1

FINANCIAL MANAGEMENT

TECHNICAL NOTES
COST OF CAPITAL AND CAPITAL STRUCTURE
COST OF CAPITAL
Concept of Cost of Capital
Investment in capital projects needs funds. These funds are provided by the investors like
equity shareholders, preference shareholders, debenture holders, etc in expectation of a
minimum return from the firm. The minimum return expected by the investors depends
upon the risk perception of the investor as well as on the risk-return characteristics of the
firm. This minimum return expected by the investors, which in turn, is the cost of
procuring funds for the firm, is termed as the cost of capital of the firm. Thus, the cost of
capital of a firm is the minimum rate of return that it must earn on its investments in order
to satisfy the expectation of the various categories of investors who have invested in the
firm.
A firm procures funds from various sources by issuing different securities to finance its
projects. Each of these sources of finance entails cost to the firm. Since the minimum rate
of return expected by various investors equity investor and debt investor will be
different depending upon their risk perception of the firm, the cost of each source of
finance will be different. Thus the overall cost of capital of a firm will be the weighted
average of the cost of different sources of finance, with the proportion of each source of
finance as the weight. Unless the firm earns this minimum rate of return, the investors
will be tempted to pull out of the company, let alone, to participate in any further capital
issue.
Definition of Cost of capital
Cost of capital may be defined as the minimum rate of return that a company has to offer
to investors to induce them to invest in the firm. It can also be thought of as the rate of
return that a firm must earn on its investment projects to maintain the market value of its
stock. If risk is held constant, projects with a rate of return above the cost of capital will
increase the value of the firm, and projects with a rate of return below the cost of capital
will decrease the value of the firm.
Significance (or Importance) of Cost of Capital
Cost of capital is an extremely important financial concept. We know that the basic
objective of financial management is to maximize the wealth of the shareholders or the
value of the firm. The value of a firm is inversely related to the cost of capital of the firm.
So in order to maximize the value of a firm, the overall cost of capital of the firm should
be minimized.

The cost of capital is extremely important in capital structure decisions and in capital
budgeting decisions.
(a) Role of Cost of Capital in Capital structure decisions
The cost of capital is an important consideration in capital structure decisions. In capital
structure planning a company strives to achieve the optimal capital structure in order to
maximize the value of the firm. The optimal capital structure occurs at a point where the
overall cost of capital is minimum.
(b) Role of Cost of Capital in Capital Budgeting Decisions
Since overall cost of capital is the minimum rate of return required by the investors, this
rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting
proposals. In fact, cost of capital is the rate of return that a firm must earn on the projects
in which it invests to maintain the market value of its stock. If risk is held constant,
projects with a rate of return above the cost of capital will increase the value of the firm,
and projects with a rate of return below the cost of capital will decrease the value of the
firm. So it is that magic number that is used to decide whether a proposed corporate
investment will increase or decrease the firms value. Obviously, only those investments
that are expected to increase the value of a firm, that is those projects for which NPV>0
or IRR> cost of capital, would be recommended.
(c ) Role of Cost of Capital in Selection of Source of Finance
Cost of capital is also useful in selection of source of finance. Once a company has
decided its target capital structure, the next step is the selection of appropriate source of
finance. Cost of capital plays an important role in the selection of source of finance apart
from other factors like risk, control and flexibility. A company usually selects a source of
finance with the least cost of capital.

(d ) Role of Cost of capital in Dividend Policy Decisions and Working Capital

Management
The concept of cost of capital is important in making appropriate dividend policy
decisions. Cost of capital is also important in working capital management decisions like
liberalization of credit policy.
(e) Role of Cost of Capital in Evaluation of the Performance of a Company and
Management
Cost of capital is useful in measuring the financial performance of a company and its
management. It is also useful in measuring the financial performance of different
divisions of a company. The performance measurement metrics like Economic Value

3
added (EVA) use cost of capital for evaluating the financial performance of a company
and its management.
Assumptions of Cost of Capital
While determining the cost of capital some key assumptions are made:
1. The business risk of a firm is assumed to be unchanged by the acceptance of a
given project.
2. The financial risk of a firm is assumed to be unchanged by the specific method of
financing a given project.
3. Each source of finance has either an explicit cost or an implicit cost.
4. Cost of each source of finance is determined on an after-tax basis
Costs of different Sources of Finance
A firm procures long-term sources of funds to finance its projects and fixed-assets
investments. These funds are procured from various sources by issuing different
securities. There are four major sources of finance used by a firm to finance its projects,
namely, Long-term debt, preference shares, equity shares and retained earnings. Longterm debt can be either debentures (or bonds) and Term loans from financial institutions.
Each of these sources of finance entails cost to the firm. Since the minimum rate of return
expected by various investors will be different depending upon their risk perception of
the firm, the cost of each source of finance will be different. Thus the overall cost of
capital of a firm will be the weighted average of the cost of different sources of finance,
with the proportion of each source of finance as the weight. Unless the firm earns this
minimum rate of return, the investors will be tempted to pull out of the company, let
alone, to participate in any further capital issue.
We have seen that the cost of capital of a firm is the minimum required rates of return of
various investors shareholders and debt investors- who supply funds to the firm. How
does a firm determine the required rates of return of each investor? The required rates of
return are market determined and is reflected in the market price of each security. An
investor, before investing in a security, evaluates the risk-return profile of an investment
and assigns a risk premium to the security. This risk premium and expected return of an
investor is incorporated in the market price of the security. Thus the market price of a
security is a function of the return expected by the investors. The required rate of return
of an investor, which is the cost of that specific source of finance to the firm, is the
internal rate of return which equates the present value of inflows to the firm from the
issue of that security to the present value of outflows to the firm with respect to that
security. It is given by the formula:
CF1
P

CF2
+

(1 + k )

(1 + k )2

+ . +

CFn
(1 + k )n

4
where,
k
P
CFn

=
=
=

Cost of the source of finance

Market price of the security
Cash outflows associated with the security

Cost of Debt
A debt may be in the form of secured/unsecured loans, debentures, bonds, etc. The debt
carries a fixed rate of interest and the payment of interest is mandatory irrespective of the
profit earned or loss incurred by the firm. Since interest payable on debt is tax deductible,
the use of debt provides a tax shield to the company. So the cost of debt is calculated
after-tax.
Cost of Debentures or Bonds
The before-tax cost of debentures or bonds is defined as the discount rate which equates
the net proceeds from issue of debentures to the present value of the expected cash
outflows in the form of interest and principal repayment. In other words, the before-tax
cost of debentures or bonds is the internal rate of return (or yield-to-maturity) on the cash
flows of the debentures or the bond. i.e.,
n

P =
t =1

It

F
+
t

( 1+ ki )

(1+ ki )n

where,
ki
I
F
P
n

=
=
=
=
=

Pre-tax cost of debenture capital

Annual interest payment per debenture capital
Redemption price per debenture
Net amount realised per debenture and
Maturity period

Net Proceeds from Issue of Debentures

In the above equation P represents the net proceeds from the issue of debentures. The net
proceeds from the issue of bonds are the funds that are actually from the issue of
debentures. In other words, the net proceeds from the issue of debentures are the funds
received from the issue of debentures less the flotation costs. Flotation costs include
underwriting commission and other issue expenses such as brokerage, legal charges and
other administrative expenses related to the issue of the debentures.
After-Tax Cost of Debentures or Bonds

