CAPITAL STRUCTURE

Capital structure refers to the composition of the amount of long-term financing. Thus, capital structure
and capitalisation are two different terms.
Capitalisation is a quantitative concept indicating the total amount of long-term financing. Whereas,
capital structure involves the decisions regarding the types of securities to be issued and in relative
preparation of each type of securities. Capital structure therefore, represents a mix of equity, preference,
debt and term loans.
The three fundamental patterns of capital structure in a new organisation is as follows:
1. Issuing only equity shares
2. Issuing of equity + preference shares
3. Issuing of equity, preference shares, bonds, debentures and term loans.

Factors affecting capital structure:-

1. Trading on equity- A company earns a profit on its total capital. On the debt capital, including
the preference capital, company pays interest or dividend at a fixed or agreed rate. If this fixed
rate is lower than the general rate of earnings of the company, the ordinary shareholders (equity
shareholders) will have an advantage in the form of additional profit. This is called trading on
equity. The trading on equity is basically an arrangement under which the company makes use
of borrowed funds, including preference capital bearing a fixed rate of interest or dividend in
such a way so as to increase the rate of return on equity shares. The rate of dividend on equity
shares could not otherwise go beyond the general rate of earnings if the entire amount of capital
is raised by the issue of equity shares. Trading of equity helps in diversifying the financial
structure without diluting the management control of the company.
2. Control of the Business: In most cases the promoters want to retain the control of the affairs of
the company. They raise the capital from the public by way of issuing different type of securities
in such a way as to retain the control of the whole or substantially the whole of the affairs of
the company with them.
3. Nature of Business: The capital structure of a company depends upon the nature and type of
business in which it is into.
4. Purpose of financing: The purpose for which funds are being raised must be taken into account
at the time of framing the financial structure of the company.
5. Elasticity of capital structure: The ideal capital structure should be flexible and its feasible to
reduce the capital when it is not needed.
6. Cost of financing
7. Market condition: the influence of the general sentiment of the capital market.
8. Legal restriction: Imposed by the country in which it is operating.

Optimum capital structure

The OCS can be defined as “that capital structure or combination of debt and equity that leads to the
maximum value of the firm” OCS maximises the value of the company and hence the wealth of its
owners and minimise the company’s cost of capital. Consideration to be kept in mind while
maximising the value of the firm in achieving the goal of the optimal capital structure:
 If ROI > the fixed cost of funds, the company should prefer to raise the funds having a
fixed cost, such as, debentures, loans etc. It will increase EPS and MV of the firm.
 If debt is used as a source of finance, the firm saves a considerable amount in payment of tax
as interest is allowed as a deductible expense in computation of tax.

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 It should also avoid undue financial risk attached with the use of increased debt financing.
 The Capital structure should be flexible.
The following objectives should be kept in mind before defining an ideal capital structure.
a) Economic objectives:
1. Minimisation of Cost- Cost of raising funds should be minimum.
2. Minimisation of risk and Maximisation of returns.
3. Preservation of control- Equity shareholders do not want to dilute their control over the affairs
of the company, as a result they issue more amount of debt capital and preference capital.
4. Full utilisation of capital.
b) Other objectives:
1. Flexibility in the capital structure.
2. Attractiveness pf the capital structure towards the investor.
3. Balanced leverage.

