Theories of Capital
Structure
BY: Dr. Anupam Jain
Meaning
The value of the firm depends upon the expected earnings and the rate of
capitalization. Therefore, the management is interested in selecting that form
of capital structure where a given level of debt minimizes the weighted
average cost or overall cost of capital and maximizes the earnings available
for owners and the total value of the firm. Such a capital structure is known
as optimal or balanced capital structure. There are various theories or
approaches of capital structure. These theories are as follows:
Theories of Capital Structure:
Net operating Modi Gilani-
Net Income
Income Miller
Approach
Theory Approach
Traditional
Theory
1 Net Income Theory
"A firm can increase the value of the firm and reduce the overall cost of capital by
increasing the proportion of debt in its capital structure to the maximum possible extent".
It is due to the fact that debt is, generally a cheaper source of funds because: (i) Interest
rates are lower than dividend rates due to element of risk and (ii) the benefit of tax as the
interest is deductible expense for income tax purpose. When a firm increases the
proportion of debt financing, a cheaper source of funds, in its capital structure, it results in
a decrease in overall cost (weighted average) of capital leading to an increase in the value
of the firm as well as market value of equity shares. The optimal structure of such a
firm is the point at which the overall cost of capital is minimum and the value of the
firm is maximum.
Assumptions of Net Income Theory :
1) The cost of debt is cheaper than the cost of equity.
2) Income tax has been ignored.
3) The cost of debt capital and cost of equity capital remain constant.
Computation of NI Theory
Under the NI theory, the total value of a firm is computed by adding the
market value of debt in the capatilised value of earnings available for equity
shareholders. It can be Expressed as:
Total value of Firm (V) = Market value of Equity (S) + Market value of Debt (D)
𝐸𝐵𝑇
Where S=
𝐾𝑒
𝐸𝐵𝐼𝑇
Overall Cost of Capital (Ko) = x100
𝑉
Example 1:
A. MK ltd expects annual net income (EBIT) of 2,00,000 and equity capitalization rate of
10%. The company has 6,00,000 debenture with an annual interest rate of 8%. There is
no corporate income tax. Calculate the value of the firm and overall (weighted average)
cost of capital according to Net Income Theory.
1. What will be the effect on value of the firm and overall cost of capital, if:
i.The firm decides to raise the amount of debentures by ₹ 4,00,000 and uses the proceeds
to repurchase equity shares.
ii.The firm decides to redeem the debentures of ₹ 4,00,000 by issue of equity shares.
Solution 1:
Calculation of the value of the firm
Particulars Amount (a) Amount (b) i Amount (b) ii
Net Income (EBIT) 200000 200000 200000
Less: Int on Debentures @ 8% 48000 80000 16000
Earning Available for Eq. Sh. (EBT) 152000 120000 184000
Cost of Capital or Eq. Capitalisation Rate 10% 10% 10%
Market Value of Equity (S= EBT/Ke) 1520000 1200000 1840000
Add: Market Value of Deb. (D) 600000 1000000 200000
Total Value of the Firm (V) 2120000 2200000 2040000
Overall cost of Capital (Ko=EBIT/V * 100 9.43% 9.09% 9.80%
Example 2:
A Company expects a net income of ₹ 80,000. It has ₹ 2,00,000 debentures of 8 per
cent rate of interest. The equity capitalization rate of the company is 10%. Calculate
the value of the firm and overall capitalization rate according to Net Income
Approach ignoring income tax.
Solution: V= 840000 and Ko= 9.53%
Example 3:
Assuming no taxes and given the earnings before interest and taxes (EBIT) ; Interest at 10%
and equity capitalization rate (Ke) below, Calculate the total market value of each firm :
Also determine the weighted average cost of capital of each firm.
Firms EBIT in ₹ Interest in ₹ Ke V Ko
A 2,00,000 20,000 12% 1700000 11.76%
B 3,00,000 60,000 16%
2100000 14.29%
C 5,00,000 2,00,000 15%
4000000 12.50%
2 Net Operating Income Theory
(NOI)
This theory has also propounded by David Durand, which is quite opposite
to the net income theory. According to this theory, the total market value of
the firm (V) is not affected by the change in the capital structure and the
overall cost of capital (Ko) remains fixed irrespective of the debt equity mix.