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The Cost of debt-calculated by using the above formula is before-tax cost of debt.
Because the interest on debt is tax deductible, the cost of debt must be stated on an aftertax basis. The after- tax cost of debt is calculated by using the following formula:
kd
ki
kd
t

=
=
=

ki (1-t)

Before-tax cost of debt

Aft-tax cost of debt and
Corporate tax rate

(a) Cost of Irredeemable Debentures (Cost of Perpetual Debt)

Cost of debentures which are not redeemable during the life time of the firm or cost of
perpetual debt is calculated using the formula:
I (1-t)
kd =
P
Where,
kd
I
t
P

=
=
=
=

After-tax cost of debt

Annual interest payment per debenture
Corporate tax rate
Net proceeds from issue of debentures

(b) Cost of Redeemable Debentures (Cost of Redeemable Debt)

The cost of redeemable debentures or debt is the discount rate which equates the net
proceeds from issue of debentures to the present value of the expected cash outflows in
the form of interest and principal repayment. i.e.,

P =

t =1

F
+

( 1+ ki )t

(1+ ki )n

where,
ki
I
t
F
P
n

=
=
=
=
=
=

Before-tax cost of debenture capital

Annual interest payment per debenture capital
Corporate tax rate
Redemption price per debenture
Net amount realised per debenture and
Maturity period

Thus, the cost of redeemable debenture is the internal rate of return of the cash flows
associated with the debenture or yield-to-maturity of the debenture.
Since the interest payments are tax-deductible, the cost of debentures must be stated on
an after-tax basis. The after-tax cost of debenture, kd, can be found by multiplying beforetax cost of debenture, ki, by 1 minus tax rate. However, it should be noted that this taxshield is available only when the firm is profitable. A firm incurring losses is not required
to pay any taxes and hence its actual cost of debt is the before-tax cost and not the aftertax cost. The relationship between before-tax cost of debenture and after-tax cost of
debenture is given below:
kd

ki (1- t )

kd
ki
t

=
=
=

After-tax cost of debt

Before-tax cost of debt
Corporate tax rate

where,

An approximate formula for the calculation of the cost of redeemable debenture is:

FP
I

(1 t )

+
n

kd

=
F+P
2

Where,
kd
I
t
F
P
n

=
=
=
=
=
=

After-tax cost of debenture capital

Annual interest payment per debenture capital
Corporate tax rate
Redemption price per debenture
Net amount realized per debenture and
Maturity period

(c) Cost of Term Loan

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The cost of term loan is equal to the interest rate multiplied by (1 tax rate). The interest
rate to be used here is the interest rate applicable to the new term loan. The interest rate is
multiplied by (1 tax rate) as interest on term loans is a tax deductible expense. The
formula for calculation of cost of term loan will be:
kt

I (1 t )

kt
I
t

=
=
=

Post-tax cost of term loan

Interest Rate
Corporate tax rate

where,

Cost of Preference Share Capital

Preference shares carry a fixed rate of dividend. Preference shareholders also have a
preferential right for dividend and repayment of capital over equity shareholders. The
cost of preference share capital is the discount rate which equates the net proceeds from
issue of preference shares to the present value of the expected cash outflows in the form
of dividend and principal repayment on redemption. i.e.,
D

P =

t =1

F
+

( 1+ kp )t

(1+ kp )n

where,
kp
D
F
P
n

=
=
=
=
=

Cost of preference capital

Preference dividend per share
Redemption value
Net amount realised per share and
Maturity period

The net amount realized on issue of preference shares is the amount of money received
on issue minus any flotation costs. Since preference dividend is not deductible for tax
purpose, no further adjustment is required for tax shield.
(a) Cost of Irredeemable Preference shares
Cost of preference shares which are not redeemable during the life time of the firm is
calculated using the formula:
D
kp =
P

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Where,
kp
P
D

=
=
=

Cost of Preference Capital

Net amount realised per share
Preference dividend per share

(b) Cost of Redeemable Preference Shares

The cost of redeemable preference shares is the discount rate which equates the net
proceeds from issue of preference shares to the present value of the expected cash
outflows in the form of dividend and principal repayment on redemption. i.e.,
n

P =

i =1

F
+

( 1+ kp )i

(1+ kp )n

where,
kp
D
F
P
n

=
=
=
=
=

Cost of preference capital

Preference dividend per share
Redemption price
Net amount realised per share and
Maturity period

So the cost of redeemable preference shares is the internal rate of return of the cash flows
associated with the preference shares.
An approximate formula for the calculation of the cost of redeemable preference shares
is:

FP
D+
n
kp

=
F+P
2

where,

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kp
D
F
P
n

=
=
=
=
=

Cost of preference capital

Preference dividend per share
Redemption price
Net amount realised per share and
Maturity period

As already stated, the net amount realized on issue of preference shares is the amount of
money received on issue minus any flotation costs. Further, since preference dividend is
not deductible for tax purpose, no further adjustment is required for tax shield.
Cost of Equity Share Capital
Theoretically, the cost of equity share capital is the minimum return expected by the
equity investors on the equity shares of a company. The minimum return expected by the
equity investors depends upon the risk perception of the investor as well as on the riskreturn complexion of the firm.
Determination of the cost of equity share capital is a complex process compared to
determination of cost of debt. This is because the interest on debt is specified by a legal
agreement while the dividend on equity shares is not stipulated by any such legal
agreement. Measurement of the cost of equity share capital requires an understanding of
the factors basically concerning the behaviour of investors and their expectations.
Because of this, there are various approaches for determining the cost of equity. The
different approaches for determining the cost of equity are discussed below.
Dividend Growth Model Approach (or Gordons Dividend Growth Model
Approach)
An investor, who invests in the equity shares of a company, does so in the expectation of
certain return. In other words, when an investor buys equity shares of a certain risk, he
expects a certain return. This expected rate of return of an equity investor is the cost of
equity share capital.
According to the Dividend Growth Model, the value of equity shares of a company is the
present value of all future cash flows an investor can expect from holding the stock. With
equity shares, these expected cash flows are the cash dividends and selling price.
However, equity shares can have an infinite life due to the perpetual nature of a company.
So the value of equity share can be expressed as the present value of all future dividends
expected from the share for infinite period. Mathematically this can be expressed as,

D1
P0

=
(1 + ke )

i.e.,

D2
(1 + ke )2

+ . +

D
(1 + ke )

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Dt

P0

ke
Dt
P0

=
=
=

t=1

Eq. (1)

(1 + ke)t

where,
rate of return required by the equity shareholders
expected dividend per share at the end of year t, and
price or value per share

In practice, the model suggested by equation (1) cannot be used in its present form
because it is not possible to forecast the future dividend stream completely and accurately
over the life of the company.
In the case of most equity shares, the dividend per share grows because of the growth in
earnings of a company. The growth in dividend can be categorized as nil or constant
growth or super normal growth. If we assume that the dividends are expected to grow at a
constant rate of g per cent per year, then:
DN

D0 (1 + g )N

DN
D0
g

=
=
=

dividend at the end of year N

dividend for year 0
constant growth rate in dividend

Where,

The equation (1) can now be rewritten as,

D1
P0

D1(1+ g )

(1 + ke )

(1 + ke )

D1(1+ g )2

... +

(1 + ke )

The above equation can be simplified to:

D0 (1+g)
P0

=
ke g

Solving the above equation for ke we get

D1
ke

D1
=

+ g

ke g

D1(1+ g )
(1 + ke )

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P0
Where,
ke

D1
P0
g

=
=
=

rate of return required by the equity shareholders, which is the

same as the cost of equity share capital
expected dividend per share at the end of year 1
current market price per share and
constant growth in dividend (in per cent)
D1
=
D0(1+g)

Where,
D0

dividend paid in current year

In the above equation ke represents the required rate of return by the equity shareholders,
which is nothing but the cost of equity share capital. The factor D1/P0 is known as
dividend yield. Thus according to dividend growth model approach, the cost of equity
share capital is equal to the dividend yield plus the expected growth rate in dividend.
Because of this, this model is also known as dividend yield plus growth model.
Capital Asset Pricing (CAPM) Model Approach
Another alternative approach to measuring the cost of equity shares is the Capital Asset
Pricing Model (CAPM).
The Capital Asset Pricing Model provides a linear the relationship between the required
rate of return (ke) of a security and its systematic or market risk. The systematic risk of a
security, which is measured by the beta coefficient of the security, is the market risk that
cannot be eliminated through diversification. According to CAPM approach, the required
return on a security is given by the equation:
ke = Rf + ( Rm Rf )
Where,

ke
Rf

Rm
Rm - Rf

=
=
=
=
=

Required rate of return on security or equity.