Capital Structure Theory

1) Net Income Approach (NI) - This approach was proposed by David Durand in 1959. According
to this approach, higher the amount of debt capital, lower the overall cost of capital and higher
will be the value of the firm.
This approach increases the valuation (V) and lowers the overall cost of capital (Ko) as it
increases the degree of leverage.
The basic assumptions of the NI approach are as follows:
i) The firm has only two sources of financing – equity and debt.
ii) There is no corporate tax, i.e. corporate tax does not exist in the system.
iii) All the earnings of the firm are paid out in the form of dividend, i.e. no retained earnings.
iv) The firms’ assets are not growing. So, its EBIT is expected to remain constant in the future.
v) The firm can change its capital structure or degree of leverage either by issuing shares by
redeeming the debt or by raising more debt by redeeming the shares.
vi) The firms’ business risk is taken as constant over time and is independent of capital
structure and financial risk. The firm has perpetual life.
vii) The risk perception of the investors does not change.
viii) The cost of debt (Kd) is less than the cost of equity (Ke) and it remains constant.
According to NI approach: V=S+D; where V=value of firm. S=market value of the equity; D=
market value of the Debt Capital. The NI approach also states that Ko=NI/V, where Ko= overall
cost of capital. From the diagram, Ke and Kd are assumed not to change with leverage. As debt
increases, it causes the WACC (Ko) to decrease.
Criticisms of Net Income (NI) Approach
• Empirical observations indicate that with the introduction of debt capital, the cost of equity
capital tends to rise and, after a certain stage of leverage, the cost of debt capital also starts rising.
• The general assumption of the distribution of entire earnings of a firm as dividend or the
similarity of risk perception among all investors have no practical feasibility.

Q1. Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10% Kd = 6%
C1: Debt capital Rs. 500,000 C2: Debt = Rs. 700,000 C3: Debt = Rs. 200,000

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Q2. A company expects its annual income of Rs 3,60,000. It has 15,000 8% Debentures of Rs 100 each.
The equity capitalisation rate is 12%.
i. Calculate the value of the firm and overall capitalisation rate as per the NI approach.
ii. If the firm utilises 21,000 8% Debentures of the same rate, will your answer change?

Net Operating Income (NOI) Approach:

According to NOI approach (also proposed by David Durand) the value of the firm (V) is unaffected
by the capital structure changes and the annual capitalisation rate remains constant irrespective of the
method of financing. Under this approach if the firm utilises more and more amount of debt, the risk of
equity shareholders enhances, which in turn increases the equity capitalisation rate. The NOI approach
is based on certain assumptions. They are:
1) The overall capitalisation rate remains constant.
2) The cost of debt is also constant.
3) The firm has only two sources of financing- equity and debt.
4) All the earnings are paid out as dividend, i.e. no retention.
5) Corporate tax does not exist.
6) Utilisation of more and more debt capital increases the risk of equity shareholders.
7) The firms’ business risk is taken as constant. (Systematic risk and Unsystematic risk).
8) The firm assets are not growing so its EBIT is expected to remain constant in future.
Under NOI approach the firm value is determined by capitalising the net operating income of the
firm at overall capitalisation rate. Symbolically its represented as: V=EBIT/Ko or V=NOI/Ko.
Criticisms of Net Operating Income Approach (NOI)
 This approach presumes that the benefits from the use of cheaper debts capital will offset the
increase in cost of equity capital.
 Change in the capital structure of a firm does not affect the market value of the firm and every
capital structure is optimum capital structure, provided there are no taxes.
 According to this approach there is no optimum capital structure and hence there is no
requirement of any financial plan.
Q3. X Ltd has an operating income is Rs.5,00,000. The firm’s cost of debt is 10% and currently the
firm employs Rs. 15,00,000 of debt. The overall cost of capital of the firm is 15%. Determine:
(i) Total value of the firm (ii) Cost of equity.

Q4. Calculate the value of firm and cost of equity for the following capital structure
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)

Q5. During a particular year a company expects its NOI of Rs 15,00,000. The company has Rs
90,00,000 9% Debentures. The overall capitalisation rate is 12%
i. Calculate the market value of the firm and the equity capitalisation rate.
ii. What will be the impact on the value of the firm and equity capitalisation rate, if the firm
uses Debt Capital of Rs 1 crore instead of Rs 90,00,000.

