Capital Structure Theories

1. Meaning of Capital structure:

a. It means finding the relative composition of debt-equity of the company.
b. It is also known as financial structure of the company.
c. Since debt is used along with the equity, it is known as trading on equity and the
term trading on equity is driven from the fact that it is the equity which is used to
raise the debt.
2. Meaning of optimum capital structure:
a. Theoretically, optimum capital structure is one where EPS and market value of share
is maximum but marginal cost of each source of fund is minimum.
b. Practically, there is no optimum capital structure. And the word Optimum is not
realistic also. Better to say appropriate capital structure.
3. Factors determining the capital structure:
a. Basically risk, control and cost are the three factors affecting the capital structure
but there are other factors also.
b. Minimization of Risk :
i. Capital structure must be consistent with business risk.
ii. It should result in a certain level of financial risk.
c. Control: It should reflect the managements philosophy of control over the firm.
d. Flexibility: It refers to the ability of the firm to meet the requirements of the
changing situations.
e. Profitability: It should be profitable from the equity shareholders point of view.
f. Solvency: The use of excessive debt may threaten the solvency of the company.
g. Cost: it refers to the overall cost capital. If it is less, the capital structure is
appropriate.
4. Capital structure theories:
a. Net income approach (NI)
b. Net operating income approach (NOI)
c. Traditional approach
d. Modigilani and Miller Approach (MM)
Net income Approach
5. Net income approach:
a. According to this approach, the weighted average cost of capital is depended on the
capital structure.
b. So by changing the debt equity ratio, firms cost and value can be changed.
c. Assumptions of this approach:
i. Kd < Ke
ii. No change in risk
iii. There are no corporate taxes.
d. Since net income means after tax earnings and while net operating income means
pretax earnings. But sine this method assumes no taxes. So NI = NOI. But whenever
debt is there in the question then Net income = NOI - interest
Effect
on
K0

Increase in leverage

Decrease in leverage

Decrease (by using less expensive debt)

Increase ( since we using more

expensive equity)
Decrease (since K0 is increased)

Value of
Increase (since K0 is decreased)
firm
Leverage means using borrowed funds. In above table since you are borrowing funds so
that must be cheaper. This is assumed.
6. Steps involved in calculating the weighted average cost of capital under Net income
approach:

a. MV of equity share =
b. MV of debt =

Net income
Ke

Net operating incomeinterest

Ke

Interest
rate of interest

c. Total value of firm = MV of equity + MV of debt

d. Weighted average cost of capital K0 =

Net operating income

Total value of the firm

Net Operating income approach

7. Net operating income approach:
a. According to this approach, K0 is independent of its capital structure. That means by
changing the debt equity ratio, a firm cannot change its value and cost of capital.
b. Assumptions of NOI approach:
i. Kd and K0 are constant.
ii. Split of market capitalization into debt and equity is insignificant since K 0
doesnt affect the value and cost of capital.
iii. There are no taxes.
iv. Neutralization :Using the less expensive debt, implicit cost (interest) and
explicit cost (increase hopes of ESH due to increase in risk since debt is
raised) are neutralized
Effect of increase in leverage
Effect on
Effect
Reason
Ke
increas High debt increases risk for ESH, so to compensate K e get increased
e
due to ESH hopes
K0
Consta Due to assumption of neutralization
nt
Total Value of
consta Since K0 is content
firm
nt
Decrease in leverage, would have same consequences expect that K e will decrease.
8. Steps for calculating the Ke:
a. Total value of firm =

NOI
K0

b. Total value of debt =

interest
interest rate

c. Value of equity = firms value debt value

d. Ke =

Net income
Value of equity

Net incomeinterest
Value of equity

Traditional Approach
9. Traditional approach:
a. Traditional approach is intermediate of NI and NOI approach. Since it considers both
the approaches.
b. The calculation and steps involved in this approach are same as NI approach.
Modigilani and Millar approach
10.MM approach:
a. According to this approach, K0 is independent of its capital structure. That means by
changing the debt equity ratio, a firm cannot change its value and cost of capital.

b. If two firms are identical in all aspects except for the degree of leverage, firms will
have different MV so the arbitrage will start.
c. Assumptions:
i. There is perfect capital market.
ii. Homogenous risk class.
iii. No taxes
iv. All investors have same expectations.
v. Company has 100% payout ratio.
d. Criticism:
i. There is no perfect market.
ii. Arbitrage may fail.
iii. Existence of corporate tax.
11.Before starting the problem, calculate the total value of Unlevered firm and Levered firm::
a. Calculation of total value of unlevered firm when there are no taxes:
i. Value of unlevered firm = NOI / Ke
ii. In case of unlevered firm, there is no debt so the question of K d doesnt arise
thats Ke = K0
b. Calculation of value levered firm when there are taxes:
i. Value of levered firm can be calculated only when the taxes are given.
ii. Value of unlevered firm when there are taxes = (NOI taxes) / K e
iii. Value of levered firm = Value of unlevered firm + tax saving ( tax paid on
debt)
When there are no taxes
Particulars

When there are taxes

Amou
nt

1.
2.
3.
4.
5.
6.

NOI
Less : Interest
NI
K0
Total Value of firm (NOI / K0)
Less: MP of debt (Interest /
rate)
7. MP of Equity
8. Ke ( NI / MP of equity)

12.Arbitrage process under MM approach:

a.

Particulars
1. Value of unlevered firm (NOI (1
t) / Ke)
2. Add: tax saving on interest on
debt
3. Total value of firm (1+2)
4. Less : MP of debt (interest /
rate)
5. MP of equity (3 4)
6. Ke (NOI interest)(1 tax) / MP
of equity

Amou
nt