Risk-free rate of return
Beta of security
Rate of return on market portfolio.
Market risk premium

The risk-free rate is the return earned on a risk-free asset like treasury bill or Government
Bond.
Since capital asset pricing model, under equilibrium conditions, provides an expression
for the minimum required return by an investor, it can be used to determine the cost of
equity. Thus, according to CAPM, the cost of equity, which is the required rate of return
by the equityholders, is the risk free rate plus beta multiplied by the market risk premium.

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Realised Yield Approach

According to this approach, the past returns on a security are taken as a proxy for the
return required in the future by the investors. The assumptions behind this approach are
that (a) the actual returns have been in line with the expected returns, and (b) the
investors will continue to have the same expectations from the security.
The realised return over a n year period is calculated as (W1 x W2 x .Wn)1/n 1
Where Wt is referred to as the wealth ratio. The wealth ratio Wt is calculated as,
Dt + Pt
Wt

and t = 1,2,.n.

Pt-1
Dt
Pt

=
=

Dividend per share for year t payable at the end of year

Price per share at the end of year t.

Earnings Price Ratio Approach (or Earnings-Capitalization Approach)

According to this approach, the cost of equity can be calculated as the ratio of expected
earnings (E1) to current market price (P) of a share. Thus cost of equity
ke

E1
P

=
=

E1/P

Where,
expected EPS for the next year
current market price per share

E1 can be arrived at by multiplying the current EPS by (1 + growth rate).

This method provides meaningful results in the following two cases:

The dividend payout ratio of the firm is 100% and

If the dividend payout ratio of the firm is less than 100 per cent, then the
retained earnings are expected to earn a rate of return equal to the cost of equity.

The method can be used only in the case of stable and matured firms. In the case of
growth firms the method gives unreliable estimates.
Bond Yield Plus Risk Premium Approach

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The logic behind this approach is that the return required by the investors is directly
based on the risk profile of a company. This risk profile is adequately reflected in the
return earned by the bondholders. Since the risk borne by the equity investors is higher
than that by the bondholders, the return earned by them should also be higher. Hence this
required rate of return on equity capital can be calculated as:
Required rate of return on equity = Yield on long-term bonds of the company + Risk
Premium.
The risk premium is arrived at after considering the various operating and financial risks
faced by the firm.
Cost of Retained Earnings
When a firm earns profit, it can either retain the profit for reinvestment or pay it as
dividend to its shareholders. If a firm pays its earnings as dividend, the same will be
available to the shareholders for investment elsewhere and earn further income. On the
other hand, if the firm retained part of its earnings for future investment, instead of
paying it as dividend, the shareholders will have to forgo an opportunity to earn further
return by investing the same. Since this opportunity cost of shareholders is their expected
return on equity, the cost of retained earnings is the same as the cost of equity. As a
result, the cost of retained earnings simply represents shareholders expected return from
the firms equity shares. Viewing retained earnings as the cost of equity shares we can set
the firms cost of retained earnings Kr to be equal to cost of equity capital.
i.e.

Kr = Ke

It is important to note that retained earnings are internally generated capital. Since they
are not raised through new issue of shares, they do not incur flotation costs. Thus, no
adjustment is required for flotation costs in the case of the retained earnings. Because of
this the cost of retained earnings is always less than the cost of new issue of common
stock.
Flotation Costs
Flotation costs are costs incurred for issuing a security. These costs include underwriting
commission, brokerage and other issuing expenses like legal charges and fees paid to
investment bankers. Flotation costs are incurred for all public issues of debentures,
preference shares and equity shares. While determining cost of capital, adjustment should
be made for flotation costs.
Costs of New Issue of Equity Shares or Cost of External Equity
Costs of new issue of equity shares, otherwise known as Cost of external equity, comes
into picture when there are certain floatation costs involved in the process of raising
equity from the market. It is the rate of return that the company must earn on the net

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funds raised, in order to satisfy the equityholders demand for return. Under the dividend
growth model, the following formula can be used for calculating the cost of external
equity:

D1

Ke

Ke
D1
P0
g
f

=
=
=
=
=

+ g
P0 (1 f )

Where,
cost of external equity
dividend expected at the end of year 1
current market price per share and
constant growth in dividend.
flotation costs as percentage of the current market price.

For all other approaches, the following formula can be used:

Ke

ke/ (1 f )

Ke
ke
f

=
=
=

cost of external equity

rate of return required by the equity investor
flotation costs as percentage of the current market price.

Where,

If flotation cost is given in amount instead of as a percentage, the adjustment for flotation
cost involves finding out the net proceeds from issue. The net proceeds from issue will be
the market price of the security minus the flotation cost.

Weighted Average Cost of Capital (WACC)

A firm uses various sources of finance to finance its projects. Each source of finance will
be having a specific cost. So in order to determine the overall cost of capital of the firm,
the weighted average cost of individual sources of finance should be determined with the
weights being the proportion of each type of capital used.
The weighted average cost of capital (WACC) is defined as the weighted average of the
after-tax cost of various sources of finance, weights being the book value or market
values of each source of finance. If WACC represents the weighted average cost of
capital or overall cost of capital then,
WACC

wdkd + wpkp + wtkt + weke + wrkr

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where,
WACC
kd
kp
kt
ke
kr
wd
wp
wt
we
wd

=
=
=
=
=
=
=
=
=
=
=

weighted average cost of capital

after-tax cost of debt
cost of preferred stock
after-tax cost of term loan
cost of equity
cost of retained earnings.
Proportion of total capital supplied by debt
Proportion of total capital supplied by preferred stock
Proportion of total capital supplied by term loan
Proportion of total capital supplied by external equity
Proportion of total capital supplied by retained earnings

If debt and equity are the only sources of finance used by the firm, the WACC can be
calculated as follows:
WACC = Cost of equity x Proportion of equity in the financing mix + Cost of debt x
Proportion of debt in the financing mix
i.e.
WACC
=
wdkd + weke or
E
WACC

ke x

D
+

kd x

D+E

D+E

Where,
D
E

=
=

proportion of debt in the financing mix

proportion of equity in the financing mix

The weights used in determining the weighted average cost of capital of a firm are
historical weights. Historical weights are based on a firms existing capital structure. The
use of these weights is based on the assumption that the firms existing capital structure is
optimal and therefore should be maintained in the future. Two types of historical weights
can be used book value weights and market value weights.
Book Value Weights
The use of book value weights in calculating the firms weighted cost of capital assumes
that new financings will be raised using the same method the firm used for its present
capital structure. The weights are determined by dividing the book value of each capital
component by the sum of the book values of all the long-term capital sources.
Market Value Weights

