Capital Structure

Relevance and Irrelevance theory

UNIT 3
FM&CF (MBA 2nd SEM)
Capital structure refers to the kinds The term capital structure refers to
of securities and the proportionate the relationship between the various
amounts that make up capitalization. long-term source financing such as
It is the mix of different sources of eq u it y c a pit al , p r e fe re n c e s h a re
long-term sources such as equity capital and debt capital. Deciding the
shares, preference shares, s u i t a b l e c a p i t a l s t r u c t u r e is t h e
debentures, long-term loans and important decision of the financial
retained earnings. management because it is closely
related to the value of the firm.
Definition of Capital Structure
According to the definition of Gerestenbeg, “Capital Structure of a company refers to the
composition or make up of its capitalization and it includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-
term financing represented by debt, preferred stock, and common stock equity”.

According to the definition of Presana Chandra, “The composition of a firm’s financing

consists of equity, preference, and debt”.

According to the definition of R.H. Wessel, “The long term sources of fund employed in a
business enterprise”.
What do you mean by Optimum
Capital Structure?
Tip
Think about it...
 is the capital structure at
which -
the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.

Optimum capital structure may be defined as the capital

Tip
structure or combination of
Minimum WACC
debt and equity, that leads to the maximum value of the Maximum Firm Value
firm. Capital = Debt + Equity
Objectives of
Capital Structure Tip:
1. Maximize the value of
the firm.
2. Minimize the overall
cost of capital.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and
debentures.
 FACTORS
DETERMINING
CAPITAL
Tip
STRUCTURE
Leverage
It is the basic and important factor, Cost of Capital
which affect the capital structure. It • Cost of capital constitutes the major part
uses the fixed cost financing such as for deciding the capital structure of a firm.
debt, equity and preference share • Normally long- term finance such as
capital. It is closely related to the equity and debt consist of fixed cost while
overall cost of capital. mobilization.
• When the cost of capital increases, value of
the firm will also decrease. Hence the firm
Government policy must take careful steps to reduce the cost
Promoter contribution is fixed by the of capital.
company Act. It restricts to mobilize
(a) Nature of the business:
large, long term funds from external
sources. Hence the company must (b) Size of the company
consider government policy regarding (c) Legal requirements
the capital structure. d) Requirement of investors
CAPITAL STRUCTURE
THEORIES
Ø Capital structure is the major part of the
firm’s financial decision which affects
the value of the firm and it leads to
change EBIT and market value of the
shares.
Ø There is a relationship among the capital
structure, cost of capital and value of the
firm.
Ø The aim of effective capital structure is
to maximize the value of the firm and to
reduce the cost of capital.
 Net Income (NI) Approach
Tip v According to this approach, the capital
Net income approach suggested
by the Durand. structure decision is relevant to the
valuation of the firm.
Assumptions: v In other words, a change in the capital
1. There are no corporate taxes. structure leads to a corresponding change
2. The cost debt is less than the in the overall cost of capital as well as the
cost of equity. total value of the firm.
3. The use of debt does not
change the risk perception of the v According to this approach, use more debt
investor. finance to reduce the overall cost of capital
and increase the value of firm.
1. A firm that finances its assets by equity and debt is called a levered firm
(geared firm). On the other hand, a firm that uses no debt and finances its
assets entirely by equity is called an unlevered firm (ungeared firm).

2. The value of the firm is the sum of the values of all of its securities.
3.The value of a firm’s shares (equity), E, is the discounted value of
shareholders’ earnings, called net income (debt and equity), NI.
E = Net Income (NI) /Cost of equity (Ke)
4. The value of a firm’s debt is the discounted value of debt-holders’ interest
income.
D = Interest (Int.) / Cost of Debt (Kd) Tip
V = E +D The firm’s overall
V = Value of firm expected rate of return
E = Market value of equity or the cost of capital
is:S
D = Market value of debt
People need to understand how rare or frequent your
examples are.

Pick 1 or 2 statistics and make them as concrete as

possible. Stats are generally not sticky, but here are a
few tactics:

➔ Relate
Deliver data within the context of a story
you’ve already told

➔ Compare
Make big numbers digestible by putting them
in the context of something familiar
 A firm has no debt in its capital structure. It has an expected annual net operating income Example:
of `100,000 and the equity capitalization rate, ke, of 10 per cent. The firm is able to Firm Value Under
change its capital structure replacing equity by debt of `300,000. The cost of debt is 5 per Net Income Approach
cent.

Since the firm is 100 per cent equity financed firm, its weighted cost of capital equals its
cost of equity, i.e., 10 per cent.
The value of the firm will be: 100,000 ÷ 0.10 = `1,000,000

Interest payable to debt-holders is: `300,000 × 0.05 = `15,000.

The net income available to equity holders is: `100,000 – `15,000 = `85,000.
The value of the firm is equal to the sum of values of all securities:

The weighted average cost of capital, ko, is:

