Capital structure

expansion

Capital Budgeting Decision

Replacement

Modernization

Need to Raises Fund

Capital Structure Decision

Existing cap
structure

Payout
Policy

Desired
Debt-Equity mix

Cont.

Effect on
RISK

Effect
On Return

Effect on
Cost OF Capital

Optimum
Capital structure

Value of
Firm

Components of Capital
Debt
Debentures
Term Loans
Equity
Equity shares
Preference Shares
Retained Earnings

Capital Structure
The capital structure of a company
refers to the mix of the long-term
finances used in the organization.
As the proportion of Debt increases in
the capital structure of an
organization , the risk of shareholders
increases.

Capital structure
Mix of long-term finance used by the firm.
Authorized Capital of Rs. 10 each
Issued, subscribed and paid up
capital
Present issue
Equity at par
16% secured loan
Term loan from bank
Buyers credit

90,00,00,000
8,25,00,000
19,34,00,000
56,50,00,000
50,60,00,000
13,50,00,000
1,48,20,00,000

Factors Affecting the capital structure

Cost of capital
Cash flow projections of the company
Size of the company
Dilution of control
Floatation costs

Optimal capital structure

Profitability
Flexibility
Control
solvency

Theories of capital structure

Net income approach (NI)

Net Operating Income approach (NOI)
Traditional Approach
Miller and Modigliani approach (M M)

In the theories we will study

What is the impact of
change in capital Structure
- On the Value of the firm
- On the Overall cost of Capital

Kd=F/B

Ke=E/S
Ko=[Kd*B/(B+S)]+
[Ke*S/(B+S)] or O/V
V=B+S

B= (1+Kd)t
E
S=
(1+Ke)t

Ko = Total cost of capital

Kd = Cost of debt
Ke = Cost of equity
V = Value of the Firm
B = Market value of debt
S = market value of equity

NI Approach
While increasing the leverage in the firm,
the Cost of Capital (Ko) of the firm is decrease.
Means the inverse relationship between Ko and
leverage
Mr. Devid Durrande invented this approach

NET INCOME APPROACH

According to this theory , if we increase
or decrease debt in the mix of capital
structure
- the cost of equity and cost of debt
remain same
- Overall cost of capital decrease with
increase in Debt
- So Value of the firm increases with
use of debt

Assumptions

No tax
Sources of finance equity and debt
No changes in risk of investors
Retained earning is reinvesting in the firm
100% dividend pay-out ratio
No changes in assets
Net operating income is not expected to
grow or decline over time
Business risk remain same

Changes in leverage = changes

in Ko
increase in leverage = decrease
in Ko and increase value of firm
Decrease in leverage = increase
in Ko and decrease value of the
firm

ke

C
O
S
t

ko
Kd

Proportion of Debt

NOI Approach
While increasing or decrease in the leverage of
the firm,

Ko remain constant.
Means the undefined relationship between Ko
and leverage
Mr. Devid Durrande invented this approach

NET OPERATING INCOME

APPROACH
According to this theory , if we
increase or decrease debt in the mix
of capital structure
- the cost of equity increases and
cost of debt remain same
- Overall cost of capital remain same
- So Value of the firm remain same

Changes in leverage = No
changes in Ko
increase in leverage = Ko
remain same and increase Ke
Decrease in leverage = Ko
remain same and decrease Ke

Ke
C
O
S
T
%

Ko

Kd

leverage

Traditional approach
When leverage increase, then at the
certain level Ko decrease. After that,
leverage increase continuously the K o
increase.
Means the us relationship between K o
and leverage is inverse at certain level
then after co-relationship.
Ezra Solomon invented this approach

TRADITIONAL APPROACH

According to this theory , if we increase

or decrease debt in the mix of capital
structure
- the cost of equity and cost of debt
remain same up to a degree of leverage,
then they rises sharply
- Overall cost of capital remain same up
to a degree of leverage, then rises
sharply
- So Value of the firm remain same up to
a degree of leverage then decrease
sharply

Traditional Approach

At 1 stage company
trading on equity
Ke
C
O
S
T
%

Ko

leverage

Kd

At 2 stage no gai
Leverage. Optim
cap. st

At 3 stage risk is inc

So Ke increase.

