The document discusses various capital structure theories including the net income approach, traditional approach, and irrelevance theories like the net operating income approach and MM approach. It provides definitions of key terms like capital structure and optimal capital structure. It also lists the assumptions and formulas used in different theories. Several factors that determine a firm's capital structure are outlined along with examples of calculating a firm's value and WACC under different approaches.

1. Capital structure theories
Mahesh k s
DoS in Commerce
Hemagangotri Hassan

2. Meaning of capital structure
Capital structure refer to the proportion
between the various long term source of
finance in the total capital of firm.
A financial manager choose that source of
finance which include minimum risk as well as
minimum cost of capital.

3. Sources of long term finance
A. Proprietors fund
1. Equity capital
2. Preference capital
3. Reserve and surplus
B. Borrowed funds
1. Long term debts.

4. Importance of capital structure
1. Capital structure determine the risk assumed
by the firm.
2. Capital structure determine the cost of capital
of the firm.
3. It affect the flexibility and solvency of the
firm.
4. It prevents over or under capitalization
5. Tax planning tool

5. .
Optimal Capital Structure
Optimal capital structure is referred to as the
perfect mix of debt and equity financing that
helps in maximizing the value of a company in
the market while at the same time minimizes
its cost of capital.

6. Factors Determining Capital
Structure
1. Nature and size of the firm.
2. Stability of Earnings.
3. Cost of capital.
4. Rate of corporate tax.
5. Retaining control.
6. Legal requirement.
7. Trading on equity.

7. Capital structure Theories
A. Relevance theories
1.Net income approach
2. Traditional approach
B. Irrelevance theories
1. Net operating income approach
2. MM approach

8. Assumption of capital structure
theories
• Firms use only two sources of funds- equity
and debt.
• No change in investment decision of the firm
• 100% dividend payout ratio,i.e. no retained
earnings.
• No corporate tax

9. NI- Approach ( Net income approach)
• This theory was propounded by David Durand.
• There is a relationship between value of firm
and capital structure.
• According to this approach the value of the
firm is increase and decrease overall cost of
capital by increasing the proportion of debt
financing in capital structure.

10. .
• It is due to the fact that debt is generally a
cheaper source of finance because:
1. Interest rate is lower than the dividend rate
2. Benefit of tax : because interest is deductable
expense.
 Under this approach optimum capital
structure is 100% debt

11. Assumption of NI approach
• There is no tax
• The cost of debt is less than the cost of capital
• The uses of debt does not change the risk
perception of the investors.

12. Formula
Calculation of total value of firm
V= S+D
• V= Total market value of the firm
• S= Market value of equity shares
• D= Value of debt
S=NI/ke

13. ‘
• Calculation of over all cost of capital or WACC
• Ko= EBIT/V

14. Traditional Approach
• Proposed by E solomon, and weston etc….
• As per the traditional approach, a firm should make
judicious use of both the debt and the equity to achieve a
capital structure which may be called the optimum capital
structure.
• At this capital structure, the overall cost of capital, WACC of
the firm will be minimum and the value of the firm
maximum
• The traditional view point states that the value of the firm
increases with increase in financial leverage but up to a
certain limit only. Beyond this limit, the increase in financial
leverage will increase its WACC and the value of the firm
will decline.

15. .
• Suppose the cost of capital for totally equity
financed company is 10%. Cost of equity and cost
of capital will be same as company is totally
financed with equity capital. If firm replaces 50%
of its equity capital with interest bearing 7% debt
capital, the cost of equity will increase slightly
because of added financial risk of equity
shareholders. New cost of equity increases to
11%.
• WACC = Cost of Equity × Weight of Equity + Cost
of Debt × Weight of Debt
• WACC (Ko) = Ke × We +Kd× Wd = 0.11 × 0.50 +
0.07 × 0.50 = 0.09 or 9%

16. Assumption of traditional approach
• No taxes
• Earnings is constant
• All earnings are distributed as dividend
• Only two source of finance ie debt and equity
• There is existence of optimum capital
structure
• Rate of debt and equity is constant certain
period

17. • First Stage: Increasing Value In the first stage, as a
company starts moving from all equity to debt
financing, the cost of equity (Ke) starts increasing
by a very less amount. Thus, this slight increase in
cost of equity is not able to set off the advantage
of low cost of debt (Kd). The cost of debt also
remains constant as the market perceives debt as
a reasonable policy. Consequently, the overall
cost of capital (WACC or Ko) goes down and thus,
the value of the firm increases.