16
Market value weights are determined by dividing the market value of each source by the
sum of the market values of all sources. The use of market value weights for computing a
firms weighted average cost of capital is more scientific than the use of book value
weights because the market values of the securities closely approximate the amount to be
received from their sale.
Steps in Calculation of WACC
The following steps are involved in calculation of WACC:
1. Determine the proportion of each source of finance in the capital structure to the
total capital.
2. Determine the after tax cost of each component of the capital structure.
3. Multiply the cost of each source of finance in the capital structure with its
respective weights.
4. Determine the total of the products of the weights and cost of each source of
finance. The resulting figure is the WACC.
Interpretation of Weighted Average Cost of Capital
The interpretation of the weighted average cost of capital is straightforward. It is the
overall return the firm must earn on its existing assets to maintain the value of its shares.
It can also be interpreted as the required return on any investment by the firm that has
essentially the same risks as existing operations.
The weighted average cost of capital of a firm is the minimum return expected by the
investors from the firm and reflects the overall risk of the firm. Any project, which has
the same risk as the average risk of the firm will be evaluated by using WACC as the
discount rate. But what if a company is considering a project that is much riskier than the
average risk of the firm? Or what if a firm has divisions in several business lines that
differ in risk? It does not make sense for a company to use the same WACC to discount
cash flows of projects and divisions with different risks. In such cases, multiple costs of
capital reflecting the risk of each project or division should be used to discount the cash
flows.
Importance of Weighted Average Cost of Capital
The weighted average cost of capital (overall cost of capital) is of utmost importance in
capital structure planning and in capital budgeting decisions.
(a) Role of WACC in Capital structure planning
In capital structure planning a company strives to achieve the optimal capital structure in
order to maximize the value of the firm. The optimal capital structure occurs at a point
where the overall cost of capital is minimum.

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(b) Role of WACC in Capital Budgeting Decisions
Since overall cost of capital is the minimum rate of return required by the investors, this
rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting
proposals.

CAPITAL STRUCTURE
The Capital structure of a company refers to the mix of the long-term finances used by
the firm. It is the financing plan of the company.
Importance of Capital Structure Decision
The capital structure decision is a significant managerial decision which influences the
risk and return of the investors. The company will have to plan its capital structure
initially when it starts its operation and also subsequently whenever it has to raise
additional funds for various new projects. Whenever a company needs to raise long-term
finance, it involves a capital structure decision because it has to decide the amount of
such finance to be raised as well as the sources from which it is to be raised.

Capital Structure decision Process

The capital structure decision process can be diagrammatically represented as:
Capital Budgeting Decision

Need for long-term sources of finance

Capital Structure Decision

18

Debt-Equity Mix

Effect on Earnings
per Share

Selection of Source of Finance

Effect on risks to be
borne by investors

Risk

Cost

Control

Flexibility

Effect on Cost of Capital

Optimal Capital Structure

Value of the Company
Factors affecting the Capital Structure (Factors determining Capital Structure)
There are many factors that affect the capital structure of a firm. Some of the important
factors that should be considered while designing the capital structure of a firm are
discussed below:
1. Risk
The capital structure of a firm should be designed in such a way that it keeps the total risk
of the firm to the minimum level.
The total risk of a firm consists of business risk, operating risk and financial risk.
Business risk may be defined as the variation in operating income of a firm due to
variation in the sales. Business risk is caused by such factors like economic cycle,
business cycle, competitive settings, etc. Operating risk is caused due to the existence of
fixed cost in the total cost structure of a firm. Operating risk is measured by the operating
leverage. Financial risk may be defined as the variation in the earnings available to equity
shareholders due to the existence of debt capital in the overall capital structure of a firm.
Financial risk is measured by the financial leverage.
While designing the capital structure, a firm should keep the total risk to the minimum.
Firms with high business or operating risk should opt a less levered capital structure, with
reduced debt, in order to balance the business risk and financial risk. The impact of the
capital structure on the long-term solvency and financial risk should be assessed. Since,
increase in debt financing affects the solvency as well as the financial risk of the firm, the
excessive use of debt financing should be avoided.

19

2. Control
The equity shareholders, being the owners of the company, are concerned about the
dilution of their control over the company. Financing by new issue of equity shares will
dilute the control of existing shareholders. If there is a dilution of control, the
management may prefer to issue debt rather than equity shares to raise funds. So the
capital structure should involve minimum dilution of control of the company.
3. Flexibility
The flexibility of a capital structure refers to ability of the firm to raise additional capital
funds whenever needed to finance profitable and viable investment opportunities. The
capital structure should be one, which enables the firm to meet the requirements of the
changing situations. More precisely, flexibility means that a capital structure should
always have an untapped borrowing powers which can be used in conditions which may
arise any time future due to uncertainty of capital market, government policies, etc. So
the capital structure of a company should be flexible to be able to meet the changing
conditions with a minimum cost and delay. The company should be able to raise funds
whenever the need arises and also retire debts whenever it becomes too costly to continue
with that particular source.
4. Profitability
A capital structure should be the most profitable from the point of view of equity
shareholders. Within the given constraints, that capital structure should be selected which
will increase the returns available to the equity shareholders.
Optimal Capital Structure
An optimal capital structure is that capital structure which will minimize the overall cost
of capital of the company. In other words, it is that capital structure which will maximize
the value of the firm. An optimal capital structure should have the following features:
(a) Minimum Risk: An optimal capital structure should keep the total risk of the firm to
the minimum level. It should not be a threat to the solvency of the company and
should ensure a proper balance between business risk and financial risk.
(b) Maximum Profitability: An optimal capital structure should be the most profitable
capital structure from the point of view of the equity shareholders. It should be that
capital structure which will maximize the value of the equity shareholders.
(c) Minimum Dilution of Control: An optimal capital structure should involve
minimum dilution of control of the company.
(d) Maximum Flexibility: The optimal capital structure should be flexible to be able to
meet the changing conditions. It should have untapped borrowing powers which
would enable the firm to raise additional capital funds whenever needed to finance
profitable investment opportunities.

20

Approaches for determining Optimal Capital Structure

The three most common approaches for determining the optimal capital structure are:

EBIT-EPS Approach
Cash Flow Approach
Valuation Approach

EBIT-EPS Approach: In EBIT-EPS approach the impact of the various alternative

capital structures on the EPS of the company is analyzed. The capital structure, which
results in the highest EPS, will be selected as the optimal capital structure.
Cash Flow Approach: In this approach, the impact of alternative capital structures on
the ability of the firm to service its debt is analyzed. Ratios such as Debt Service
Coverage Ratio can be used for this purpose. The capital structure, which ensures the
payment of all debt obligations under any circumstances, is selected as the optimal capital
structure.

