Unit II.

2 – Capital Structure
 Topics
- Planning for Sources of Finance (Presentation/Assignment)
- Capital Structure Theories
- Net Income (NI) Approach
- Net Operating Income (NOI) Approach
- Modigliani-Miller (MM) Approach
- Traditional Approach
- Operating, Financial & Combined Leverage
- EBIT-EPS Analysis
- Leverages (Operating, Financial & Combined)
- Capital Gearing /Debt-Equity Ratio
- Designing Capital Structure
- Generation of Internal Funds (Self Study)
 Sources of Finance
Capital Market
Equity
Preference
Debentures/Bonds

Money Market
• Call/ Notice/ Term Money
• Repo/ Reverse Repo
• T-bills
• Inter Corporate Deposits
• Commercial Paper
• Certificate of Deposit
• Inter Bank Participation Certificate
 Overview
• Capital Structure refers to the mix of long-
term debt and equity employed by a firm.
• The capital structure, or financing mix, has
an impact on the earnings (EPS) of equity
shareholders.
• Thus, keeping in view the SWM objective,
choosing an optimum capital structure is an
important decision for a finance manager.
 Capital Structure Theories/Approaches

• There are four main theories regarding

optimal capital structure:

1) NI Approach 2)NOI Approach

3) MM Approach 4) Traditional Approach
 Assumptions
1)There are only two sources of funds – equity
and debt
2)There are no corporate taxes. (This
assumption was later removed)
3) Dividend payout ratio is 100%
4)The firm’s total assets remain constant. This
means that the investment decisions remain
constant.
5)The firm’s total financing remains constant.
However, the firm can change its degree of
leverage by issuing debentures and using the
proceeds to retire equity capital, or vice versa.
6)EBIT (operating profits) are expected to
remain constant over the years
7)All investors have the same expectations with
regard to future profits of a firm.
8)The firm’s business risk is constant over
time and is assumed to be independent of its
capital structure and financial risk.
9) Perpetual life of the firm
 Symbols and Notations
• EBIT/NOI = Earnings before interest and
taxes/ Net operating income
• S = Total market value of equity
• B = Total market value of debt
• V = Total market value of firm (V = S + B)
• I = Total interest payment
• NI = net income available to equity
shareholders
 Formulae
1.

2.
3.

or
 Net Income Approach
The NI Approach, put forth by Durand,
suggests that capital structure decision
is relevant to the valuation of the firm.
• This approach is primarily based on three
assumptions:

• Absence of taxes
• Cost of debt is lesser than cost of equity
• Use of debt does not change the risk
perception of investors (this means that
increased use of debt does not lead to an
increase in cost of debt or equity)
 Ke
Cost of Capital
(Ko, Kd & Ke) Ko

Kd

Leverage (B/V)
 Sample Problem
• X Co. Has a net operating income of Rs. 2,00,000 on
an investment of Rs. 1,000,000 in assets. It can raise
debt at a 16% rate of interest. Assume that taxes do
not exist.
Using the NI approach and an equity capitalisation
rate of 18%, compute the total value of the firm and
the weighted average cost of capital if the firm has
(i) no debt
(ii) Rs. 3,00,000 debt
(iii) Rs. 6,00,000 debt

Pg 348, I.M. Pandey, ‘Financial Mngmnt’, 9th edition

Net Operating Income (NOI) Approach

This theory of capital structure was also suggested

by Durand, but is exactly opposite to what NI
approach suggests.

According to this approach capital structure

decision, or leverage, is irrelevant.

Simply stated, this means that any change in the

capital structure of a firm will not affect the
overall cost of capital or valuation of a firm.
Assumptions of NOI Approach:
• Kd remains constant.
• An increase in cheaper debt funds is exactly
offset by an increase in the required rate of
return on equity, thus ko remains constant.
• The market capitalizes the firm as a whole,
therefore the split between debt and equity is
not important.
 Ke
Ko
Cost of Capital
(Ko, Kd & Ke)

Kd

Leverage (B/V)
 Sample Problem
• X Co. Has a net operating income of Rs. 2,00,000 on
an investment of Rs. 1,000,000 in assets. It can raise
debt at a 6% rate of interest. Assume that taxes do not
exist.
Using the NOI approach and an overall
capitalisation rate of 12%, compute the total value
of the firm, value of the shares and the cost of
equity if the firm has (i) no debt
(ii) Rs. 3,00,000 debt (iii) Rs. 6,00,000 debt