18. • Second Stage: Optimum Value As the company
keeps increasing debt financing, there comes a
point which gives optimum value of the firm. In
this case, any further increase in debt causes the
cost of equity to increase by such an amount
which completely off sets the advantage of low
cost debt. The result of this is that the WACC
shows no change and therefore attains the
minimum level. Such a point or range shows the
maximum value of the firm due to lowest WACC.
At this stage, firm achieves its optimum debt-
equity ratio.

19. • Third Stage: Decreasing Value After reaching
the optimum level, any increase in debt
results into very large increase in the cost of
equity as required by the shareholders for the
increased financial risk. Such a large increase
in cost of equity is not able to set off the
advantage of low cost debt. Moreover, the
cost of debt also increases, as a result of
which the WACC increases and thus, value of
the firm goes down.

21. Criticism of Traditional Approach
• Its assumption of financial risk premium is not
justifiable.
• Existence of corporate tax.
• It assumes existence of optimum capital
structure.
• Existence of transaction cost

22. NOI Approach
• The Net Operating Income Approach is
opposite to the Net Income Approach.
• According to Net Operating Income Approach,
the market value of the firm depends upon
the net operating profit or EBIT
• The financing mix or the capital structure is
irrelevant and does not affect the value of the
firm

23. •The investor sees the firm as a whole and thus capitalizes the
total earnings of the firm to find the value of the firm as a
whole.
•The overall cost of capital, Ko, of the firm is constant and
depends upon the business risk, which also is assumed to
be unchanged.
•The cost of debt, Kd , is also taken as constant.
•The use of more and more debt in the capital structure
increases the risk of shareholder and thus results in the
increase in the cost of equity capital, Ke. The increase in Ke
is such as to completely off set the benefits of employing
cheaper debt.
•There is no tax.

25. Formula
• Value of the Firm = Net Operating Profit
WACC
OR = EBIT
Ko
• (Ke) = Net Income
Value of Equity

26. MM Hypothesis with No Taxes:
Irrelevance of Capital Structure
• Modigliani and Millar hypothesize that capital
structure is irrelevant for firm valuation. That
is by changing the proportion of debt and
equity, a firm cannot change its value. Firm’s
value depends on earnings and risk of its
assets rather than leverage (debt-equity ratio).

27. Assumptions of MM hypothesis
1) Perfect Capital Markets:
2) Homogeneous Risk:
3) No Taxes
4) Full Payout:
5) All investors have the same expectation.
6) Investors are rational
7) Only two source of finance

28. .
• Against NI and traditional approach
• According to this approach leverage will not
affect value of the firm and cost of capital
remain unaffected
• No optimal capital structure or optimal debt
equity mix.

29. Proposition 1: Capital structure is
irrelevant for firm’s valuation.
• First proposition of MM hypothesis states that
capital structure does not affect the value of a
firm.
• Value of levered firm is equal to value of
unlevered firm

30. Arbitrage and home made leverage
• Its is operational justification by Modigliani
and Miller
• The arbitrage refers to an act of buying a
security in one market at a lower price and
selling it to another market at a higher price
with a view to earn profit.

33. MM Proposition 2: Capital structure
affects investors’ returns
• MM proposition 1 states that capital structure
does not affect the value of a firm. But second
proposition of MM says that it affects returns of
investors (shareholders) i.e. return on equity
(ROE) and earnings per share (EPS). It says that as
the leverage increases, variability of dividends to
shareholders also increases. Thus, the risk for
shareholders increases. Now, to compensate for
this increasing risk, they expect higher return.
Thus, it can be said that with increasing leverage,
the risk and return of shareholders increase.

34. rE = Cost of levered equity
ra= Cost of unlevered equity
rD = Cost of debt
D/E = Debt-to-equity ratio

35. MM approach with Tax

36. .
Problems on NI approach
• The expected Earnings before interest and
taxes (EBIT) of a firm is Rs 2,00,000. It has
issued equity share capital and the cost of
equity is 10%. It has also issued 6% debt of Rs
5,00,000. Find out the value of company and
overall cost of capital (WACC).