Valuation Approach: under this approach alternative capital structures are analyzed as
to their impact on the overall cost of capital and value of the firm. The capital structure,
which will minimize the overall cost of capital of the firm or maximize the value of the
firm, will be selected as the optimal capital structure.
Capital Structure Theories
Capital structure theories examine the relationship between capital structure and the value
of the firm. The capital structure theories are based on the following general assumptions:
1. A firm employs only two types of capitals: debt and equity.
2. The total assets of the firm are given and there would be no change in the investment
decisions of the firm.
3. The net operating income of the firm is given and is not expected to grow.
4. The firm has a policy of distributing 100 per cent of its earnings as dividend, i.e., it
follows 100 per cent dividend payout policy.
5. The business risk complexion of the firm is given and is constant and is not affected
by the financing mix.
6. The investors have the same subjective probability distributions of expected future
operating earnings of the firm.
7. There are no corporate or personal income taxes.
8. A firm can change its capital structure instantaneously without incurring any
transaction costs.
In our analysis of capital structure theories, the following legends will be used.
E

Total market value of equity shares

21
D
V
I
EBIT
NP
D0
D1
P0
P1
kd
ke
k0

=
=
=
=
=
=
=
=
=
=
=
=

Total market value of the debt

Total market value of the firm, i.e., V = D+E
Annual interest charges
Earnings before interest and tax
Net profit or profit after tax
Dividend paid by the company at time 0 (i.e., now)
Expected dividend at the end of year 1 (from now)
Current market price of the share
Expected market price of the share after 1 year
After tax of cost of debt
Cost of equity
Overall cost of capital, i.e., WACC.

Based on the above assumptions and some more stated as and when required, the cost of
debt, equity and the firm are derived as follows.
Assuming that the debt capital is perpetual,
I
kd

=
D

Based on the assumption of 100% dividend payout and constant earnings, cost of equity
NP
ke

=
E

Given the net operating income to be constant, the cost of capital of the firm,
EBIT
ko

=
V

Where V = D + E
Since overall cost of capital ko is the weighted average cost of capita, WACC, it may be
expressed as,

Kd x D
ko

ke x E
+

(D + E)
NET INCOME APPROACH

(D + E)

22
The Net Income Approach (NI) states that there is a relationship between capital structure
and the value of the firm. According to this theory, the capital structure is relevant in
determining the value of the firm. A firm can increase its value or reduce its overall cost
of capital by increasing the proportion of debt in the capital structure. Both the overall
cost of capital, ko and the value of the firm, V, are affected by the firms use of leverage.
The Net Income approach makes the following specific assumptions:
1. The total capital requirement of the firm is given and remains constant.
2. The debt-capitalisation rate is less than the equity-capitalisation rate. That is, kd is
less than ke.
3. The use of debt does not change the risk perception of investors; as a result, the
equity-capitalisation rate, ke and the debt-capitalisation rate, kd remain constant with
change in leverage. That is, both kd and ke remain constant.
4. There is no corporate tax.
The Net Income approach states that, a change in the capital structure of a firm will lead
to a change in the overall cost of capital, ko, and the value of a firm. As kd is less than ke,
the increased use of cheaper debt (and simultaneous decrease in equity proportion) in the
overall capital structure will result in a decrease in ko and increase in the value of the
firm. the relationship between leverage and cost of capital under NI approach is presented
graphically below.

Cost of
Capital (%)

ke
ko

kd

23

Leverage (degree)

From the graph it is clear that ke and kd are constant for all levels of leverages. As the
leverage of a firm increases, the overall cost of capital of the firm, ko decreases since kd is
less than ke. This decrease in overall cost of capital of the firm will lead to an increase in
value of the firm. From the graph it is can be seen that ko will approach kd as the debt
proportion is increased. For an all equity firm ko will be equal to ke and for an all debt
firm it will be equal to kd.
The NI approach suggests that a firm is able to increase its value, V, and lower its cost of
capital, ko, as it increases the degree of leverage. With a judicious use of the debt and
equity, a firm can achieve an optimal capital structure. This optimal capital structure is
one at which the overall cost of capital, ko of the firm is minimum and the value of the
firm, V, is maximum.
NET OPERATING INCOME APPROACH
The Net Operating Income (NOI) approach suggests that the firms overall cost of
capital, ko, and its value, V, are both independent of the leverage of the firm. According
to the Net Operating Income approach, the market value of the firm is not affected by the
change in capital structure of the firm and the capital structure is irrelevant in determining
the value of the firm. The key assumption of this approach is that the overall cost of
capital ko is constant regardless of the degree of leverage. The NOI approach makes the
following specific assumptions:
1. The market capitalizes the value of the firm as a whole. Thus the proportion in which
debt and equity have been used in the capital structure is not relevant in determining
the value of the firm.
2. The market uses an overall capitalisation rate, ko to capitalize the net operating
income. ko depends on the business risk of the firm. It is assumed that the business
risk of the firm remains unchanged and the overall cost of capital, ko of the firm is
constant.
3. The cost of debt, kd is also constant.
4. The use of more and more debt in the capital structure increases the risk of the
shareholders and thus results in the increase in the cost of equity capital i.e., ke. The
increase in ke is such as to completely offset the benefits of employing cheaper debt.
5. There is no corporate tax.
The NOI is approach is based on the premise that the market values the firm as a whole
for a given risk complexion. Thus, for a given value of EBIT, the value of the firm
remains same irrespective of the capital structure of the firm and instead depends on the

24
overall cost of capital. Under NOI approach, the total value of the firm is found out by
dividing the net operating income (EBIT) by the overall cost of capital, ko. The market
value of equity, E, can be determined by subtracting the value of debt, D, from the total
market value of the firm V. i.e.,

EBIT
ko

and
E
=
VD
The cost of equity capital, ke, is
EBIT - I
ke

=
VD

Where,
V = total market value of the firm, i.e., V = D + E
E = total market value of the equity
D = total market value of the debt.
I = total interest payments
ke = cost of equity
ko = overall cost of capital, i.e. WACC
Thus, the NOI approach states that the financing mix is irrelevant for determining the
value of the firm. The value of the firm remains the same for all debt-equity mix.
The relationship between leverage and the cost of capital is presented graphically below:

Cost of
Capital (%)

ke

ko

25
kd

Leverage (degree)

From the graph, it can be seen that the cost of debt kd and the overall cost of capital, ko,
are constant for all levels of leverage. As the proportion of debt or financial leverage
increases, the risk of the shareholders also increases and thus the cost of equity capital, ke
also increases. However, the overall cost of capital, ko remains constant because increase
in ke is just sufficient to offset the benefits of cheaper debt financing.
Since NOI approach assumes that ko is constant at all levels of leverage, this approach
suggests that there is no optimal capital structure. In other words, as the cost of capital is
the same for all capital structures, every capital structure is optimum.
TRADITIONAL APPROACH
The NI approach and the NOI approach hold extreme views on the relationship between
the leverage, cost of capital and the value of the firm. the traditional approach takes a
midway between these two approaches.
According to traditional approach, there exists an optimal capital structure for every firm.
At this capital structure, the overall cost of capital of the firm is minimized and the value
of the firm is maximized. The traditional viewpoint 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 overall cost of capital also and
hence the value of the firm will decline.
Under the traditional approach, the cost of debt (kd) is assumed to be less than the cost of
equity. (ke). In the case of a 100 per cent equity firm, the overall cost of capital of the
firm (ko) is equal to the cost of equity (ke). But when cheaper debt is introduced in the
capital structure and the financial leverage increases, the cost of equity (ke) remains
constant as the equity investors expect a minimum leverage in every firm. The ke does not
increase even with increase in leverage. This constant ke and kd makes the ko to fall
initially. But this position does not continue when leverage is further increased. The
increase in leverage beyond a limit increases the risk of the equity investors also and as a
result the ke also starts increasing. However, the benefit of use of debt may be so large
that even after offsetting the effects of increase in ke, the ko may still go down or may
become constant for some degree of leverages. However, if the firm increases the
leverage further, then the risk of the debt investor may also increase and consequently the
kd also starts increasing. The already increasing ke and the now increasing kd makes the