Suppose the firm uses more debt in place
of equity and increases debt to `900,000.
As shown in Table 15.1, the firm’s value
increases to `1,450,000, and the weighted
average cost of capital reduces to 8.1 per
cent. Thus, by increasing debt, the firm is
able to increase the value of the firm and
lower the WACC.
 Value of the firm (V) can
NI approach is based on be calculated with the help
the following important
assumptions;
Net Operating Income of the following formula
V = EBIT /K
• The overall cost of (NOI) Approach Where,
capital remains
● suggested by Durand. V = Value of the firm
constant;
● This is just the opposite to the Net Income EBIT = Earnings before
• There are no
approach. interest and tax
corporate taxes;
● According to this approach, Capital Ko = Overall cost of capital
• The market
capitalizes the value Structure decision is irrelevant to the
of the firm as a valuation of the firm.
whole; ● The market value of the firm is not at all
affected by the capital structure changes.
● According to this approach, the change in
capital structure will not lead to any
change in the total value of the firm and
market price of shares as well as the
overall cost of capital.
 Solution:Net operating income = Rs. 2,00,000
Example Overall cost of capital = 10%
Market value of the firm (V) = EBIT /K
= 2,00,000× 100 /10
XYZ expects a net operating = Rs. 20,00,000
income of Rs. 2,00,000. It has Market value of the firm = Rs. 20,00,000
8,00,000, 6% debentures. The Less: market value of Debentures= Rs. 8,00,000
overall capitalization rate is 10%. 12,00,000
Equity capitalization rate (or) cost of equity (Ke)= (EBIT - I)/(V- D)
Calculate the value of the firm and
Where, V = value of the firm
the equity capitalization rate (Cost D = value of the debt capital
of Equity) according to the net =( 2,00,000 – 48,000)/(20,00,000 8,00,000) ×100
operating income approach. If the = 12.67%
debentures debt is increased to Rs. If the debentures debt is increased to Rs. 10,00,000, the value of the
10,00,000. What will be the effect firm shall remain
on volume of the firm and the changed to Rs. 20,00,000. The equity capitalization rate will
increase as follows:
equity capitalization rate?
= (EBIT- I)/(V- D)
=(2,00,000 – 60,000)/(20,00,000 -10,00,000) ×100
= 1,40,000/10,00,000 ×100
= 14%.
Modigliani and Miller Approach
Modigliani and Miller approach Assumptions: Value of the firm can be calculated
states that the financing decision • There is a perfect capital market. with the help of the following
of a firm does not affect the • There are no retained earnings. formula:
market value of a firm in a perfect • There are no corporate taxes. EBIT* (l -t) /K0
capital market. • The investors act rationally. Where
In other words MM approach • The dividend payout ratio is EBIT = Earnings before interest and
maintains that the average cost of 100%. tax
capital does not change with • The business consists of the Ko = Overall cost of capital
change in the debt weighted same level of business risk. t = Tax rate
equity mix or capital structures of
the firm.

Quotes for illustration purposes only

Proposition I:
MM’s Proposition I is that, for firms in the same risk class, the total market
value is independent of the debt-equity mix and is given by capitalizing the
expected net operating income by the capitalization rate (i.e., the opportunity
cost of capital) appropriate to that risk class:
Value of levered firm = Value of unleverd firm
V l = Vu
Value of the firm = Net operating income/Firm’s opportunity cost of
capital
V = Vl = Vu = NOI/kd
MM’s approach is a net operating income approach because the value of the Assumptions
firm is the capitalized value of net operating income. • Perfect capital markets
Since the values of the levered and unlevered firms and the expected net • Homogeneous risk classes
operating income (NOI) do not change with financial leverage, the weighted • Risk
average cost of capital would also not change with financial leverage. • No Taxes
Hence, MM’s Proposition I also implies that the weighted average cost of • Full Payout
capital for two identical
firms, one levered and another unlevered, will be equal to the opportunity
cost of capital.
Proposition II:
Financial leverage does not affect a firm’s net operating income, but
as we have discussed in Chapter 14, it does affect shareholders’
return (EPS and ROE). EPS and ROE increase with leverage when
the interest rate is less than the firm’s return on assets. Financial
leverage also increases shareholders’ financial risk by amplifying
the variability of EPS and ROE. Thus, financial leverage causes two
opposing effects: it increases the shareholders’ return but it also
increases their financial risk. Shareholders will increase the required
rate of return (i.e., the cost of equity) on their investment to
compensate for the financial risk. The higher the financial risk, the
higher the shareholders’ required rate of return or the cost of
equity.
The Traditional View
Like the NI approach, it does not assume constant cost of equity with financial leverage
and continuously declining WACC.
According to this view, a judicious mix of debt and equity capital can increase the value of
the firm by reducing the weighted average cost of capital (WACC or k0) up to certain level
of debt.
This approach very clearly implies that WACC decreases only within the reasonable limit
of financial leverage and after reaching the minimum level, it starts increasing with
financial leverage.
Hence, a firm has an optimum capital structure that occurs when WACC is minimum, and
thereby maximizing the value of the firm.
Financial leverage, resulting in risk to shareholders, will cause the cost of equity to
increase. But the traditional theory assumes that at moderate level of leverage, the increase
in the cost of equity is more than offset by the lower cost of debt.
 The traditional theory on the relationship
According to the traditional between capital structure and the firm value
theory, the financial risk has three stages.
caused by the introduction of
debt may increase the cost of First stage: Increasing value
equity slightly, but not so In the first stage, the cost of equity, ke, the rate at which the
much that the advantage of shareholders capitalize their net income, either remains
cheaper debt is taken off constant or rises slightly with debt.
totally.
WACC will decrease with Second stage: Optimum value
the use of debt. But as Once the firm has reached a certain degree of leverage, any
leverage increases further, subsequent increases in leverage have a negligible effect on
shareholders start expecting WACC and hence, on the value of the firm. Within that
higher risk premium in the range or at the specific point, WACC will be minimum,
form of increasing cost of and the maximum value of the firm will be obtained.
equity until a point is Third stage: Declining value
reached at which the Beyond the acceptable limit of leverage, the value of the
advantage of lower-cost debt firm decreases with leverage as WACC increases with
is more than offset by more leverage. This happens because investors perceive a high
expensive equity. degree of financial risk and demand a higher equity-
capitalization rate, which exceeds the advantage of low-
cost debt