37. • given that
• EBIT = Rs. 200,000.
• Ke = 10%,
• Kd = 6% and
• Value of Debt = Rs. 500,000

38. .
• EBIT 2,00,000
• Less: Interest (6% of Rs 5,00,000) 30,000
• Net Profit available to eq holders 1,70,000
• Cost of Equity (Ke) 10%
• Value of Equity (1,70,000/0.10) 17,00,000
• Value of Debt 5,00,000
• Total Value of Firm 22,00,000
• Weighted Average Cost of Capital (WACC) = Ko =
2,00,000/2200000 = 0.09 or 9%
• WACC can also be calculated as follows: WACC =
Cost of Equity×Weight of Equity + Cost of
Debt×Weight of

39. Now if the company had issued 6% debt of Rs 7,00,000 instead
of Rs 5,00,000 the position have been as follows:
• EBIT 2,00,000
• Less: Interest (6% of Rs 7,00,000) 42,000
• Net Profit (EBT) 1,58,000
• Cost of Equity (Ke) 10%
• Value of Equity (158,000/0.10) 15,80,000
• Value of Debt 7,00,000
• Total Value of Firm 22,80,000
Weighted Average Cost of Capital (WACC) =
2,00,000 /2280000= 0.087 or 8.7%
So, if 6% debt is increased from Rs 5,00,000 to Rs 7,00,000 the value
of firm increases from Rs 22,00,000 to Rs 22,80,000 and WACC
decreases from 9% to 8.7%

40. Now suppose that the company has issued 6% debt of Rs 2,00,000
only instead of Rs 5,00,000. The position would be as follows:
• EBIT 2,00,000
• Less: Interest (6% of Rs 2,00,000) 12,000
• Net Profit provided to equity shareholders (EBT) 1,88,000
• Cost of Equity (Ke) 10%
• Value of Equity (188,000/0.10) 18,80,000
• Value of Debt 2,00,000
• Total Value of Firm 20,80,000
• Weighted Average Cost of Capital (WACC) = 2,00,000 =
0.096 or 9.6% 20,80,000
• So, when the proportion of 6% debt is reduced to Rs
2,00,000 the value of firm reduces to Rs 20,80,000 and
WACC increases from 9% to 9.6%.

41. .
• Calculate the value of firm and WACC from the
following information under Net Income
approach
• EBIT of a firm Rs 200000
• Ke = 10%
• Kd = 6%
• Case 1 – debt capital Rs 500000
• Case 2 – Debt capital Rs 800000
• Case 3 – Debt capital Rs 200000

42. .
Particulars Case 1
(Debt
500000)
Case 2
(Debt
800000)
Case 3
(Debt
200000)
EBIT 200000 200000 200000
Less interest on debt @6% 30000 480000 12000
Net income available to Eq share holders 170000 152000 188000
Value of Eq share NI/ Ke 170000 1520000 1880000
Add value of Debt 500000 800000 200000
Total value of firm 2200000 2320000 2080000
WAAC 0.0909 0.0862 0.0962
Under NI approach when firm is using maximum debt its WACC is
minimum and total value of the firm is maximum

43. Problem 2
• An organization expects a net income of Rs
100000 and it has Rs 150000, 10% debentures.
The equity capitalization rate of the company is
12%. Calculate the value of the firm and overall
capitalization rate according to the Net income
approach( ignore income tax).
• If the debenture increased to Rs 200000 what
shall be the value be the firm and the overall
capitalization rate?

44. Problem no 3
• Sterling co. Furnishes the following details
• Expected net operating income Rs 400000 P.A
• The cost of equity capital 18%
• The co. has 14%debenture of Rs 1000000
• The co. wishes to borrow additional Rs 1000000
debenture to finance its operation
• Find out the values of the firm the overall cost of
capital and the effects of new borrowings on the
value of the firms as per durands net income
approach

45. .
• Calculation of total value of firm and WACC under NI
approach for existing capital structure
Particulars Existing capital
structure
EBIT 400000
Less int on debenture (1000000*14/100) 140000
Net income 260000
Equity capitalization rate 18%
Value of equity 260000/.18 1444444
Add value of debt 1000000
Total value of firm 2444444
WACC 400000/2444444*100 16.36%

46. Calculation of value of firm and WACC under NI approach for
proposed capital structure
Particulars When additional debt
barrowed
EBIT 400000
Less interest 2000000*14/100 280000
Net income 120000
Equity capitalization rate 18%
Value of equity 120000/.18 666667
Add value of debt 2000000
Total value of firm 2666667
WACC 400000/2666667*100 15%

47. Problem no 4
• Spring ltd issues 12% debenture of Rs
3000000
• Summer ltd issues only equity capital of Rs
3000000 .
• Both co. earn 20% before interest and taxes
on their total assets of 6000000 assume tax
rate at 40% and capitalization rate of 15% for
the all equity co. calculate the value of both
the companies using NI approach