26
ko to increase. Therefore the use of the leverage, beyond a point will result into an
increase in the overall cost of capital of the firm and a decrease in the value of the firm.
Thus, there is a level of financial leverage in any firm, up to which it favourably affects
the value of the firm but thereafter if the leverage is increased further, then the effect may
be adverse and the value of the firm may decrease. In other words, a firm can be
benefited from a moderate level of leverage when the advantage of using debt (having
lower cost) outweighs the disadvantage of increasing ke (as a result of higher financial
risk).
The relationship between leverage and the cost of capital is presented graphically below:

Cost of
Capital (%)

ke

ko

kd

O
Optimal Capital
Structure
MODIGLIANI AND MILLER APPROACH

Leverage (degree)

Modigliani and Miller (MM) approach states that the value of a firm and its cost of
capital are independent of its capital structure. In other words, according to Modigliani
and Miller, capital structure is irrelevant in determining the value of a firm. Modigliani
and Miller argue against the traditional approach and state that the relationship between
leverage and value of a firm is explained by the Net Operating Income (NOI) approach.
They have , in fact, restated the NOI approach by offering a behavioural justification for
having the cost of capital ko, remain constant throughout all degree of leverage. The MM
model is based on the following assumptions:
Assumptions of the MM Model

27
1. The capital markets are perfect and complete information is readily available to all
the investors free of cost.
2. The capital markets are frictionless and there are no transaction costs or flotation
costs.
3. All securities are infinitely divisible and no investor is large enough to affect the
market price of the securities.
4. Investors are assumed to be rational and choose a combination of risk and return that
is most advantageous to them.
5. The firm has a given investment policy and is not subjected to change.
6. All investors have same probability distribution about the expected future earnings of
the firm.
7. Firms can be grouped into equivalent return classes on the basis of their business
risks. All firms falling into one class have the same degree of business risk.
8. The personal leverage and the corporate leverage are perfect substitute.
9. There is no corporate or personal income tax.
Based on the above assumptions MM derived the following three propositions.
Proposition I
MM proposition I states that the value of a firm is independent of its capital structure.
M & M proposition I states that the value of a firm is independent of its capital structure.
In other words it states that capital structure is irrelevant for the value of the firm. The
value of a firm depends upon its investment decision and not on how a firm chooses to
finance its investments. The right hand side of the balance sheet (asset side) creates value
and the left hand side of the balance sheet only determines how this value is sliced among
the investors.
One way to illustrate the MM proposition I is using a Pie model. Imagine two firms
identical in all respects, except in their capital structure. Their assets and operations are
exactly the same. The only difference is in their capital structure; that is they use different
proportions of debt and equity to finance their operations.
The values of the two firms then can be represented in the form of Pies as shown
below:

Value of firm

Equity
40%

Debt
60%

Value of firm

Equity
60%

Debt
40%

28

The above figure shows two possible ways of cutting up the pie between equity slice, E,
and the debt slice, D: 40% - 60% and 60% - 40%. However, the size of the pie in the
above figure is the same for both firms because the value of the assets is the same. This is
precisely what MM proposition I states: The size of the pie does not depend on how it is
sliced. In a perfect market, no matter how one slices the corporate pie between debt and
equity, there is a conservation of value, so that the sum of the parts is always the same. In
other words nothing is lost or gained in the slicing.

Thus, according to MM theorem, two firms, identical in all respects, except in their
capital structure, cannot command two different values. If that is not so, an arbitrage
operation will set in, driving the values of the two firms to equality. To prove their
argument, MM suggested an arbitrage process.
An arbitrage process involves undertaking two related actions simultaneously in order to
derive a benefit. The benefit from the arbitrage may be either increased income fron same
level of investment or same income from a lesser investment.
The arbitrage process suggested by MM can be explained with the help of the following
example:
Consider two firms A and B identical in every respect except that firm A is not levered
and firm B is a levered firm with a 10% debt of Rs. 3,00,000 in its capital structure.
Assume further that both firms have the same net operating income (EBIT) of Rs.
1,00,000 and their cost of equity are 20%. According to traditional approach the value of
the two firms would be different as shown below:

EBIT
(-) Interest
Net Profit
Equity capitalization rate, ke
Value of equity
Value of debt
Total value of firm, V
WACC, ko

Firm A
Rs. 1,00,000
1,00,000
0.20
5,00,000
5,00,000
20%

Firm B
Rs.1,00,000
30,000
70,000
0.20
3,50,000
3,00,000
6,50,000
15.38%

Though, the unlevered firm A and the levered firm B are in the same risk class and have
the same net operating income, the market value of the levered firm B is higher than that
of the unlevered firm A. MM argue that this situation cannot continue for long and soon

29
an arbitrage process will drive the values of the two firms equal. According to them, if
two firms are alike in all respects, except that they differ only in their capital structure, as
we have now, then investors will develop a tendency to sell the shares of the overvalued
firm (creating a selling pressure) and to buy the shares of the undervalued firm (creating a
buying pressure). This, buying and selling pressures will continue till the two firms have
the same value.
The arbitrage process, which would make the values of the two firms, can be explained
by the following steps:
1) Suppose an investor is holding 10% of the equity share capital of the levered firm B.
Then the value of his ownership right will be Rs. 35,000, i.e., 10% of Rs. Rs.
3,50,000. Further, out of the total net profit of Rs. 70,000 of the firm, he will be
entitled to 10%, i.e., Rs. 7,000 per annum.
2) In order to make a profit, suppose he now decides to convert his holdings from firm B
to firm A.
3) He disposes of his 10% holding in firm B for Rs. 35,000 and acquires 10% holding in
the unlevered firm A.
4) In order to buy 10% holding in firm A he requires a total sum of Rs. 50,000 (10% of
Rs. 5,00,000) where as his proceeds from sale of holdings in firm B are only Rs.
35,000.
5) The investor, thus, borrows Rs. 30,000 at 10%. This personal debt of the investor is
equal to 10% of the debt of the company B, his previous proportional ownership of
the company. This process would shift his corporate leverage in firm B to an
equivalent personal leverage. The investor now has a total sum of Rs. Rs. 65,000 (i.e.,
the proceeds of Rs.35,000 from the sale of his 10% holdings in company B and the
proceeds of his personal borrowings of Rs.30,000).
6) Out of the total funds of Rs.65,000, he now invests Rs.50,000 in shares of company A
in order to buy 10% of the holdings of the company. Still he has funds of Rs.15,000
available with him. The net returns available to the investor from the firm A are:

Profit available from firm A (being 10% of net profit)

Rs. 10,000
(-) Interest payable @10% on Rs.30,000 borrowing
3.000
Net return
7,000
7) So, the investor is able to get the same return of Rs.7,000 from firm A also, which he
was receiving as an investor of firm B. He is also having funds of Rs.15,000 left over
for investment elsewhere. Thus, his total return may now be more than Rs.7,000
(inclusive of some return on the investment of Rs.15,000).
8) More over his risk is the same as before. Though his new outlet, i.e., firm A is an
unlevered firm (hence no risk), the position of the investor is levered because he has
created a homemade leverage by borrowing Rs.30,000 from the market. In fact, he
has replaced the corporate leverage of firm B by his personal leverage.