Traditional Approach Theory

The traditional approach (given by Ezra Solomon) makes a compromise between the NI and the NOI
approach. Here, the value of the firm (V) increases and the overall capitalisation rate (Ko) decreases by

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an optimum mix of the debt and equity. The optimum capital structure can be achieved by optimum use
of Debt Equity Mix. Optimum capital structure occurs at the range of point when cost of capital is
minimum and the value of the firm is maximum. According to this approach there are 3 distinct stages:

Stage 1- Increase in value – Here the cost of equity (Ke) remains constant or rises slightly in such a way
that it cannot offset the advantage of low-cost debt (as Kd < Ke). Consequently, the value of the firm
(V) rises and the overall cost of capital (Ko) decreases with an increasing leverage.
Therefore Ko= Ke + Kd.
Stage 2-Optimum value - After reaching a certain degree of leverage using of more debt will have
adverse effect on the value of the firm and in the overall value of the cost of capital of the firm. This is
because the increased use of debt will increase the financial risk. As a result, the cost of equity will
increase due to financial risk which affects the advantage of low-cost debt. Before commencement of
the increase in cost of equity (Ke), optimum capital structures occur. Reduction in WACC ceases and
it tends to stabilize. At this range or point when OCS occurs the value of the firm will be maximum
and overall cost of capital will be minimum.
Stage 3- Decreasing value - If leverage is at more than optimum level value of the firm decreases and
the overall cost of capital increases with leverage. It is because the investor predicts a high degree of
financial risk consequently, they demand higher equity capitalisation rate which compensates the
advantages of low-cost debt. Increase in financial leverage and the associated increase in Ke and Kd
more than offsets the benefits of lower cost debt financing
The above 3 stages of traditional view suggest that cost of capital is a function of leverage. In the first
stage cost of capital decreases with leverage and in the second stage the cost of capital reaches a
minimum point and then in the third stage cost of capital begins to increase with leverage.
Criticism of the traditional view
The value of the firm actually depends on net operating income and the risk attached to the firm, but
the pattern of financing has nothing to do with this. Financial structure has an impact of distribution of
operating income between equity holders and the debt holders.

Q6. EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%.
Introduction of debt to the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000@12%.
For case I, Ke = 17% and for case II, Ke = 20%.
Find the value of firm and the WACC.

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Q7. X Ltd has an EBIT of Rs 4,00,000. The firm currently has outstanding debts of Rs 15,00,000 at an
average cost of 10%. Its cost of equity capital is estimated to be 16%. You are required to:
i. Determine the current value of the firm using the traditional valuation approach.
ii. Determine the firms’ overall capitalisation rate.
Q8. X Ltd has Rs 1 crore in 10% Debentures. The equity capitalisation rate is 12.5%. The company is
expecting annual earnings before interest and taxes of Rs 25,00,000. You are required to:
i. Calculate the value of the firm and the overall cost of capital using the NI Approach. Ignore
tax.
ii. Calculate the value of the firm and the overall cost of capital if the company decides to
raise;
a. Rs 25,00,000 by the issue of 10% Debentures and use the proceeds to redeem some of
the equity shares.
b. Rs 25,00,000 by the issue of equity shares and use the proceeds to redeem some of the
debentures.
Comment on the results.
Q9. The finance manager of Y Ltd supplies the following information:
i. Value of the total capital structure is Rs 400 lakhs.
ii. Weighted average cost of capital is 12%
iii. Cost of Debt Capital is 8%
iv. EBIT is Rs 60 lakhs
Compute the cost of equity and the value of the firm assuming the degree of leverage is:
i. 0% ii. 50% iii. 75% as per the NOI Approach.