48. .
• Calculation of value of firm and WACC under NI approach
Particular Springs ltd Summer ltd
EBIT 6000000*20% 1200000 1200000
Less interest 3000000*12/100 360000 ------------
EAIBT 840000 1200000
Less tax @ 40% 336000 480000
Net income available to Eq share holders 504000 720000
Equity capitalization rate 15% 15%
Value of equity 3360000 4800000
Add value of debt 3000000 -----------
Total value of firm 6360000 4800000

49. Problems on NOI approach
Value of the Firm = Net Operating Profit
WACC
OR = EBIT
Ko
(Ke) = Net Income
Value of Equity
Value of equity = V - D

50. Problem no 1
• Company A has annual Net operating income
(EBIT) of Rs 360000. And the company has Rs
1400000 12% debt. The over all cost of capital
of the company is 14%
• What would be the value of the company and
also calculate equity capitalization rate under
NOI approach .

51. ‘
• Calculation of value of firm under NOI
approach
Value of the Firm = Net Operating Profit
WACC
= 360000
.14
Calculation of equity capitalization rate
(Ke) = Net Income
Value of Equity

52. .
• Value of equity = V – D
= 2571428 – 1400000
= 1171428
Net income = EBIT – interest
= 360000 – 168000
= 192000
(Ke) = Net Income
Value of Equity
= 192000
1171428
= 0.1639 or 16.39%

53. • Ke = EBIT- Interest
V – D
= 360000 – 168000
2571428 – 1400000
= 192000
1171428
= 0.1639 0r 16.39%

54. Problem no 2
• ABC co ltd has annual NOI of Rs 90000. the
company has Rs 300000, 10% debenture. The
over all cost of capital is 12%. Find out value of
the firm and equity capitalization rate under
NOI approach.

55. Problem no 3
A company ltd has furnish the following
information calculate firm value and equity
capitalization rate under NOI approach
Particulars Existing capital
structure
Proposed
capital
structure
EBIT 120000 120000
Debt @10% 100000 400000
Equity capitalization rate ? ?
Over all cost of capital 12% 12%

56. ‘
• Calculation of value of firm and equity
capitalization rate under NOI approach
Particular Existing capital
structure
Proposed
capital
structure
EBIT 120000 120000
Less interest 10000 40000
Net income 110000 80000
Value of firm 12000/0.12 1000000 1000000
Equity capitalization rate (NI/E)*100 12.22% 13.33%

57. Problem no 4
• A firm has an EBIT of Rs 2,00,000 and belongs
to a risk class of 10%. What is the value of
equity capital if it employees 6% debt to the
extent of 30%, 40% or 50% of the capital fund
of Rs 10,00,000 under NOI approach.

58. .
• Calculation of value of firm under NOI
approach
Particular 30% Debt
(300000)
40% Debt
(400000)
50% Debt
(500000)
EBIT 200000 200000 200000
Less interest 18000 24000 30000
Net income 182000 176000 170000
Total Value of the firm
(200000/.10)
2000000 2000000 2000000
Less value of debt 300000 400000 500000
Value of equity 1700000 1600000 150000
Equity capitalization rate 10.7% 11% 11.33%

59. ‘
• The cost of equity capital (Ke) of 10.7%, 11% and
11.33% can be verified for different proportion of
debt by calculating WACC as follows:
For 30% Debt:
• 𝐾𝑂 = 0.107 ∗ 17,00,000 /20,00,000 + 0.06 ∗ 3,00,000/
20,00,000
= 0.10 𝑜𝑟 10%
• For 40% Debt:
• 𝐾𝑂 = 0.11 ∗ 16,00,000/ 20,00,000 + 0.06 ∗ 4,00,000
/20,00,000
= 0.10 𝑜𝑟 10%
• For 50% Debt:
• 𝐾𝑂 = 0.1133 ∗ 15,00,000/ 20,00,000 + 0.06 ∗ 5,00,000
/20,00,000
= 0.10 𝑜𝑟 10%

60. Problems of Traditional approach
Indra ltd has EBIT of Rs 100000, the company
make use of debt and equity capital. The firm
has 10% debenture of Rs 500000 and firm
equity capitalization rate is 15%
You are require to compute
1) Firm value
2) Over all cost of capital