30
The above example shows that, the investor, who originally owns a part of the levered
firm and enter into the arbitrage process as above, will be better off selling the holding in
levered firm and buying the holding in unlevered firm using his home made leverage.
MM argue that this opportunity to earn extra income through arbitrage process will
attract many investors. The gradual increase in sales of the shares of the levered firm will
push its prices down and the tendency to purchase the shares of unlevered firm A will
drive its prices up. These selling and buying pressures will continue until the market
values of the two firms are equal. At this stage, the values of the levered and the
unlevered firms and their costs of capital will be the same. Thus the value of a firm and
its overall cost of capital, ko, are independent of its capital structure.
Proposition II
MM proposition II states that a firms cost of equity capital is a positive linear function of
the firms capital structure.
MM proposition II states that the cost of equity of a firm is a positive linear function of
its capital structure. This proposition can be algebraically expressed as:

ke = ko + ( ko kd) x (D/E)
where,
ke
ko
kd
D
E

=
=
=
=
=

Cost of equity of a levered firm

Overall cost of capital of a firm or Cost of equity of an unlevered firm
cost of debt
Value of the debt
Value of the equity

So MM proposition II states that the cost of equity capital of a levered firm is equal to the
overall cost of capital of the firm (or cost of equity capital of an unlevered firm) plus a
risk premium related to the financial risk equal to the debt-equity ratio times the
difference between the overall cost of capital and the cost of debt.
The term ( ko kd) x (D/E) in the preceding equation represents the financial risk
premium, that is, the premium related to the use of debt. In other words, Proposition II of
the MM model states that the cost of equity of a firm is a linear function of its capital
structure. MM proposition II can be graphically represented as follows:

Cost of
Capital (%)

ke

31

ko

kd

Leverage (D/E Ratio)

From the above graph, it is clear that as the financial leverage, measured by the debtequity ratio, increases, the cost of equity ke also increases due to increase in risk of the
equity holders. The overall cost of capital ko remains constant for all levels of leverage.
This implies that a tradeoff takes place between debt and equity: The advantages of using
cheaper debt are neutralized by the increasing costs of equity.
Note that, in the above graph, the overall cost of capital does not depend on the leverage
(debt-equity ratio); it is the same no matter what the debt-equity ratio is. This is another
way of stating MM proposition I: The firms overall cost of capital is unaffected by its
capital structure.
Proposition III
MM proposition III states that the cut-off rate for investments of a firm is equal to the
overall cost of capital (WACC) of the firm, which is independent of the capital structure.
In other words, according to MM proposition III, the cut-off rate for investments is
independent of the firms financing choice and depends only on the risk of the projects in
which investment is made. The proposition emphasizes the point that the weighted
average cost of capital of a firm is not affected by the firms financing decisions, as both
investment and financing decisions are independent.

MM Propositions with Corporate Taxes

The irrelevance of capital structure rests on an absence of market imperfections To the
extent that there are capital market imperfections, however, changes in the capital
structure of a company may affect the total value of the firm. That is to say, the firms
valuation and cost of capital may change with changes in its capital structure. One of the

32
most important imperfections is the presence of taxes. In this regard, we will examine
now the impact of corporate taxes on the value of the firm.

MM Proposition I with Corporate Taxes

Debt financing is advantageous to a firm when corporate tax is present. The reason is that
interest on debt is a tax-deductible expense whereas dividends are not deductible for tax.
Consequently, the total amount of payments available to both debt holders and
stockholders is greater if debt is employed.
To illustrate this point, suppose the earnings before interest and taxes are Rs. 2,00,000 for
companies X and Y, and they are alike in every respect except in leverage. Company Y
has Rs. 5,00,000 in debt at 12 percent interest, whereas company X has no debt. If the
corporate tax rate is 40 percent for each company, we have:
Company X
Rs.
Earnings before interest and taxes
Interest income to debt holders
Earnings before taxes
Taxes
Income available to shareholders
Income to debt holders plus income
To shareholders

2,00,000
0
-------------2,00,000
80,000
----------1,20,000
=======
1,20,000
=======

Company Y
Rs.
2,00,000
60,000
-------------1,40,000
56,000
------------84,000
=======
1,44,000
=======

Thus, total income to both debt holders and shareholders is larger for the levered
company Y than it is for the unlevered company X. Total income to all investors
increases by the interest payment times the tax rate. In our example this amounts to Rs.
60,000 x 0.40 = Rs. 24,000. This figure represents the tax shield or tax savings on interest
payments, due to the existence of debt in the capital structure of the levered firm Y. If the
debt employed by the company is permanent (or perpetual), present value of the tax
shield using perpetuity formula is,

Present value of the tax shield

Present value of tax shield

D x ke x t
--------------ke
D x t = Debt x t

33

Where,

D = Value of debt
t = Corporate tax rate
ke = Cost of debt
Note that the discount rate used is cost of debt, because the tax shield is generated by
paying interest on debt and so it has the same risk as the debt. So the appropriate discount
rate is ke. Thus the value of a levered firm is:

Value of a levered firm

= Value of an unlevered firm + Value of tax shield.

Thus, debt financing will increase the value of the firm by an amount equal to the present
value of the tax shield on the interest payments. In general, when corporate taxes are
considered the value of the firm that is levered would be equal to the value of the
unlevered firm increased by the tax shield associated with the debt. That is,

VL

VU + Debt x (t)

VL
VU
Debt
t

=
=
=
=

value of the levered firm

value of the unlevered firm
total debt raised by the levered firm
corporate tax rate.

Where,

Criticisms of MM model
One of the important assumptions of MM theory is that capital markets are perfect. So the
irrelevance of capital structure in valuation of a firm, as postulated by MM hypothesis,
rests on the absence of the capital market imperfections. However, in the face of
imperfections in the capital markets, the capital structure of a firm may affect the
valuation of the firm; i.e., the firms value and cost of capital may change with changes in
its capital structure. The following imperfections of the capital markets will affect the
value of the firm:
(a) Bankruptcy Costs
Existence of bankruptcy costs is another important imperfection affecting the capital
structure. Capital markets when perfect, has no costs associated with the bankruptcy.
Assets of a bankrupt firm can be sold at their economic values and legal and

34
administrative expenses are not present. However, in the real world, there are costs
associated with bankruptcy. Under distress conditions, assets are sold at a significant
discount below their economic values. Moreover, costs like legal and administrative costs
associated with bankruptcy proceedings are high.
The probability of bankruptcy for a levered firm is higher than that for an unlevered firm.
The probability of bankruptcy increases as the debt-equity ratio increases. This means
that the expected cost of bankruptcy increases when the debt-equity ratio increases.
Investors expect a higher rate of return from a firm which is faced with the prospect of
bankruptcy, as bankruptcy costs represent a loss that cannot be diversified away.
The following figure is a graphical representation of the relationship between the required
rate of return on equity, ke, and the leverage ratio, D/E.
Required rate
of return
on equity

ke

Premium for
Financial risk

Premium for
Business risk
Risk free rate

Leverage D/E

Agency Costs
Another set of market imperfections that make the debt-equity mix relevant to the firms
value is agency costs. Agency costs are costs due to conflict of interest. Agency costs
arise when the interests of stockholders conflict with those of the bondholders or the
managers.
Firstly, conflict between shareholders and managers arise because managers are not
entitled to 100% of the residual claims. Consequently the managers do not capture the
entire gain from the profit enhancement activities, but they do bear the entire costs of
these activities. The managers may, therefore, put in less efforts in value enhancement
activities and may also try to maximise their private gains through lavish perquisites,

