CAPITAL STRUCTURE

THEORY
USE OF FINANCIAL LEVERAGE –
INCREASES SHAREHOLDERS EXPECTED RETURNS
ALSO IT INCREASES RISK FOR SHAREHOLDERS

BECAUSE OF FINANCIAL LEVERAGE THE SHAREHOLDERS

WILL ALSO HAVE TO BEAR FINANCIAL RISK ALONG WITH
BUSINESS RISK
The question is:
Is the increase in expected return
sufficient to compensate the risk?
TO HELP ANSWER THIS QUESTION
IT’S USEFUL TO EXAMINE CAPITAL STRUCTURE
THEORY
THEORY DOES NOT PROVIDE INSIGHTS INTO THE EFFECTS OF
DEBT VERSUS EQUITY FINANCING
AN UNDERSTANDING OF “CAPITAL STRUCTURE THEORY”
WILL AID MANAGERS
IN ESTABLISHING THEIR FIRM’S
OPTIMAL CAPITAL STRUCTURE
 ASSUMPTIONS OF THE
THEORY
1. Firms employ only two types of capital: debt and equity
2. The degree of leverage can be changed by selling debt to
repurchase shares or selling shares to retire debt.
3. Investors have the same subjective probability distributions of
expected future operating earnings for a given firm.
4. The firm has a policy of paying 100 per cent dividends
5. The operating earnings of the firm are expected to be constant
6. The business risk is assumed to be constant and independent of
capital structure and financial risk
7. The corporate and personal income taxes do not exist (Though the
assumption is relaxed later)
 NET INCOME APPROACH
ACCORDING TO NET INCOME APPROACH:
THE FIRM CAN INCREASE ITS VALUE
OR
LOWER THE OVERALL COST OF CAPITAL
BY
INCREASING THE PROPORTION OF DEBT
IN THE CAPITAL STRUCTURE
 ASSUMPTIONS OF NET INCOME
APPROACH
1. The use of debt does not change the risk perception of investors; as
a result, the equity capitalisation rate, ke, and the debt
capitalisation rate kd, remain constant with changes in leverage
2. The debt capitalisation rate is less than the equity capitalisation rate
3. The corporate income taxes do not exist.
Assume that a firm has an expected annual net operating income of
Rs.200,000, an equity rate, ke, of 10% and Rs. 10,00,000 of 6% debt.
The value of the firm according to NET INCOME approach:
Net Operating Income NOI 2,00,000
Total cost of debt Interest= KdD, (10,00,000 x .06) 60,000
Net Income Available to shareholders, NOI – I 1,40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) 14,00,000
Market value of debt D (Rs. 60,000/.06) 10,00,000
Total 24,00,000

The cost of equity and debt are respectively 10% and 6% and are
Assumed to be constant under the Net Income
Approach
 Ko= NOI/V = 200,000/24,00,000 = 0.0833
Or
Ko = Kd (D/V) + Ke (S/V)
= 0.06 (10,00,000/24,00,000) + 0.10 (14,00,000/24,00,000)
= 0.025 + 0.0583 = 0.0833 or 8.33%

If the firm employs a debt or Rs.14,00,000 instead of Rs. 10,00,000

The value of the firm under NET INCOME approach will be
The value of the firm according to NET INCOME
approach:
Net Operating Income NOI 2,00,000
Total cost of debt Interest= KdD, (14,00,000 x .06) 84,000
Net Income Available to shareholders, NOI – I 1,16,000
Therefore:
Market Value of Equity (Rs. 116,000/.10) 11,60,000
Market value of debt D (Rs. 60,000/.06) 14,00,000
Total 25,60,000
Ko= NOI/V = 200,000/25,60,000 = 0.078125
Or
Ko = Kd (D/V) + Ke (S/V)
= 0.06 (14,00,000/25,60,000) + 0.10 (11,60,000/25,60,000)
= 0.03281+ 0.04531 = 0.07812 or 7.81%
 NET OPERATING INCOME
APPROACH
ACCORDING TO NET OPERATING APPROACH (NOI)
THE MARKET VALUE OF THE FIRM IS NOT AFFECTED
BY THE CHANGE IN CAPITAL STRUCTURE
THE WEIGHTED AVERAGE COST OF CAPITAL
IS SAID TO BE CONSTANT
 ASSUMPTIONS OF NOI
APPROACH
1. The market capitalises the value of the firm as
a whole. Thus, the split between debt and
equity is not important.
2. The market uses an overall capitalisation rate,
Ko to capitalise the net operating income. Ko
depends on the business risk. If the business
risk is assumed to remain unchanged, Ko is a
constant.
3. The use of less costly debt funds increases the
risk to shareholders. This causes the equity
capitalisation rate to increase. Thus the
 PROBLEM ON NOI
APPROACH
Assume that a firm has annual net operating income of Rs. 2,00,000, an
average cost of capital Ko, of 10 % and initial debt of Rs.10,00,000 at
6%