61. • Firm value = 833333
• WACC= 12%

62. .
• Determine the optimal capital structure of a
company from the following information
Options Cost of debt (%) Cost of equity (%) Percentage of debt on
total value
1 11 13 0
2 11 13 10
3 11.6 14 20
4 12 15 30
5 13 16 40
6 15 18 50
7 18 20 60

63. .
• Alpha ltd and beta ltd are identical except for capital
structure. Alpha ltd has 50% debt and 50% equity where as
beta ltd has 20% debt and 80% equity(all % are in market
value terms). The borrowing rate for both companies is 8%
in a no tax world and capital markets are assumed to be
perfect.
A) 1)If you own 2% of the shares of Alpha ltd, determine your
return if the company has net operating income of Rs
360000 and the overall capitalization rate of the company
Ko is 18%?
2) calculate the implied required rate of return on equity
B) Beta ltd has the same net operating income as Alpha ltd
1) determine the implied required equity return of beta ltd
2) analyze why does it differ from that of alpha ltd?

64. .
Particulars Alpha ltd
Debt(50%)
Beta ltd
Debt(20%)
EBIT 360000 360000
Less interest @8%
Net income
Total value of firm 360000/0.18 2000000 2000000
Less value of debt
Value of equity
Calculation of equity capitalization rate

65. MM approach:1958 without tax
1) Value of firm
V= NOI
Ko
2) A firm having debt in capital structure has higher
cost of equity than an unlevered firm. The cost of
equity in a levered firm is determined as under
Ke= Ko+(Ko-Kd)Debt/equity
3) The structure of the capital does not affect the
overall cost of capital. The cost of capital is only
affected by the business risk.

67. Shortcoming of this approach
Arbitrage process fails to work because
1. Capital market is not perfect
2. Existence of transaction cost
3. Existence of tax
4. Non homogeneous risk class

68. MM approach 1963 with tax
• In 1963 MM model was amended by
incorporating tax they recognized that the
value of the firm will increase or cost of capital
will decrease where corporate taxes exist. As a
result, there will be some difference in the
earning of equity and debt holders in levered
and unlevered firm and value of levered firm
will be greater than the value of unlevered
firm by an amount equal to amount of debt
multiplied by corporate tax rate

69. MM has developed the formulae for
computation of cost of capital, cost of equity for
the levered firm.
1) Value of levered firm= value of unlevered
firm+ tax benefits
V= Vu + TB
2) Cost of equity in a levered firm is
Ke= Keu+(Keu-Kd)Debt/equity+ debt

70. WACC in levered firm
• KOL = KOU(1-TL)
• KOL= overall cost of capital in levered firm
• KOU= overall cost of capital in unlevered firm
• T= tax
• L = leverage ( debt/debt+equity)

71. .
There are two company N ltd and M ltd having
EBIT is 20000. M ltd is a levered company
having a debt of 100000 @ 7%rate of interest.
The cost of equity of N ltd is 10% and M ltd is
11.50%
Compute how arbitrage process will be carried
on
Given
Particulars M ltd N ltd
EBIT 20000 20000
debt 100000 ----------------
Ke 11.5% 10%
Kd 7% ----------------

72. .
M ltd N ltd
EBIT 20000 20000
Less interest @ 7% 7000 --------
Net income 13000 20000
Value of equity (Net income/ ke) 113043 200000
Add debt 100000 -----
Total value of firm 213043 200000

73. Step 1 if you have 10% shares in M ltd
• Your total investment=(113043*10/100)= 11304
• Your return is 10% on net income (13000*10/100)= 1300
• Step 2 sell the shares of M ltd and barrow 10%
debt(100000*10/100)
sales amount = 11304
+ barrowed amount = 10000
you have total source = 21304

74. Step 3 invest 10% in N ltd( unlevered )
Your total source = 21304
10% of N ltd (200000*10/100) = 20000
your surplus will be = 1304
Step 4 your return in unlevered firm
10% of net income in N ltd (20000*10/100) = 2000
less intest for debt 10000*7/100 = 700
your final return will be = 1300

75. .
• i.e. your return is same i.e. 1300 which are
getting from N ltd. Before investing in M ltd.
But still you have Rs 1304 excess money
available with you. Hence, you are better off
by doing arbitrage.

76. .
• A and B firms are identical in all aspect
except capital structure B firm is levered firm
with total 6% debt of Rs 500000.
• EBIT of both the firm is Rs 90000
• Cost of equity of A ltd is 10% and B ltd is 15%
• Compute how arbitrage process will be carried
on ?