Capital Structure

Capital Structure

• Capital structure is the proportion of debt,

preference and equity shares on a firm’s balance

sheet.
• Thus, capital structure refers to the proportions or
combinations of equity share capital, preference
share capital, debentures, long-term loans, retained
earnings and other long-term sources of funds in
the total amount of capital which a firm should raise
to run its business.
• “Capital structure of a company refers to the make-
up of its capitalisation and it includes all long-term
capital resources viz., loans, reserves, shares and
bonds.”—Gerstenberg.
• “Capital structure is the combination of debt and
equity securities that comprise a firm’s financing of
its assets.”—John J. Hampton.
• When a company is analyzing what capital
structure to adopt it can opt for
Capital structure with equity shares only

Capital structure with equity and preference shares

Capital structure with equity shares and debentures

Capital structure with equity, preference shares and
debentures
 • Factors Affecting Capital Structure
Size of Company-
 Nature of Business –

 The Regularity of Earnings-

Conditions of the Money Markets–

Government policy.

Cost of Floating–

Debt -Equity Ratio–

 Optimal Capital Structure
• Optimum Capital Structure is the capital
structure at which the weighted average cost
of capital is minimum and thereby maximum
value of the firm.
 Assumptions of Capital Structure
• There are only two sources of funds used by a firm: perpetual
riskless debt and equity shares.
• Perpetual life of the firm
• Investment decision of the firm remain same.
• Maximisation of value of the firm is consistent with
maximisation of shareholders’ wealth
• Optimal capital structure is one that minimises WACC
• No retained earnings
• From the following information, calculate the
capitalization, capital structure and financial
structures.
 Calculation of capitalisation
Equity share capital 50,000
Preference share capital 5,000
Debentures 6,000
Capitalization 61,000
 Theories of Capital Structure
• Net Income approach
• Net operating income approach
• Traditional approach
• Modigliani and Miller approach (MM
Approach)
 Net Income approach
• Given by David Durand
• Capital structure decision is relevant to the
valuation of the firm.
• A change in the financial leverage will lead to a
corresponding change in the WACC as well as total
value of the firm.
• If degree of financial leverage increases, WACC will
decline, while the value of the firm will increase.
 Assumptions of NI Approach
• No taxes
• Cost of debt is less than the cost of equity
• Use of debt does not change the risk
perception of investors.
Formula
• Total Value of firm = value of debt + Value of
equity
 Net Income Approach Example
• A company expected a net income of RS.2,00,000

I t has Rs 5,00,000,8% Debenture.

The equity capitalization rate is 12%.

Calculate the value of the firm and overall capitalization

rate according to the net income approach.
If debenture debt is increased to RS 7,00,000, What shall
be the value of the firm and the overall capitalization rate.
 Calculation of value of the Firm
NET INCOME 2,00,000

LESS INTREST ON 8% DEB, OF RS 5,00,000 (-40,000)

EARNING AVAILABLE TO EQUITY 1,60,000

SHAREHOLDER

EQUITY CAPITALIZATION RATE 12%

MARKET VALUE OF EQUITY(1,60,000/12%) 13,33,333

MARKET VALUE OF DEBENTURE 5,00,000

VALUE OF FIRM 18,33,333

• Market value of equity=1,60,00/12%

• =13,33,333RS
 Calculation of overall capitalization rate

WACC(K0)=EARNING/VALUE OF THE FIRM

= EBIT/V

= 2,00,000/18,33,333

WACC=10.91%
 Calculation of value of the Firm if debt
increases
NET INCOME 2,00,000(RS)

LESS INTREST ON 8% DEB, OF RS 7,00,000 (-56,000)

EARNING AVAILABLE TO EQUITY 1,44,000

SHAREHOLDER

EQUITY CAPITALIZATION RATE 12%

MARKET VALUE OF EQUITY(1,44,000/12%) 12,00,000

MARKET VALUE OF DEBENTURE 7,00,000

VALUE OF FIRM 19,00,000

 Calculation of overall capitalization
rate
WACC(K0)=EARNING/VALUE OF THE FIRM
= EBIT/V

= 2,00,000/19,00,00

WACC=10.52%
OVERALL RESULT BEFORE AND AFTER
BEFORE AFTER

VALUE OF THE FIRM=18,33,333 19,00,000

WACC=10.91% 10.52%

THUS IT IS EVIDENT THAT WITH THE INCREASE IN DEBT FINANCING THE

VALUE OF THE FIRM HAS INCREASED AND OVERALL WACC GONE DOWN
 Net Income Approach
  Scenario Scenario Scenario
A B C
Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance      
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate      
Equity, re 20% 20% 20%
Debt, rd 10% 10% 10%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