Pg 348, I.M. Pandey, ‘Financial Mngmnt’, 9th edition

 Traditional Approach
• Traditional approach states that up to a
particular point, use of debt is likely to
favourably affect value of a firm , but beyond
that point use of debt is likely to have an
adverse impact on the value of a firm.
• As per this approach, the effect of increase in
leverage on cost of capital and valuation of
the firm involves three phases:
• Phase 1: As leverage increases from zero, Ko
decreases and V increases

- This happens since a costlier source of finance

(equity) is being replaced by a relatively
cheaper source of finance (debt).
- Kd either remains constant or rises marginally
as the risk perception of lenders at this stage is
not very high.
• Phase 2: Constant V and constant Ko

- After a certain degree of leverage is reached,

further increase in debt has negligible effect on
market value of firm. This is largely due to the
fact that any benefits due to additional debt is
compensated by the increase in cost of equity.
Thus overall cost of capital also remains more
or less constant.
• Phase 3: Decreased V and increased Ko.

- Beyond a certain critical point, any additional

debt will have an adverse impact on market
valuation and Ko will increase.

- This is because the additional debt increases

financial risk to such an extent that both Kd
and Ke start rising rapidly.
 Traditional Approach

Ke

Ko

Cost of Capital Kd
(Ko, Kd & Ke)

Leverage (B/V)
• EBIT of a firm is Rs. 20,00,000 which is expected
to remain constant.
• Let us assume that the firm has Rs. 20,00,000
debt and Rs. 1,80,00,000 equity. Kd and Ke are
assumed at 10% and 15% respectively. What is
the overall cost of capital?
• Let us further assume that the company increases
the amount of debt in its capital structure to Rs.
90,00,000 and total capital remains the same at
Rs, 200,00,000. Due to increased financial risk Kd
and Ke increase to 11% and 16% respectively.
What is the impact on cost of capital?
• Let us see what happens if the amount of debt is
increased to Rs 120,00,000 and resultantly Kd
and Ke increase to 13% and 18% respectively
 Modigliani-Miller (MM) Approach
The Modigliani-Miller theorem, proposed
by Franco Modigliani and Merton Miller, forms
the basis for modern thinking on capital
structure and offers behavioural justification
of NOI approach.

The theorem states that, in a perfect market,

how a firm is financed (capital structure) is
irrelevant to its value.
 Basic Propositions of MM Approach
• Proposition I
• overall cost of capital (Ko) and the value of a
firm (V) are independent of its capital
structure and are constant for all degrees of
leverage. The total value of a firm is calculated
by capitalising the net operating income at an
appropriate rate.
• Proposition II
Their second 'proposition' stated that the cost of
equity for a leveraged firm is equal to the overall
cost of capital for an unleveraged (pure equity)
firm, plus an added premium for financial risk.

Ke = Ko + [(Ko – Kd) x B/S]

• This implies that, as leverage increases, while the

burden of individual risks is shifted between
different investor classes, total risk is conserved
and hence no extra value created.
• Proposition III
The cut-off rate for investment purposes is
completely independent of the way in which
an investment is financed.

In terms of capital structure theories we are

largely concerned with proposition I which is
based on certain assumptions:
1) Perfect Capital Markets
- Infinite divisibility of securities
- No restrictions on buying/selling of securities by
investors
- Individual investors can borrow freely at the same
rate and terms as corporate firms.
- No transaction costs.
- Same information is available to all investors at the
same time and at no cost.
- Investors are rational.
2) All investors have the same expectation of EBIT with
which to evaluate value of a firm.
3) Firms can be divided into homogenous risk classes.
4) Dividend payout ratio is 100%.
5) There are no taxes.
 MM Approach – Value of Leveraged
Firm and its Cost of Equity
In the case of Absence of Taxes

VL = VU + B

KeL = KeU + (KeU - Kd) x B/E

In the case of presence of Taxes
VL = V U + B x t

KeL = KeU + (KeU - Kd) x B/E x (1-t)

Where,
VL = Val+ue of Leveraged Firm
VU = Value of Unleveraged Firm
B = Value of Debt in Leveraged Firm
KeL = Equity Capitalization Rate of Leveraged Firm
KeU = Equity Capitalization Rate of Unleveraged Firm
t = Corporate Tax Rate
 MM Theory and Arbitrage
• The process of buying an asset or security in
one market and selling the same in another to
derive benefit from the price differential is
referred to as ‘arbitrage’.
• MM use the arbitrage process to support their
view as to why two equivalent firms which
differ only in their capital structure will
eventually arrive at an equilibrium total value.
• The following data relate to two companies belonging to
the same risk class:

Particulars X Ltd. Y Ltd.