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plush offices, empire building through sub-optimal investments. These inefficiencies
decrease with the increase in the managers stakes in the firm.
Secondly, conflicts also arise between the interests of debt holders and equity holders. If
an investment financed with debt yields high return (higher than the cost of debt), equity
holders are entitled to the gains. On the other hand, if the investment fails, the debt
holders suffer the losses due to limited liability of the equity holders. As a result, equity
holders may benefit from investing in very risky projects even if they are value
decreasing. Such investments result in a decline in the value of debt. The loss in the value
of the equity from poor investments can be more than offset by the gains in equity value
at the expense of the lenders. The lenders to the firm protect themselves against
expropriation by imposing certain conditions on the firm. These conditions are called
protective covenants and remain in force till the debt is repaid. These conditions may
relate to restrictions on further borrowings by the firm, cap on payment on dividends,
managerial remuneration, sale of assets, limitations on new investments, etc. these
conditions may lead to sub-optimal operations resulting in inefficiencies. Further, the
lenders put in place strong monitoring and corrective mechanisms to enforce the debt
covenants. The monitoring and enforcement costs are passed on to the firm in the form of
higher cost of debt (kd). These costs, together with the cost of inefficiencies (due to the
covenants) are called agency costs.
Monitoring costs are a function the level of debt in the capital structure. When the
amount of debt is considerably less, then the creditors may limit their monitoring activity.
But if the level of debt is high, then they may insist on continuous monitoring which
entails substantial costs. The agency cost may be virtually non-existent at low levels of
leverage. However, after the threshold point, the lenders start perceiving the firm to be
increasingly risky. This may result in a disproportionate increase in the agency costs due
to the need for extensive monitoring.
The agency costs are reduction in the value of the firm due to these conflicts. These
conflicts were assumed not to exist in Modiglianis and Millers perfect market
environment.

Critical Evaluation of MM Model

MM hypothesis states that the value of a firm is independent of its capital structure.
This conclusion of MM model is based on a set of assumptions, including existence of a
perfect and frictionless market. However many of these assumptions may not be valid in
real world. The following are the major objections or limitations of the model:
1. Non-Substitution of personal and corporate leverage: MM model assumes
that personal and corporate leverage are perfect substitutes. This may not be so
because of the following reasons:

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a. An individual normally cannot borrow at the same rate at which a
corporate can borrow, because the credit rating of a corporate firm would
be better than that of the individual.
b. When an individual investor borrows money in his personal capacity, his
liability is unlimited. However, as a shareholder of a levered firm, his
liability is limited only to the capital subscribed irrespective of the level of
borrowings of the firm.
2. Transaction costs: MM model assumes that the market is frictionless with the
absence of transaction costs like brokerage. However, brokerage and other
transaction costs do exist, and they impede the arbitrage process assumed by MM.
3. Availability of complete information: MM model assumes a perfect capital
market with complete information available to all investors. In real world this
assumption is not valid.
4. Corporate taxes: The MM model assumes that there is no corporate tax. This
assumption is also unrealistic in real world.
5. Costs of Financial distress and Agency costs: MM model also assumes that
there is no costs associated with financial distress and ignores agency costs. This
is also not correct.

CAPITALISATION
Meaning of Capitalisation
Capitalisation means the sum of the shares and debentures outstanding for a company.
Capitalisation also includes capital reserve and revenue reserve provided that the
company plans to retain them permanently. In the broadest sense, capitalisation means
the sum of all long-term sources of funds of a company, i.e., the sum of the shareholders
funds and long-term debt funds.
The total value of capitalisation of a company can be determined either by taking the total
cost of fixed assets and working capital or by capitalizing the operating earnings of a
company at the overall cost of capital of the company.
Over-Capitalisation
Over-capitalisation is a situation where:
(a) the aggregate of the par values of shares and debentures of a company exceeds
the true economic values of its fixed assets or
(b) the capitalized value of the operating earnings of the company, capitalized at the
normal rate of return for similar companies in the same industry, is less than the
aggregate value of the shares and debentures of the company.
Causes of Over-Capitalisation

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Some of the factors, which lead to over-capitalisation, are discussed below:
1. Diversity between book value and real worth of assets: Some times, the value of
the assets of a company has no relevance to its earning capacity. This might happen
when the assets of a company are revalued at higher prices on merger. This results in
the book value of the company being more than its real worth.
2. Existence of Non-Productive Assets: Existence of non-productive assets will
depress the operating earnings of the company, thereby leading to over-capitalisation.
Examples will be existence of fictitious intangible assets like patents, goodwill, etc.
3. Low Operating Efficiency and Under-Utilisation of Capacity: Lower operating
efficiency and under utilization of capacity will lead to lower productivity and higher
operating cost. This will depress the operating earnings of a firm, thus leading to
over-capitalisation.
4. High Financial Leverage and Gearing: High financial leverage indicates, excessive
reliance on debt. When the return on investment is less than the cost of debt, this
might lead to reduction of earnings leading to over-capitalisation.
5. Effect of Inflationary Conditions: Inflationary conditions results in higher operating
costs, thereby depressing the operating profits. Inflationary conditions also result in
higher capital cost for procuring new assets. The depressed operating earnings and
higher capital cost for additional investments under inflationary conditions lead to
over-capitalisation.
6. Technological Obsolescence: Technological obsolescence of assets lead to depressed
operating earnings, due to lower operating revenue and productivity and higher
maintenance cost. These reduced operating earnings will result in over-capitalisation.
Under-Capitalisation
Under-capitalisation is a situation where:
(a) the true economic values of the fixed assets of a company exceed the aggregate
of the par values of shares and debentures of the company or
(b) the capitalized value of the operating earnings of the company, capitalized at the
normal rate of return for similar companies in the same industry, is more than
the aggregate value of the shares and debentures of the company.
When a company is earning an extraordinarily large return on its outstanding stock, it is
said to be undercapitalized. When the real worth of the assets of a company exceeds their
book value and the rate earnings of the company is higher than the normal rate of
earnings of similar companies in the same industry, it is a situation of undercapitalisation.
Causes of Under-Capitalisation
Some of the factors leading to under-capitalisation are as follows:

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1. Higher Operating Efficiency: When a company is operating at an improved
efficiency, the productivity of the company would be high resulting in higher earning
capacity. This higher earning capacity will result in under-capitalisation.
2. Disparity between Book Value and Real Value of Assets: When the assets of a
company are undervalued, the real worth of the assets might be higher than their book
values. Such a situation will indicate under-capitalisation.
3. Higher Capacity Utilisation: A higher utilization of capacity will result in higher
operating earning leading to under-capitalisation.
Distinction between Over-Capitalisation and Under-Capitalisation
1. A company is said to be over-capitalized when its rate of earning is lower than the
normal rate of earnings of similar companies in the same industry.
A company is said to be under-capitalized, when its rate of earning is higher than the
normal rate of similar companies in the same industry.
2. Over-capitalisation is a common phenomenon in the business. Under-capitalisation is
a rare phenomenon.
3. Over-capitalisation is an indication of weak financial position. Under-capitalisation
indicates strong financial position
4. Over-capitalisation can be reduced by restructuring the debts and reorganizing the
affairs of the company. Under-capitalisation can be reduced by augmenting the
capital of the company by issuing further shares or raising further debt capital.
5. The causes of over-capitalisation are higher valuation of assets, existence of nonproductive assets, lower operating efficiency and productivity and sub-optimal
utilization of capacity. The causes of under-capitalisation are under valuation of asset,
higher operating efficiency, higher productivity and higher capacity utilization.
6. Over-capitalisation indicates inefficient utilization of resources. Under-capitalisation
indicates efficient utilization of resources.