Net Operating Income, 2,00,000

Therefore:

Market value of the Firm, V = S + D = 2,00,000/0.10 = 20,00,000

Market value of the Debt, D -10,00,000
Market value of the Equity S = V – D 10,00,000
 Ko= NOI/V = 200,000/0.10 = 20,00,000
Here, Ke is not a constant as that in NI approach
It is computed by using the formula
Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10 – 0.06) 10,00,000/10,00,000
= 0.10 + 0.04 (1) = 0.14

To verify that the weighted average cost of capital is a constant:

Ko = Kd (D/V) + Ke (S/V)
= 0.06 (10,00,000/20,00,000) + 0.14 (10,00,000/20,00,000)
= 0.06 (0.50) + 0.14 (0.5)

= 0.03 + 0.07 = 0.10

 IF DEBT IS INCREASED FROM
10,00,000 TO 14,00,000
Ke is not a constant in NOI approach
It has to be computed by using the formula
With the increase in leverage the cost of equity tends to go up

Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10 – 0.06) 14,00,000/6,00,000
= 0.10 + 0.04 (2.33) = 0.1933 or 19.33%

To verify that the weighted average cost of capital is a constant:

Ko = Kd (D/V) + Ke (S/V)
= 0.06 (14,00,000/20,00,000) + 0.1933 (6,00,000/20,00,000)
= 0.06 (0.70) + 0.1933 (0.3)
= 0.042 + 0.05799 = 0.9999 or 10%
 THE TRADITIONAL VIEW
THIS IS ALSO KNOWN AS INTERMEDIATE APPROACH
IT IS A COMPROMISE BETWEEN THE NI & NOI APPROACH
ACCORDING TO THIS VIEW
THE VALUE OF THE FIRM CAN BE INCREASED OR THE COST
OF CAPITAL CAN BE REDUCED BY A JUDICIOUS MIX OF
DEBT AND EQUITY CAPITAL
THIS APPROACH IMPLIES THAT THE COST OF CAPITAL
DECREASES WITHIN THE REASONABLE LIMIT OF DEBT
AND THEN INCREASES THE WITH LEVERAGE
 TRADITIONAL VIEW
FIRST STAGE
In the first stage, the cost of equity rises less than proportionate to
cost of debt ie
It does not increase fast enough to offset the advantage of low cost
debt
During this stage the cost of debt, Kd, remains constant or rises
negligibly
on the assumption that the market views use of debt as a
reasonable policy
 SECOND STAGE
Once the firm has reached a certain degree of leverage,
A further increase in leverage will have a negligible effect on the
value, or the cost of the capital of the firm.

B’cause
The increase in the cost of equity due to the added financial risk
offsets the advantage of low cost debt.
At a specific point, the value of the firm will be maximum or the
cost of capital will be minimum
 THIRD STAGE
Beyond the acceptable limit of leverage, the value of the firm
decreases with leverage or the cost of the capital increases with
leverage

B’cause the investors perceive a high degree of financial risk and

increase equity capitalisation rate by more than to offset the
advantage of low cost debt.
 GRAPHIC PRESENTATION
Y

V
A
L
E
U

O
F

S
T
O
C
K
Threshold Debt Level Optimal capital structure Marginal tax
Where bankruptcy shelter benefits = marginal Bankruptcy
costs become related costs
material

