Made By:-Vikram, Ankit, Preeti, Arpan & Vikas

Capital Structure refers to the combination of

mix of debt and equity which a company uses to finance its long term operations.

… can a company increase its value simply by altering its capital structure?

…yes and no

…we will see….

The additional risk placed on the common stockholders as a result of the decision to finance with debt.

Leverage increases shareholder risk.Leverage also increases the return on equity

(to compensate for the higher risk).

There are only two source of finance Debt & Equity, no Preference.

No tax.No flotation cost.Assets of a firm remains constant.Business risk remains constant (that is

EBIT remains constant).No retained earnings.

Main objective of financial management is maximization of share holder’s wealth.

To be optimum which maximize the market value of equity shares.

Price Earning ratio= Market Price per share

earning per shareTo Increase growth of company

Net Income Approach Net Operating Income Approach Traditional Approach MM( Modigliani-Miller) Approach

Assumption:-Kd (Cost of Debt) and Ke (Cost of Equity) remains

constant at all level of leverage.

This Approach is between leverage, Cost of Capital and Value of firm. There is a straight relationship between capital structure and Value of firm.

A Firm can assess its value by increasing or decreasing the Debt proportion in overall proportion mix.

Financial Leverage

Overall Cost of Capital

Value of Firm VF=EBIT/Ko

Value of Firm (Net Income Approach)

Increase Decrease

Net Operating Income (EBIT) 50000 50000 50000

Less Intrest on Debenture 20000 30000 10000

Earning available to Equity Holder(NI) 30000 20000 40000

Equity Capitalisation rate (Ke) 0.125 0.125 0.125

Market value of Equity(S)=NI/Ke 240000 160000 320000

Market Value of Debt(B) 200000 300000 100000

       

Total Value of firm(S+B=V) 440000 460000 420000

Overall Cost of Capital(Ko)=EBIT/V(%) 11.36% 10.90% 11.90%

Cost of Equity 0.10(200000/4400000)

+0.125(240000/440000)

 _ _ 

Cost of Capital

Leverage

KD

KE

Ko

This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. 

Assumption:-Kd (Cost of Debt) and Ko (Overall cost of capital)

remains constant at all level of leverage.

With the increase in leverage (D/E ratio) Debt which has a cost less than cost of equity gain a higher weight but still Ko remains constant at the same level since with the increase in leverage, there is an increase in financial risk.

With the increase in leverage debt as a cheaper

source of finance gain the higher wealth.

Value of Firm (Net Operating Income Approach)

Net Operating Income (EBIT) 50000

Overall Capitalization rate (Ko) 0.125

Total Market value of Firm(V)=EBIT/Ko 400000

Total Value of Debt(B) 100000   

Total market Value of Equity(S)=(V-B) 300000

Ke =50000-10000/300000 0.133

Ko=0.125 0.10(100000/400000) +0.133(300000/400000)

Cost of Capital

Leverage

KD

KE

Ko

Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same. 

Assumption:- Kd (Cost of Debt) and Ke (Cost of Equity)

tends to rise slowly, with the increase In leverage(D/E ratio) continues to rise, then increase in Kd and Ke becomes sharp.

With the increase in leverage( D/E ratio), Ko tends to fall at first, but with consistent increase in both Kd & Ke , Ko tends to rise slowly at first and sharply thereafter.

Value of Firm (Traditional Approach) 

   

Net Operating Income (EBIT) 40000

Less - Intrest 10000

Earings Available to Equity Holders (NI) 30000

Equity Capitalisation rate (Ke) 0.16

   

Total market Value of Equity(S)=NI/Ke 187500

Total market Value of Debt(B) 100000

Total Value of firm (V)=(S+B) 287500

(Overall Cost of Capital)Ko=EBIT/V 0.139

Debt Equity ratio(B/S)=(100000/187500) 0.53

r

DE

rD

rE

WACC

Optimal Capital Structure

This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:

Ist Stage

In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 

2nd Stage

In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 

3rd Stage

Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. 

Modigiliani – Miller model (MM) was presented in 1958 on the relationship between the leverage, cost of capital and the value of the firm. They have shown that the financial leverage does not matter and the cost of capital and value of firm are independent of the capital structure.

The capital markets are perfect and complete information is available to all the investors free of cost.

The securities are infinitely divisible. Investors are rational and well-informed about

the risk-return of all the securities. All the investors have same probability

distribution about the expected future earnings. There is no corporate income tax The personal leverage and the corporate

leverage are perfect substitute.

Proposition IThe overall cost of capital (Ko) and the value of the firm (V)

are independent of its capital structure. The Ko and V are constant for all degree of leverage.

levered firm value = unlevered firm value. VL = VU

= (EBIT/WACC) = EBIT/ksU

where: ksU = cost of equity for an unlevered firm.

Firm value is independent of leverage.

Basic Propositions

Proof with capital structure arbitrage

Particulars LEV & Co.

ULE & Co.

EBIT 10,00,000 10,00,000

(-) Interest 3,00,000 -

Net Profit 7,00,000

10,00,000

Equity capitalisation rate, Ke,

.20 .20

Value of equity 35,00,000 50,00,000

Value of debt 30,00,000 -

Total Value, V, 65,00,000

50,00,000

WACC, Ko = EBIT/V 15.38% 20%

Arbitrage Process The arbitrage process refers to simultaneous undertaking by

a person of two related actions or steps in order to derive some benefit .

Sale of 10% Equity in LEV & Co. 3,50,000

10% Loan 3,00,000

Total funds available 6,50,000

Less : Purchase of 10% Equity in ULE & Co. 5,00,000

Capital funds saved 1,50,000

Return available

Profit available from ULE & Co. (being 10% of net profit)

1,00,000

(-) Interest payable @10% on Rs. 3,00,000 loan

30,000

Net Return 70,000

Proposition II:

ksL = ksU + Risk premium

= ksU +(ksU - kd)(D/S)

where: ksU = cost of equity for an unlevered firm,

ksL= cost of equity for a levered firm, D = market value of firm’s debt, S = market value of firm’s equity, kd= cost of risk-free debt.

As a firm increases its use of debt, its cost of equity also increases; but its WACC remains constant.

Critical Evaluation of MM Model

Non-Substitutability of Personal & Corporate Leverages

Transaction Costs Availability of Complete Information Corporate Taxes