Capital

Structure

- Chitra Potdar
Optimal Capital Structure
 The capital structure includes
combination of debt & equity
 Total capital structure is mix of owners
funds and outsiders funds represented by
equity & debt
 Optimal capital structure is that which
reduces the overall cost of capital and
leads to the maximum value of the firm
Features of Optimal Capital
Structure
 Profitability
 Solvency
 Flexibility
 Conservatism
 Simple
 Control
 Economic
Theories of Capital Structure

 Net Income Approach

 Net Opening Income Approach
 Traditional Approach
 Modigliani – Miller (MM) Approach
Assumptions of theories of
capital structure
 Only two sources of funds Debt & Equity
 No corporate or personal income taxes
 No retained earnings
 Total assets are constant
 EBIT is not expected to grow
 The firm’s business risk is constant
 Expected future earnings are the same
 The firm has perpetual life
Cost of sources of capital
 Cost of Debt = Annual Interest Charges (I)
Market Value of Debt (B)
 Cost of Equity = EBIT – Interest
Market Value of Shares (S)
 Overall Cost of Capital = Net Operating
Income
Total Market Value of Firm (B+S)
WACC – Market Value

 WACC = Kd (B /V) + Ke (S /V)

where Kd is the cost of debt
Ke is the cost of equity
B is market value of debt
S is market value of equity
V is the market value of debt
+ equity
Net Income Approach
 Assumes that Capital Structure Decision is
relevant to the valuation of the firm
 If the degree of financial leverage as measured
by the ratio of debt to equity increased the
weighted average cost of capital will decline
 Assumptions: No taxes, Kd < Ke, the use of debt
does not change the risk perception of investors
Illustration
 RQR Ltd. has 10% debenture of the value of
Rs.8 Crores in its capital structure. The
operating profit of the company before interest
and tax is Rs.2 Crores with the cost of equity
capital or equity capitalization rate is 12.5%
Find out 1. Total value of the firm 2. Overall
Cost of Capital under NI approach
Solution
 Total Value of Firm V = B + S
S = EAT / capitalization rate
= (20000000 – 8000000) / 12.5 * 100
= 96000000
Total Value of Firm = 20000000 + 96000000
= 176000000
 Cost of Capital = EBIT/V
= 20000000/176000000*100
= 11.36%
Illustration
 PPP Ltd. expects a net income of Rs.80 lacs. It
has 2 crores of 8% debentures. The equity
capitalization rate of the company is 10%.
Calculate 1. Value of the Firm 2. Overall
Capitalization rate as per NI approach 3. If the
debenture debt is increased to 3 crores what
shall be the value of the firm and the overall
capitalization rate?
 1. 84000000 2. 9.52% 3.a. 86000000 b.9.30%
Illustration
 The company P has 10% debentures at the
value of 12 crores in its capital structure. The
company Q has 10% debentures worth 14
crores. The operational profit of the companies
is Rs. 2 crores with equity capitalization rate
being 12%.
Fine out 1. Value of the Firm 2. Overall cost of
capital under NI approach
Company P
 Market Value of Equity S = (20000000 –
12000000) / .12 = 66666667
 Total Value of Firm = B + S
120000000 + 66666667 = 186666667
 Overall cost of Capital =
20000000/186666667 * 100 = 10.71%
Company Q
 Market Value of Equity S = (20000000 –
14000000) / .12 = 50000000
 Total Value of Firm = B + S
140000000 + 50000000 = 190000000
 Overall cost of Capital =
20000000/190000000 * 100 = 10.52%
Net Operating Income(NOI)
Approach
 There is no optimal capital structure
 Total value of the firm is unaffected by its
capital structure
 The total value of the firm remains
constant irrespective of the debt equity
mix of financing
Determination of the Value of
the firm
 V = EBIT / Overall cost of capital
 Value of Equity (S) = V – B
or
 Cost of equity = (EBIT – I) / S or (V – B)
 Verification by calculating overall cost of capital
K0 less Kd ( B / V) = Ke (S/V)
Illustration
 A company has a operating income (EBIT) of
Rs.2 cr, The cost of debt is 10% and
outstanding debt amounts to Rs.8 cr. The
overall capitalization rate is 12.5%. You are
required to calculate 1.Total value of the firm
2.Equity capitalization rate under NOI
approach
Solution
 Total Value of the firm V = EBIT / K0
= 20000000 / 0.125 = 160000000
 Market value of equity = V – B
= 160000000 – 80000000 = 80000000
 Equity Capitalization rate = EBIT – I/ S
= (20000000 – 8000000) / 80000000* 100
= 15%
Illustration
 The company expects operating income
of Rs.2 crores. It has 8 crores of 10%
debentures. The overall capitalization
rate of the company is 12.5%.
If the amount of debt is increased to 10
crores what shall be the value of the firm
and the overall capitalization rate
according to NOI approach.
Traditional Approach