It means the overall cost of capital or weighted average cost of capital will
remain the same whether the debt equity is 50:50 or 30:70 or 0:100. It is also
known as 'Irrelevant theory' of capital structure.
Assumption of NOI
1. The split of total capitalization between debt and equity is not
relevant.
2. The business risk at each level of debt-equity mix remains constant.
3. Overall cost of capital (Ko) also remain constant.
4. The debt capitalization rate is constant
5. The corporate income tax does not exits.
Computation of NOI Theory
Under the NOI theory, the total value of a firm (V) is computed by
capitalizing the Net operating Income by overall cost of capital (Ko). It can be
Expressed as:
𝐸𝐵𝐼𝑇
Total value of Firm (V) = 𝐾𝑜
𝐸𝐵𝑇 𝑜𝑟 𝐸𝐵𝐼𝑇−𝐼
Ke= X100
𝑆 𝑜𝑟 𝑉−𝐷
Example: 4
G. K. ltd expects annual net operating income of ₹ 4,00,000. It has ₹ 10,00,000 outstanding
debts; cost of debt is 10%. If the overall capitalization rate is 12.5%, what would be the total
value of the firm and the equity-capitalizing rate according to net operating income theory?
What will be the effect of the following on the total value of the firm and equity
capitalization rate if:
(i) The firm increases the amount of debt from ₹ 10,00,000 to ₹ 15,00,000 and uses the
proceeds of the debt to repurchase equity shares.
(ii) The firm returns debt of 5,00,000 by issuing fresh equity shares of the same amount.
Solution 4:
Calculation of the value of the firm
Particulars Amount (a) Amount (b) i Amount (b) ii
Net Income (EBIT) 400000 400000 400000
Less: Int on Debentures @ 8% 100000 150000 50000
Earning Before Tax (EBT) 300000 250000 350000
Overall Cost of Capital (Ko) 12.50% 12.50% 12.50%
Total Value of the Firm (V= EBIT/Ko) 3200000 3200000 3200000
Less: Market Value of Deb. (D) 1000000 1500000 500000
Total Value of the Equity (S) 2200000 1700000 2700000
Equity Capitalised Rate (Ke=EBIT-I/S * 100 13.64% 14.70% 12.96%
Example 5:
Sardana and Co. provides you with the following information
Weighted average cost or overall cost of capital (K O ) 12%
Cost of debt capital 10%
Net Operating Income or EBIT ₹ 30,000
Total Capital Structure value ₹ 2,00,000
You are required to calculate the cost of equity and the value of the firm according to Net Operating Income
Approach if the firm has
(i) ₹ 40,000 and (ii) ₹ 1,00,000 debt capital in its total capital structure value.
Solution 5:
Options Total value of Firm (V) Cost of Equity Capital (Ke)
(i) 250000 12.38%
(ii) 250000 13.33%
Traditional Theory
Debt is a cheap source of raising funds as compared to equity capital. Therefore,
according to this approach a firm can reduce the overall cost of capital or increase
the total value (V) of the firm by increasing the debt proportion in its capital
structure to a certain limit. Beyond this limit, the additional debt may result in a
decrease in the total value of the firms. Through judicious mix of debt and equity
the overall cost of capital can be minimized and the total value of the firm
maximized.
There may be three following stages:
Stages
(i) First stage: In this stage, the use of debt in capital structure increases the value of the firm (V) and decrease
the overall cost of capital (K O ).
(ii) Second stage: Upto a particular limit of debt in the capital structure, the additions of debt capital will have
insignificant or negligible effect on the value of the firm and the overall cost of capital. It is because the increase
in the cost of equity capital, due to increase in financial risk, affects the advantage of using low cost of debt.
Therefore, during this stage, there is a range in which the value of the firm will be maximum and the overall cost
of capital will be minimum.
