Financing Decision

Capital Structure theories

Net Income Approach

Net Operating Income Approach
Modigliani Miller Approach
Traditional Approach

Net Income Approach

Durand David suggested this approach

Capital Structure decision is relevant to the
valuation
In other words, a changing the financial
leverage will lead to a corresponding
change in the cost of capital as well as the
total value of the firm

V = (S+B)

V = value of the firm

S = Value of the equity
B = Value of the debt
Assumptions
There is no taxes

NIA

Cost

ke, ko

ke

kd

ko
kd

Debt

Example

A companys expected annual net

operating income (EBIT) is Rs.50000. The
company has Rs.200000 @ 10%
debentures. The equity capitalization rate
(ke) 12.5%.

Example
Net Operating Income (EBIT)
(Less) Interest on
PBT ( no tax so) PAT (NI)
Ke
Value of equity (S) [ NI/Ke)
Value of debt (B)
Value of the firm [S+B]
Overall cost of capital Ko = EBIT/V

Rs.
50000
20000
30000
0.125
240000
200000
440000
11.36%

Suppose, the company raise debt by

100000 i.e.., Rs.300000
Net Operating Income (EBIT)
(Less) Interest on
PBT ( no tax so) PAT (NI)
Ke
Value of equity (S) [ NI/Ke)
Value of debt (B)
Value of the firm [S+B]
Overall cost of capital Ko = EBIT/V
Thus the Ko is differ when Debt differ

50000
30000
20000
0.125
160000
300000
460000
10.9%

Net Operating Income Approach

(NoI)

According
to
NOI
approach the value of
the firm and the
weighted average cost
of
capital
are
independent of the
firms
capital
structure., Therefore
value of the company
is the same.

Cost
ke

ko
kd

Debt

Example

A companys expected annual net

operating income (EBIT) is Rs.50000. The
company has Rs.200000 @ 10%
debentures. The Overall cost of
capitalization rate (ko) 12.5%.

Example

Rs.

Net Operating Income (EBIT)

50000
Overall cost of capital (Ko)
0.125
Value of the firm [ EBIT/ Ko ]
400000
Value of the debt (B)
200000
Value of the equity (S) = V-B
200000
Ke = Eps / Value of Equity shares
Eps = EBIT I = 50000 20000 =
30000/200000 =
0.15
Ko = K [B/V ]+ Ke [S/V]
=0.10 [ 200000/400000]+ .15 [200000/400000]
= 0.125

Suppose, the company raise debt by

100000 i.e.., Rs.300000
Rs.
Net Operating Income (EBIT)
50000
Overall cost of capital (Ko)
0.125
Value of the firm [ EBIT/ Ko ]
400000
Value of the debt (B)
300000
Value of the equity (S) = V-B
100000
Ke = Eps / Value of Equity shares
Eps = EBIT I = 50000 30000 =
30000/100000 =
0.20
Ko = K [B/V ]+ Ke [S/V]
=0.10 [ 300000/400000]+ .20 [100000/400000]
= 0.125

MM approach

The Modigliani Miller Approach is relating

to the relationship between the capital
structure, Cost of capital.
MM Approach supports the NoI approach
MM Approach maintains that the WACC
does not change, with a change in the
proportion of debt to equity in the capital
structure.

Traditional Approach

NI approach clearly says that there is

relevant between the CS and the Ko and
Value of the firm.
NOI approach argues there is no relevant
between the CS & Ko , Value of the firm
MM approach stands together to the NOI
approach

Contd

Traditional Approach is midway between NI

approach and NOI approach
It is also known as Intermediate approach
It argues that Ko will not change upto
certain level of change in debt equity
proportion.

Example:

Assume a firm has EBIT of Rs. 40000. the

firm has 10 % debentures of Rs. 100000
and its current equity capitalisation rate is
16 %. Then ,,,,

Particulars

Amount
Rs.

EBIT
Less : Interest (10% on Debt)
EAT [NI]
Equity Capitalisation rate
Total MV of Equity (S) [NI/Ke]
Total MV of Debt (B)
Total Value of the Firm [V=S+B]
Ko [EBIT/V]
Therefore the Ko is approx

40000
10000
30000
0.16
187500
100000
287500
0.139
14%

Suppose debentures increase by

Rs. 50000 i.e. Rs.150000 and Interest Is increase by 11% and Ke 17%
Ensure whenever Debt increase interest will also increase
Rs.

EBIT
40000
Less : Interest
16500
NI
23500
Ke
0.17
S = NI / Ke
138235
B=
150000
Then V = (S+B)
288235
Ko = [ EBIT / V ]
0.138
Therefore the Ko is approx
14%
Thus we can understand that there is no relevant of
the Ko with the proportion of S: B

At the same time suppose if the firm issue additional debt Rs.100000
i.e. Rs.200000 then int is 12.5% and Ke 20 % then Ko will differ from the
past CS
Rs.

EBIT
Less : interest
NI
Ke
Value of the Equity (S) [NI / Ke]
Value of the Debt (D)
Value of the firm V = [S+D]
Ko = EBIT / V

40000
25000
15000
0.20
75000
200000
275000
0.145

Elements of Capital Structure

Capital mix
Maturity & priority
Terms & conditions
Currency

Framework for capital structure

FRICT - Analysis

Flexibility
Risk
Income
Control
Timing

Practical considerations in determining

the Capital Structure

Assets
Growth opportunities
Debt and Non debt tax shields
Financial flexibility & Operating strategy
Loan covenants
Financial slack
Early repayment
Limits in financial flexibility
Sustainability and feasibility
Control
Widely held companies
Closely held companies
Marketability and timing
Capital market conditions
Issue costs
Capacity of raising funds