2,00,000. If the overall cost of capital is 12.5%,
what would be the total value of the firm and the equity capitalization
rate?

5. (a) A company expects a net operating income of Rs. 1,00,000. It has
Rs. 5,00,000 6% debentures. The overall capitalization rate is 10%.
Calculate the value of the firm and the equity capitalization rate
according to Net Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000. What will be the
effect on the value of the firm and equity capitalization rate?
6. Summer Ltd. And Winter Ltd. are identical in all respects including risk factor
except for Debt/ Equity Mix. Summer Ltd. having issued 12% debentures of Rs. 30
lakhs, while winter Ltd. issued only equity capital. Both the companies earn 24%
before interest and taxes on their total assets of Rs. 50 lakhs. Assuming the
corporate effective tax rate of 40% and capitalization rate of 18% for an all equity
company.
Compute the value of summer Ltd. and Winter Ltd. using (i) Net Income Approach
and (ii) Net operating income approach.

7. (a) A firm has EBIT of Rs. 40,000. The firm has 10% debentures of Rs. 1,00,000
and its current equity capitalization rate is 16%. Calculate current value of firm and
overall cost of capital using traditional approach.
(b) If firm is considering to increase its leverage issuing additional Rs. 50,000
debenture and using the proceeds to retire that amount of equity. However if firm
increases proportion of debt Ki would rise to 11% and Ke to 17%. What will be the
effect on the value of the firm and overall capitalization rate?
(c) If firm is considering to increase its leverage issuing additional Rs. 1,00,000
debenture and using the proceeds to retire that amount of equity. Due to increased
financial risk , Ki would rise to 12.5% and Ke to 20%. What will be the effect on
the value of the firm and overall capitalization rate?
8. Companies U and L are identical in every aspect, except that the
former does not use debt in its capital structure, while the later employs
Rs. 6,00,000 of 15% debt. Assuming that:

a. All the MM assumptions are met
b. Corporate tax rate is 50%
c. The EBIT is Rs. 2,00,000
d. The equity capitalization of the unlevered company is 20%,

What will be the value of firms U & L? Also determine the weighted
average cost of capital for both the firms.
9. The following is the data regarding two companies X and Y
belonging to the same equivalent risk class:
Company X Company Y
Number of ordinary Shares 90,000 1,50,000
Market Price per share Rs. 1.2 Rs. 1
6% Debentures 60,000 ------
Profit before interest Rs. 18000 Rs. 18000
All profit after debentures interest are distributed as dividends.
Explain how under Modigilani & Miller approach, an investor
holding 10% of shares in Company X will be better off in
switching his holding to Company Y.
(MU MMS 2010)

10. The two companies, Q & R, belong to an equivalent risk class. These two firms
are identical in every respect except that Q company is unlevered while Company R
has 10% debentures of Rs. 30 lakh. The other relevant information regarding their
valuation and capitalization rates are as follows:
Particulars Firm P Firm Q
EBIT 7,50,000 7,50,000
Less: Interest 3,00,000
EATESH 7,50,000 4,50,000
Ke 0.15 0.2
Market Value of Equity (S) 50,00,000 22,50,000
Market Value of Debt (B) 30,00,000
Total Value of Firm (V=S+B) 50,00,000 52,50,000
Implied overall cost of capital(Ko) 0.15 0.143
Debt Equity Ratio (B/S) 0 1.33
a. An investor owns 10% equity share of company Q. Show the arbitrage process
and the amount by which he could reduce his outlay through the use of
leverage.
b. According to Modigilani & Miller, when will this arbitrage process come to an
end?
11. The companies ACC Cements and Dalmia Cements belong to
same risk class and are identical in every fashion except ACC Cements
uses debt while Dalmia Cement does not. The leveraged company has
Rs.9,00,000 debenture carrying 10% rate of interest. Both firms earn
20% before interest and taxes on their total assets of Rs. 30 lakhs.
Assume perfect capital market, rational investors and so on; Both
companies pay tax at 40% and capitalization rate for an all equity
company is 15%.

You are required to:
a. Compute the value of the two firms using the Net Income and
Modigilani-Miller Approach.
b. Using the M.M. approach, Compute the overall capitalization rate
for both the companies.
(MU MMS 2011)

12. Following information is available from the books of XYZ Ltd:
Rs. in Lakhs
Sales 500
Cost of Raw Materials 200
Labour cost of manufacturing 100
Interest on Borrowings 60
The capitalization rate for debt is 10% and the capitalization rate for the entire firm is
12.5%. Assuming that the firm does not retain any earnings and there is no tax, As per
NOI approach:
a. What is the total market value of firm?
b. What is the market value of debt of the firm?
c. What is the market value of the equity of the firm?
d. What is the equity capitalization rate?
(MU MMS 2009)