ke
ko
Kd

C
O
S
t

Proportion of Debt

A company has NOI Rs 2,00,000. Total

investment is Rs 10,00,000.
Options
(A)If company issues only equity shares
then Ke is 15%
(B)If company issues 10% debentures
Rs. 4,00,000 then Ke become 16%
(C)If company issues 12% debentures
Rs. 6,00,000 then Ke become 18%

particular

NOI
-Interest
NI
Ke
Equity
capitalization
+debenture
Value of the firm

2,00,000
0
2,00,000
15%
13,33,333

2,00,000
40,000
1,60,000
16%
10,00,000

2,00,000
72,000
1,28,000
18%
7,11,111

Ko=NOI/V

15%

0
4,00,000 6,00,000
13,33,333 14,00,000 13,11,111
14.29%

15.25%

MM APPROACH
According to this theory , if we increase
or decrease debt in the mix of capital
structure,
- the cost of equity and cost of debt
remain same
- Overall cost of capital will remain
same
- So Value of the firm remain same
In support of it they gave arbitrage
process

M.M Approach
Relationship between Ko and
leverage is undefined.
Its just equal to NOI approach but
presentation is quiet different.
M M theory is centered on behavior
of investor.

Assumption

No tax
Loan on securities is available
Same business risk
100%dividend pay-out.
No transferring cost of securities
Competent capital market

Assumptions of MM

Capital Market are Perfect

Investors are rational
No corporate or personal income Tax
Individual can borrow at same rate as
borrowed by corporate
No transaction Cost
No agency Cost
No bankruptcy cost

Proposal of M M theory
1.

1.
2.

Value of firm (V) and total cost (Ko) have no

relationship with capital structure.
(Equity and debt )
Ke = Ke+ risk premium
Sources of finance is not depended on cost of rate
of return.

Arbitrage process
Purchase security at low price and s
high price and gain profit.
This price difference call arbitrage.

Arbitrage Process
According to MM , if value of the leveraged
firm increases , the investors of leveraged
firm sells his investment in the firm and
create home leverage in the same proportion
In this way he can earn same money with
lesser Investment
And the value of the leveraged firm comes
down and become equal to unleveraged firm
So capital structure is irrelevant in deciding
the value of the firm

ARBITRAGE PROCESS
Suppose there are two firm A and B having
following capital structure having equal
income of 2,00,000 each
Firm A
Equity- 16,00,000
Firm B
Equity- 10,00,000
Debt (10%)6,00,000

Firm A
Income
Less Interest

2,00,000
NIL
------Earning Available to
shareholder
2,00,000
Ke
12.5%

Firm B
Income
Less Interest
Earning Available to
shareholder
Ke

2,00,000
1,00,000
---------------1,00,000
16%

 FIRM A
Value of Debt
Value of Equity
--------------------Value of the firm
FIRM B
Value of Debt
Value of Equity
--------------------Value of the firm

NIL
16,00,000
16,00,000
10,00,000
6,25,000
16,25,000

 Suppose an Investor is holding 10 %

shares in Firm B, his earning will be Rs.
10,000
He will sell all his share for Rs. 62,500
He will Take Loan of Rs. 1,00,000 at the
same interest rate of 10 % and Use his
Rs. 60,000 (Total Rs. 1,60,000) to
purchase 10 % share in A firm
His Earning will be Rs. 20,000 out of
which he will pay Rs. 10,000 Interest to
Loan, his remaining earning will be Rs.
10,000 , which is equal to the previous
earning

 In this way he can get the same earning

by sparing Rs. 2500 (62,500- 60,000)
So every investor like this will start
selling his investment in Firm
B( Leveraged firm) and start purchasing
shares in Firm A (Unrevealed Firm) , So
value of Firm will come down and
become equal to Firm A
In this way value of the firm remain same
irrespective of the capital structure

Ke2
C
O
S
T
%

Ke
Ke1
Ko
Kd

leverage

A and B has same business risk. A

companys cap. Structure based
on only equity and B company
has 10% Debenture Rs.
12,00,000.
NOI is Rs.3,00,000. Ke is 13% in A
company and 15% in B company.
1.What is value of the firm?
2.Ko
3.Mr. Ajit has 90% equity share in
B Company, How he reduce his
investment without any reducing
of his income?

particular

NOI
-Interest
NI
Ke
Equity capitalization
+debenture
Value of the firm
Ko=NOI/V

3,00,000
0
3,00,000
13%
23,07,692
0
23,07,692
13%

3,00,000
1,20,000
1,80,000
15%
12,00,000
12,00,000
24,00,000
12.5%

When Arbitrage process completed?

Value of the firm V

Total cost Ko

A company B company
23,07,692 24,00,000
13%
12.5%