MM Theory of capital structure or capital structure irrelevance theory

MM argues that there is no impact on capital structure on the value of the firm and the cost of capital
in the absence of tax. The MM approach supports the NOI approach regarding the independence of
leverage to effect cost of capital and value of the firm at any level of debt equity ratio.
Assumptions of MM Theory - There are two propositions explaining the MM hypothesis, based on
the following assumptions:
1) The investors have total liberty to buy and sell securities.
2) Investors can borrow freely at the same terms as the firms do.
3) Investors behave rationally.
4) There is an absence of cost of buying and selling securities.
5) Homogenous risk classes- if a group of firms have identical expected earnings with identical risk
characteristics then they are considered as homogeneous risk classes. It is generally implied in MM
hypothesis that firms within the same industry make up a homogeneous class.
6) Risk- all the firms operating under the same operating environment, will have the same degree of
risk. All the firms can be classified under equivalent risk class or homogeneous risk class depending
upon the same degree of operating risk of the firm. Generally, all the firms under the same industry
are assumed to have the same risk characteristics.
7) The firm distributes all its net earnings to the shareholders i.e. the dividend pay-out ratio is 100%.
8) In the original formulation of the MM hypothesis there is an absence of corporate income tax. (This
assumption was removed later).

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PROPOSITION 1
Under the above assumptions, MM argues that the total market value is independent of the debt-equity
mix for the firm within the same risk class. Value of the firm according to the MM approach can be
calculated as follows: V = S + D or V = NoI/Ko or V = EBIT/Ko.
Since the cost of capital (Ko) is defined as the ratio of the expected net operating income divided by the
value of the firm and MM concluded that the capital structure is irrelevant to influence the market value
of the firm which implies that the cost of capital is independent of the capital structure and is equal to
the cost of equity i.e. Ke.
The cost of capital function as described by MM in Proposition 1 is shown in the graph below:

Cost of Capital Ke
Ko
Leverage
Arbitrage Process – it is the operational justification of the MM Approach. Arbitrage refers to the act
of buying an asset or security in one market having a lower price and selling the same in another market
at a higher price.
Arbitrage refers to buying asset or security at lower price in one market and selling it at a higher price
in another market. As a result, equilibrium is attained in different markets. This is achieved by taking
two identical firms of which one has debt in the capital structure while the other does not.
Investors of the firm whose value is higher will sell their shares and instead buy the shares of the firm
whose value is lower. They will be able to earn the same return at lower outlay with the same perceived
risk or lower risk. They would, therefore, be better off.
The value of the levered firm can neither be greater nor lower than that of an unlevered firm according
this approach. The two must be equal. There is neither advantage nor disadvantage in using debt in the
firm’s capital structure.
MM did not accept the NI Approach. The argued, that two identical firms having different degree of
leverage have to exercise the same level of market value and cost of capital. Their opinion is that if two
identical firms having different capital structures enjoy different market value then arbitrage will occur
to enable the investor to engage in personal leverage as against the corporate leverage to maintain
equilibrium in the market.
PROPOSITION 2
MM’s proposition 2 defines cost of equity from MM’s definition of average cost of capital. Therefore,
the cost of capital is equal to: Ke = (NoI-KdD)/S or Ke = Ko + (Ko – Kd)*D/S,
Where D = market value of debt and S = market value of equity. Therefore, the cost of equity is a linear
function of leverage measured by D/S. So, leverage helps to increase the EPS but also increase in cost
of equity for the reason of increase in financial risk. The benefit of leverage is exactly compensated by
the increased cost of equity. As a result, the firms market value remains unaltered.

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Criticisms of MM Theory
1. Discrepancy among lending and borrowing rate: In reality the firm having substantial holding
of the fixed assets, enjoys borrowing at lower rate of interest than individuals. Therefore,
lending and borrowing rates can never be the same.

2. Non-substitutability of personal and corporate leverage: The assumption that the personal
leverage is a perfect substitute for corporate leverage is incorrect because the firm has limited
liability unlike individuals who have unlimited liability.

3. Transaction Cost: Another obstacle for working of arbitrage is the existence of transaction cost.
It would be rational to invest a greater amount at a time in order to earn same returns and to
minimise the cost involved in buying and selling securities. So levered firms will have a greater
market value.

4. Existence of Corporate Taxes: MM assumes that there is no existence of corporate tax while
corporate tax does exist in reality. This assumption was however lifted and MM proposed a
new theory indicating the relevance of capital structure under corporate taxes.