 It is an intermediate approach which

suggests that there is optimal capital
structure
 A firm can increase its value and reduce
cost of capital using more debt as it is the
cheaper source of funds than equity
The Modigilani-Miller (M-M)
 The Modigilani- Miller Approach was
developed during 1958
 Emphasis was on the relationship between the
cost of capital, capital structure and valuation
of the firm
 According to approach overall cost of capital
(weighted average) does not make any change
with a proportionate change in debt equity mix
(degree of leverage)in the total capital structure
The Modigliani-Miller (M-M)
Proposition
 Assumptions:
 there are no taxes
 The dividend payout ratio is 100%
 the capital market is efficient and competitive
 there are no transaction costs
 there are no costs associated with bankruptcy
 shareholders and firms can borrow and lend at the same
rate of interest
 the cost of debt is constant, whatever the level of gearing
The Modigliani-Miller (M-M)
Proposition I
 The total market value of a firm is equal to its
expected operating income divided by the
discount rate appropriate to its risk class. It is
independent of degree of leverage
 V = S + B = O / K0
V = value of the firm, S = market value of Equity
B = market value of Debt, O = expected operating
income of firm K0 = discount rate applicable to
the risk class to which the firm belongs
The Modigliani-Miller (M-M)
Proposition II
 The expected yield on equity Ke is equal to K0
plus a premium. This premium is equal to the
debt-equity ratio times the difference between
K0 and the yield on debt Kd
 Ke = K0 + (K0 – Kd) B/S
The Modigliani-Miller (M-M)
Proposition III
 The overall cost of capital (K0) is the cut
off point for all investment decisions
 The cut off rate for investment decision
making for a firm in a given risk class is
not affected by the manner in which
investment is financed
Arbitrage Process
 The value of a leveraged (over valued) firm
must be equal to the value of unleveraged
(under valued) firm
 If this is not the case the shareholders will sell
their shares of the over valued firm and
purchase the shares of undervalued firm and
this process will continue until the market
values of both the stocks are equal
The Modigliani-Miller (M-M)
Proposition
 If the assumptions hold, the total market value of two
firms that are identical except for their levels of gearing
must be the same, and their WACCs must be the same
 If they were not the same, investors could improve their
position by “arbitrage”, selling the shares of one and
buying shares in the other, which would alter the
relative prices of shares until the WACCs become equal
 The level of gearing is therefore irrelevant to the
WACC and the value of the firm
The Modigliani-Miller (M-M)
Limitations
 The assumption that borrowing and lending by the
firms and individuals can borrow at the same rate of
interest does not hold good
 The transaction costs do exists
 Corporate borrowings are higher than individual
borrowings and both are not perfect substitutes
 No tax scenario is rare. Because of the tax deduction on
interest a company with debt capital has more market
value than a company without debt capital
Market Value of Equity

 Market Value of Equity (S) =

Profit available to equity shareholders
Equity Capitalisation rate
 The value of unleveraged firm (Vu) =
(1 – t) EBT / Ke
In case of leveraged firm the value will be
Vu + Dt
IIlustration
 Company A is without debt capital whereas
company B has 6% debt of Rs. 6 Crores. The
equity capitalisation rate is 10% and tax
bracket of both the companies is 60%. Both the
firms earn EBT of 2.40 crores each. Both the
companies have identical volume of business.
Calculate the value of the two companies.
Solution
 Value of unleveraged Co A
Vu = (1-t) EBT / Ke
= (1-0.6) 24000000 / .10
= 96000000
 Value of leveraged Co B
= 96000000 + 60000000*0.6
= 96000000 + 36000000
= 132000000
 Leveraged Firm enjoys higher market value
Illustration
 There are two firms X and Y. Both the firms
have the same net operating incomes of Rs.4
Crores before taxes. The income tax rate for
both the companies is 50%.
Both the companies have an after tax
capitalisation rate of 16%. However, company
Y has borrowed Rs. 4 Crores by issuing 10%
debentures.
Calculate the value of both the companies.