Expected NOI Rs. 2,40,000 2,40,000
10% Debt Rs. 7,20,000
Equity capitalization rate 15%
a) Determine the Equilibrium Value, Equity Capitalization
Rate and the Weighted Average Cost of Capital for each
company assuming no taxes as per MM Approach.

b) Determine the Equilibrium Value, Equity Capitalization

Rate and the Weighted Average Cost of Capital for each
company assuming 40% corporate taxes as per MM
Approach.
• Companies U and L are similar in all respects,
except that U is unlevered while L is levered.
Company L has Rs. 20,00,000 of 8%
debentures outstanding. 1) Assume that all
MM assumptions are met 2) the tax rate is
40% 3)EBIT is Rs. 6,00,000 and equity
capitalization rate for company U is 10%.

Required:
a) What would be the value of each firm
according to MM’s hypothesis
b) Suppose VU = Rs. 25,00,000 and VL = Rs.
45,00,000 do they represent equilibrium
values? If not explain the process by which
equilibrium will be restored.

GGSIPU 2016 Q 7
 Sample Problem
• Two companies X & Y belong to equivalent risk group.
The two companies are identical in every respect except
that company Y is levered, while X is unlevered. The
outstanding amount of debt of the levered company is Rs.
6,00,000 in 10% debentures. The other information for
the two companies is as follows:
X Y
NOI Rs. 1,50,000 Rs. 1,50,000
Equity cap. Rate 0.15 0.20
Overall cap rate 0.15 0.143
Debt/equity ratio 0 1.33
 An investor owns 5% equity shares of
company Y. Show the process and the amount
by which he could reduce his outlay through
the use of the arbitrage process. Are there any
limits to the process?

• Adapted from: Pg 19.42, Q No. 19.17, Khan

&Jain, ‘Financial Mngmnt’, 6th edition, TMH.
 X Y
Net Operating Income (EBIT) Rs. 7,50,000 Rs. 7,50,000
Interest on Debt 50,000
Earnings to equity holders 7,50,000 7,00,000
Equity capitalization 0.125 0.14
Market value of equity 60,00,000 50,00,000
An
Overall capitalization rate 0.125 0.1363
Debt equity ratio 0 0.1
Market value of firm 60,00,000 5000000+500000
=55000000

• An investor owns 10% of the equity shares of the overvalued firm.

Determine his investment cost of earnings the same income so that
he is at a break-even point. Will he gain by investing in the under
valued firm?

• GGSIPU Q. Paper (Q 3, May 2011)

LEVERAGES
 Introduction
• “Employment of an asset or source of fund for
which the firm has to pay a fixed cost or fixed
return” - James Horne
• In financial terms, leverage refers to the
employment of an asset or source of fund (for
which the firm has to pay a fixed cost or fixed
return), in a manner meant to increase profits.
• Sometimes, however, the result may be contrary
to expectations, that is, profitability may be
adversely affected due to the use of these very
fixed cost incurring assets and funds.
• Thus, the earnings available to the shareholders
as well as the risk are affected by leverage.
 Types of Leverages
• There are three types of leverage – ‘operating’, ‘financial’ and
‘composite/combined’ leverage.

• The leverage associated with investment (asset acquisition) activities

is called operating leverage, while finance leverage associated with
financing activities is called financial leverage.

• The operating leverage studies the relationship between a firm’s

sales revenues and its earnings before interest and taxes (EBIT). The
EBIT is usually also referred to as operating profits.

• Financial leverage focuses on the relationship between the firm’s

operating profits (EBIT) and the earnings available to equity
shareholders.