Q10. The value of 2 firms X Ltd and Y Ltd, as per the traditional theory is given below:

Particulars X Ltd Y Ltd

Expected Operating Income Rs. 5,00,000 Rs. 5,00,000
(Rs)
(-) Total cost of Debt - Rs 1,00,000
EBT/EAS Rs 5,00,000 Rs 4,00,000
Cost of Equity 10% 11%
Market Value of Shares Rs 50,00,000 Rs 36,00,000
Market Value of Debt - Rs 20,00,000
Total Value of the Firm (V) Rs 50,00,000 Rs 56,00,000
Average Cost of Capital 10% 9%
Debt Equity ratio 0 0.556
Compute the value of the firm as per the MM Hypothesis assuming:
i. Corporate income tax does not exist
ii. The equilibrium value of Ko is 12.5%
Q11. Company X and Y are in the same risk group. The two companies are identical in every respect
except that Company Y is levered while Company X is unlevered. Company Y has a debt of Rs
12,00,000 in 10% Debentures. Other information are as follows:

Particulars Company X (unlevered) Company Y (levered)

EBIT (Rs) Rs 3,00,000 Rs 3,00,000
(-) Interest on Debt - Rs 1,20,000
EBT/EAS Rs 3,00,000 Rs1,80,000
Equity Capitalisation Rate 0.15 0.20
Market Value of Equity Rs 20,00,000 Rs 9,00,000
Market Value of Debt - Rs 12,00,000
Total Value of the Firm (V) Rs 20,00,000 Rs 21,00,000
Overall Capitalisation Rate 15% 14.3%
Debt Equity ratio 0 1.33

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Mr A, an investor owns 5% equity shares of Company Y and 5% Debentures of Company Y. Show the
process and the amount by which he would gain from switching over his investment from Company Y
to Company X.
Q12. There are two firms U and L having same NOI of Rs. 20,000 except that the firm L is a levered
firm having a debt of Rs.1,00,000 @ 7% and cost of equity of U & L are 10% and 18% respectively.
How arbitrage process will work?
MM HYPOTHESIS UNDER CORPORATE TAXES
MM corrected their view in 1963 in a paper titled, “Taxes and the Cost of Capital: A Correction”. They
argued that the value of the firm increases and the cost of capital increases with the degree of leverage
and vice-versa. MM argued that inclusion of corporate tax in the exercise will make the value of the
firm and the overall cost of capital decrease with leverage. This is because interest on debt is tax
deductible. Consequently, a levered firm has more market value than an unlevered one. MM states more
specifically that the value of the levered firm is more than the unlevered firm by exactly an amount
equal to the levered firms’ debt, multiplied by the tax rate. Symbolically it can be represented as:
Vl = Vu + Dt, where Vl = value of the levered firm, Vu = value of the unlevered firm, D is the amount
debt and t = tax rate.
Q13. P Ltd. (Unlevered) – Total Asset Rs. 10,00,000; Ke =10%; Q Ltd (Levered) - Total Asset Rs.
10,00,000; 5% Debt – Rs. 4,00,000.
EBIT – Rs.2,00,000; Tax: 35%
a) Value of both the firms b) Cost of Equity (Ke) c) Overall cost of capital for both the firms.
Q14. The debt equity ratio of a company ABC Ltd is 4:6. The cost of debt is 6% and the cost of equity
is 15%. Compute
i. The overall cost of capital
ii. If the EBIT is Rs 22,80,000 calculate the value of the firm under the NOI Approach.
Q15. X Ltd and Y Ltd are in the same risk class, identical in every respect expect that X Ltd is levered
and Y Ltd is unlevered. X Ltd has Rs 30,00,000 5% Debentures in its Capital Structure. Both the
companies earn 10% return before interest and taxes on their total assets of Rs 50,00,000. Assume
perfect capital markets, rational investors, tax rate of 50% and an equity capitalisation rate of 10% for
both the companies. Calculate value of the firm under the NI and NOI Approach.