Chapter 16 Capital Structure – Theory 27

 Net Income Approach
Capitalization Rates
EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders
Market value of debt 100.00 500.00 900.00
(I/rd)
Market value of 2,450.00 2,250.00 2,050.00
equity
(EBIT – I - Taxes)/re
Total Value of the 2,550.00 2,750.00 2,950.00
firm
Overall capitalisation 19.61% 18.18% 16.95%
rate (r)

Chapter 16 Capital Structure – Theory 28

 Net Operating Income approach
• Capital structure of the firm is irrelevant.
• Any change in leverage will not lead to any
change in total value of the firm.
• Change in capital structure of a company does
not affect the market value of the firm and
WACC remains constant irrespective of the
method of financing.
 Assumptions
• WACC is constant
• Total value of equity = Total value of firm –
Total value of debt
• Cost of equity increases with increased use of
debt capital or financial leverage.
• No optimum capital structure.
 Cost of equity

WACC
Cost of
Capital
Cost of debt

Degree of leverage
 Formula
• Total market value of firm = EBIT/WACC
• Total market value of equity = Total market
value of firm – Total market value of debt
 EXAMPLE
  Scenario Scenario Scenario
A B C
Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance      
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate      
Debt 10% 10% 10%
Overall 20% 20% 20%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

 SOLUTION
EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders (EAT)

Market value of debt 100.00 500.00 900.00

(I/rd)
Market value of firm 2,500.00 2,500.00 2,500.00
(EBIT/r)

Value of equity (E) 2,400.00 2,000.00 1,600.00

Equity capitalisation 20.42% 22.50% 25.63%

rate (EAT/E)
 Modigliani and Miller approach (MM Approach)

Proposition I ( In the absence of taxes)

(Theory of irrelevance or NOI)

Proposition II (In the presence of taxes)

(Theory of relevance or NI)
 Assumptions
• The overall cost of capital and value of the firm
remain constant for all the degrees of leverage.
• With increased use of debt, cost of equity increases.
• No retained earnings
• No transaction cost
• Information is available free of cost to all the
investors.
• Substitution of personal leverage for corporate
leverage.
 Propositions I (Absence of taxes)
• Change in leverage will not lead to any change
in total value of the firm.
• The Proposition I is based on the concept of
arbitrage process.
• The term arbitrage refers to an act of buying a
security in one market at lower price and
selling it in another market at higher prices.
Continued…
• If two firms are similar in all respects except
leverage, the total value of both the firms can
not be different because of operation of
arbitrage.
• The investors of the firm whose value is higher
will sell their shares and instead will buy the
shares of the firm whose value is lower.
 Presence of taxes
• Based on the assumption of taxes
• Capital structure affects the value of the firm
• Value of levered firm = value of Unlevered firm
+ Present value of tax shield
• VL = VU + T x D
 Traditional Approach
• Traditional approach is a midway between the
NI approach and NOI approach.
• Through judicious use of debt-equity
proportions, a firm can reduces its overall cost
of capital and thereby increase its total value .
• Because debt is the cheaper source of funds.
Continued…
• If use of debt increases , WACC will decline, while the value of
the firm will increase.
• If use of debt is increased further, the cost of equity will
increase and advantage of using debt is more, therefor WACC
will still decrease.
• If debt is used after this level, the cost of equity will increase
more and advantage of using debt will be exactly offset with
increased cost of equity. Therefore WACC will remain constant.
• Beyond a certain level of debt, the cost of equity as well as cost
of debt will increase and therefore WACC will also start
increasing and value of the firm will decrease
 TRADITIONAL APPROACH - CAPITALISATION RATES

Rates of
Return c = optimal capital structure

re
r0

r
rd

D/E
0 c
 Factors Affecting Capital Structure
1. Tangible Fixed Assets ( If High – More debt)
2. Control (Desire to control – More debt)
3. Nature of Industry ( If sales fluctuate widely –
less debt)
4. Earning capacity of the firm ( If higher
earning firm – More debt)
5. Size of the firm ( Large – More debt)
6. Nature of the firm
 Continued…
7. Tax Planning
8. Timing of issue (good state of economy and
capital market– equity capital)
9. Flexibility