• Thus EBIT is an important element of both operating and financial

leverage.
 OPERATING LEVERAGE
• In order to understand operating leverage it is
important that we understand the nature of costs
associated with a business operation.
• The total operating costs of a firm may be
categorized into fixed costs and variable costs.
• Fixed costs are those costs that remain constant
(fixed) irrespective of the level of activity, they
are a function of time and must be paid
regardless of the amount of revenues available.
• Variable costs are those costs which vary directly
with the level of activity.
• Operating leverage exists when a change in
sales (revenues) produces a more than
proportionate change in operating profit. This
is primarily because of fixed operating costs
are a part of the total cost structure.

Operating Leverage = Contribution

EBIT
Alternate Technique For Computing Operating
Leverage

• Since operating leverage measures the impact

on EBIT of a change in expected sales, this can
be used in the following form to measure
degree of operating leverage

• Operating Leverage = % change in EBIT

% change in Sales
 Financial Leverage
• Financial leverage is defined as the ability of a
firm to use fixed financial charges to magnify
the effects of changes in EBIT on the firm’s
earnings per share.
• Simply stated, financial leverage measures the
response of EPS to a change in operating
profits (EBIT) of a firm.
• Financial leverage results from the presence of
fixed financial charges in the firm’s income
stream.
• Fixed financial charges are payable in the form
of interest on debt funds and dividend
payable to preference capital providers.
• These fixed charges have to be paid
irrespective of any fluctuations in the
operating profits (EBIT) of a firm.
• The residual income available after paying
these charges belongs to equity shareholders.
• The degree of financial leverage may be calculated with the help of
either of the following formulae, depending on the nature of
information available :

DFL = EBIT

EBIT – I – Dp
(1-T)

where, EBIT = Earnings Before Interest and Tax (operating profits)

I = amount of interest payable on debt
Dp = dividend amount payable to preference shareholders
T = tax rate
Dp/(1-T) = pre-tax amount of preference dividend payable
 Alternate Technique For Computing Financial Leverage

Financial Leverage = % change in EPS

% change in EBIT

• For eg., a financial leverage of 2 indicates that if EBIT

changes by 5% then EPS will change by twice that. i.e. by
10% during the same time. Thus leverage is often referred
to as a “double-edged sword” since an increase in EBIT level
will have a positive impact on EPS but conversely there will
be a similar negative impact on EPS due to a change in EBIT.

• Therefore, in our example, since FL is 2 if EBIT decreases by

5% then EPS will decrease by 10%.
 Degree of Combined Leverage

DCL = DOL X DFL

• Q4 (a) Explain “Arbitrage Process” under Modigliani/Miller
theorem.
• (b) A company needs Rs. 31,25,000 for the construction of plant.
The following three plans are feasible:
• (i) The company may issue 3,12,500 equity shares at Rs. 10 per
share.
• (ii) The company may issue 1,56,250 equity shares at Rs. 10 per
share and 15,625 debentures of Rs. 100 denomination bearing an
8% rate of interest.
• (iii)The Company may issue 1,56,250 equity shares at Rs. 10 per
share and 15,625 preference shares of Rs. 100 per share bearing an
8% rate of dividend.
• If the company earnings before interest and taxes are Rs. 62,500,
Rs. 1,25,000, Rs. 2,50,000, Rs. 3,75,000 and Rs. 6,25,000. What are
the earnings per share under each of three financial plans? Assume
a Corporate Income Tax of 40%.
• Which alternate would you recommend and why?

GGSIPU End Semester Q Paper 2014

EBIT-EPS Analysis Practice Problem
• A recently established firm needs to raise Rs. 10,00,000 and is
evaluating the following alternatives
i) Raise the entire amount by issuing equity shares of Rs. 100 each.
ii) Raise half the required amount through issue of Rs. 100 equity
shares and the remaining amount through issue of 5% debentures.
iii) Raise half the required amount through issue of Rs. 100 equity
shares and the remaining amount through issue of 6% preference
capital.
iv) Which capital structure would you suggest to the company based
on an expected EBIT of
• a) Rs. 1,20,000 and b) Rs. 2,00,000? Assume tax rate at 50%.
• c) Also calculate the financial BEP of each plan
• d) determine the EBIT indifference level between plan i and iii
• And plan ii and iii
References:

1. M Y Khan & P K Jain, “Financial Management, Text,

Problems and Cases”, McGraw Hill, 6e, pp 19.1-
19.43.
2. I M Pandey, “Financial Management”, Vikas
Publications, 9e.
3. Srivastava & Misra, “Financial Management”,
Oxford University Press, 2008.