(iii) Third stage: From the shareholders point of view, further increase of debt in the capital structure, beyond
the acceptable limit increases the financial risk. This increases cost of equity capital that cannot be set off by the
advantage of low cost debt. Hence, the total value of the firm will decrease and the overall cost of capital will
increase.
Example 6:
Compute the total value of the firm, value of equity shares and the overall (average) of capital from the
following, information:
Net operating income ₹ 2,00,000
Total investment ₹ 10,00,000
Equity capitalization rate
(a) If the firm uses no debt 10%
(b) If the firm uses ₹ 4,00,000 debentures 11%
(c) If the firm uses ₹ 6,00,000 debentures 13%
Assume that ₹ 4,00,000 debentures can be raised at 5% rate of interest whereas ₹ 6,00,000 debentures can be
raised at 6% rate of interest.
Solution 6:
Calculation of the value of the firm & Overall Cost of Capital
In case of In case of ` In case of `
Particulars No Debt 400000 Deb. 600000 Deb.
Net Income (EBIT) 200000 200000 200000
Less: Int on Debentures @ 8% NIL 20000 36000
Earning Available for Eq. Sh. (EBT) 200000 180000 164000
Cost of Capital or Eq. Capitalisation Rate 10% 11% 13%
Market Value of Equity (S= EBT/Ke) 2000000 1636363 1261538
Add: Market Value of Deb. (D) NIL 400000 600000
Total Value of the Firm (V) 2000000 2036363 1861538
Overall cost of Capital (Ko=EBIT/V * 100 10.00% 9.80% 10.70%
4 Modi Gilani- Miller Approach
The Modigliani — Miller theory is identical with net operating income theory in the absence
of corporate taxes and net income theory when corporate taxes exist.
In the absence of corporate taxes
According to this approach the market value of the firm (V) and its overall cost of capital
(K o ) are independent of its capital structure. In other words, the debt equity mix of the firm
is irrelevant in determining the total value of the firm.
WHEN CORPORATE TAXES EXIST
Modigliani — Miller original argument that the value of the firm and overall cost of capital
remain constant with the increase of debt in capital structure does not hold good when
corporate taxes, which is a reality, are assumed to exist. Modigliani — Miller revised their
original stand in their article in 1963. They recognized that the value of the firm will
increase and cost of capital will decrease with the increase of debt in capital structure. They
accepted that the value of levered firm (V) will be greater than then the value of unlevered
firm (V).
Assumptions of MM Approach
The Modigliani — Miller approach is based on the following assumptions:
(i) Perfect capital market: Investors are free to buy or sale securities. They are rational and every
information is available to them.
(ii) No transaction cost: No cost like commission, brokerage etc, is involved in purchase or sale of
securities.
(iii) Cent percent distribution: All the earnings shall be distributed to the shareholders i.e. their will
be no retained earnings.
(iv) No corporate taxes: Initially Modigliani — Miller have assumed that no corporate tax is paid, but
later on in 1969 they removed this assumption.
Example 7:
There are two firms P and Q which are exactly identical except that P does not use
any debt in its financing, while Q has ₹ 4,00,000, 10% debentures in its financing.
Both the firms have earnings before interest and tax of ₹ 3,20,000 and the after tax
capitalization rate is 16%. Assuming the corporate tax of 50%, Calculate the value
of the firm according to Modigliani — Miller hypothesis.
𝐸𝐵𝐼𝑇 (1−𝑡) 320000−(1−.5)
Solution: Vu= = = 1000000
𝐾𝑒 .16
Vl= Vu+Dt= 1000000+400000 (1-.5) = 1200000
Conclusion: Q have excess market value due to debentures in Capital Structure.
Example 8:
Hari Limited and Har Limited are identical in every respect except that Hari
Limited is unlevered whereas Har Limited is levered. Har Limited has 40 lacs 8 per
cent debentures outstanding. Assume that all the M-M assumptions are fulfilled.
The corporate tax rate is 50 per cent and capitalization rate for an all equity
Company is 10 per cent. The EBIT is 12 Lakhs.
Calculate the value of both the Companies according to M-M model.
Solution: Value of Firm (V) = Hari Ltd. 6000000 & Har Ltd. 8000000