LEVERAGE X
 Some considerations in the
Capital Structure Decision:
1. Managerial conservatism
2. Lender and Rating Agency Attitudes
3. Reserve Borrowing capacity and Financing Flexibility
4. Control
5. Business Risk
6. Asset Structure
7. Growth Rate
8. Profitability
9. Taxes
10. Market conditions
 MM HYPOTHESIS
1. Securities are traded in the perfect capital market situation.
2. Investors are free to buy and sell securities
3. They can borrow without restriction at the same terms as the
firms do;
4. Investors behave rationally
5. There is no transaction cost
6. Firms can be grouped into homogeneous risk classes
7. The expected NOI is a random variable, with a constant mean
probability distribution and a finite variance
8. Firms distribute all net earnings to the shareholders, which
means the dividend payout ratio is 100%
9. No corporate income taxes (later they relaxed)
 Assignment Problem
Capital Structure Debt (Rs.) Kd% Ke%
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
 SOLUTION
Particulars Plan I II III IV V
EBIT 300000 300000 300000 300000 300000

Less Interest 30,000 40,000 55,000 72,000 98,000

Net Profit 270,000 260,000 245,000 228,000 202,000

Ke 0.12 0.125 0.135 0.15 0.18

MV of Eq. 22,50,000 20,80,000 18,14,815 15,20,000 11,22,222

MV of Debt 300,000 400,000 500,000 600,000 7,00,000
Total Mkt. 25,50,000 24,80,000 23,14,815 21,20,000 18,22,222
Value 11.76 12.10 12.95 14.15 16.46
Ko
 CASE – SOFT DRINK
COMPANY
A SOFT DRINK MANUFACTURING COMPANY IS
PREPARING TO MAKE CAPITAL STRUTURE
DECISION.
IT HAS OBTAINED ESTIMATE OF SALES AND THE
ASSOCIATED LEVELS OF EARNINGS BEFORE
INTEREST AND TAXES FROM ITS FORECASTING
GROUP.
THE PROJECTED SALES ACCORDING TO THE
GROUP ARE AS FOLLOWS:
 PROJECTED SALES

SALES (25% CHANCE) 400,000

SALES (50% CHANCE) 600,000
SALES (25% CHANCE) 800,000
FIXED OPERATING 200,000
COSTS
VARIABLE 50% OF SALES
OPERATING COSTS

Further . . . . . . . .
 COMPANIES CURRENT
CAPITAL STRUCTURE
LIABILITIES AMOUNT ASSETS AMOUNT

EQUITY 500,000 FIXED AND 500,000

CURRENT
LONG TERM 000,000 MISC. 000,000
DEBT EXPENSES
TOTAL 500,000 TOTAL 500,000

ASSUME THAT THE SHARE

VALUE IS Rs. 20
 ASSUMPTIONS UNDERLYING
THE CASE
1. THE FIRM HAS NO CURRENT LIABILITIES
2. ITS CAPITAL STRUCTURE CURRENTLY
CONTAINS ALL EQUITY AS IN THE B/S.
3. THE TOTAL AMOUNT OF CAPITAL
REMAINS CONSTANT.
THAT THE FIRM IS CONSIDERING SEVEN ALTER-
NATIVE CAPITAL STRUCTURES WITH A DEBT OF
0, 10, 20, 30,40,50 AND 60 PER CENTS AND THE
RATE OF INTEREST WILL BE 9.0%, 9.5%, 10.0%,
11.0%, 13.5%, AND 16.5% RESPECTIVELY.
 WHAT TO DO?
AS A FINANCE MANAGER – USING THE DATA – DECIDE
UP ON A CHOICE OF THE CAPITAL STRUCTURE THAT
YOU WOULD ADVISE THE FIRM.
THE REASONS FOR THE SPECIFIC PROPORTION OF
USAGE OF DEBT i.e. LEVERAGE
WHAT CAN BE THE BEST OPTION FOR THE FIRM;
WHY YOUR OPTION IS THE BEST BET – REASONS TO
SUBSTANTIATE THE SAME.