Capital Structure

Balvinder Singh Uppal J054

Tejas.A.M
J057
Harsh Pittroda J055
Pranav Palsule J056
 ● One form of capital needs to be replaced
with another

Optimum capital ● Maximization of the value of the firm is

consistent with maximisation of

structure & shareholders wealth

Assumptions ● Optimum capital structure in the one that

minimizes WACC - estimation of value of
the firm.

● Constancy of the earning levels

● As a measure of capital structure , we shall

use debt-equity ratio
 Net Income Approach was presented by
NET ●

David Durand.
INCOME
● The theory suggests increasing value of
APPROACH the firm by decreasing the overall cost of
capital which is measured in terms of
Weighted Average Cost of Capital
through higher debt proportion.
● Increasing the D/E ratio reduces costs.
 The increase in debt will not affect
ASSUMPTIONS
●
the confidence levels of the investors.

OF NET ● No sources of finance like Preference

share capital and retained earnings.

INCOME ● All companies have uniform dividend

payout ratio; it is 1.
APPROACH ● Capital market is perfect and infinite
sources of finance.
EXAMPLE
Consider a company ABC with below figures. All figures are in USD. Calculate the value of the company.

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

Cost of Equity = 14%

Valuation of the company
EBIT = 100,000

Less: Interest cost (10% of 300,000) = 30,000

Earnings (since tax is assumed to be absent) = 70,000

Market value of Equity = (EAT/Ke) = (70,000/14%) = 500,000

Market value of Debt = (I/Kd) = 300,000

Total Market value = (D+E) = 800,000

Overall cost of capital = EBIT/(Total value of firm) = 100,000/800,000

= 12.5%
Valuation of the company debt = 400,000

EBIT = 100,000

Less: Interest cost (10% of 400,000) = 40,000

Earnings (since tax is assumed to be absent) = 60,000

Market value of Equity (60,000/14%) = 428,570 (approx)

Market value of Debt = 400,000

Total Market value = 828,570

Overall cost of capital = EBIT/(Total value of firm) = 100,000/828,570

= 12% (approx)
Conclusions
● As observed with increase in debt
proportion, the total market value of the
company increases and cost of capital
decreases.
● Reason for this conclusion is that assumption
of NI approach that irrespective of debt
financing in capital structure, cost of equity
will remain same.
● Further, cost of debt is always lower than
cost of equity, so with increase in debt
finance WACC reduces and value of firm
increase.
 ● This theory was propounded by “David
NET Durand” and is also known as irrelevant
OPERATING theory.

INCOME
APPROACH ● Acc. to this theory, the total market value of
the firm is not affected by the change in the
capital structure and the overall cost of capital
remain constant irrespective of debt-equity
ratio
 ● The market capitalizes the value of the
firm as a whole. Thus, the split between
debt and equity is not important
ASSUMPTION
OF NET ● The cost of debt is lower than cost of
OPERATING equity

INCOME
The risk perception of the investor is not
APPROACH ●
changed by the use of debt

● There is no corporate tax

The effect of leverage on the cost of capital

It is clear from the diagram 4.2 that with

increase to financial leverage, the overall cost
of
capital (ko) and cost of debt (kd) remains at
the same level but cost of equity increases
with increase in financial leverage. This is
because the expected rate of return on equity
increases with the increase in financial risk in
the business. Overall cost of capital
remains constant because the benefit of low
cost of debt is neutralized by increase in the
cost of equity.
Example
Contd.
Contd.
With the increase in debt
proportion, the total market value
of the company remains
unchanged, but the cost of equity
increases.
 ● This theory was propounded by “David
TRADITIONAL Durand”.
APPROACH
● As per this approach, debt should exist in the
capital structure only up to a specific point,
beyond which, any increase in leverage would
result in the reduction in value of the firm.
 ● Cost of debt remains constant upto
certain level of leverage, rises at
PROPOSITIONS increasing rate
● Cost of Equity remains constant or
OF increases gradually upto certain
level, rises sharply
TRADITIONAL ● Average cost of Capital
Decreases to certain point
APPROACH
○
○ Remains moderate
○ Rises after certain point
The effect of leverage on the cost of capital
EXAMPLE
Net Operating Income 2,00,000

Total Investment 10,00,000

Equity Capitalization Rate

The firm uses no debt 10%

If the firm uses the debt Rs. 4,00,000 11%

(Rate of Interest 5%)

If the firm uses Rs. 6,00,000 13%

(Rate of Interest 6%)
SOLUTION
No Debt Debt of 4,00,000 Debt of 6,00,000

EBIT 2,00,000 2,00,000 2,00,000

(-) Interest - 20,000 36,000

EBT 2,00,000 1,80,000 1,64,000

Taxes - - -

EAT 2,00,000 1,80,000 1,64,000

Market Value of Debt - 4,00,000 6,00,000

(+) Market Value of Equity EAT/Ke 20,00,000 16,36,363 12,61,538

Value of Firm V 20,00,000 20,36,363 18,61,538

WACC EBIT/V 10% 9.8% 10.7%

THANK YOU!!!