Capital structure and value of

firm
 Capital structuring decision
• Decision regarding how to finance the
investment
• Optimal debt-equity to maximize shareholders
wealth
• These decisions aimed at
– Minimizing cost (weighted average cost of capital)
– Minimizing risk
 Cost of capital
• Cost of capital refers to the discount rate used
in determining the present value of future
estimated cash proceeds.
• Minimum required rate of return that a firm
must earn on its investment for the market
value of the firm to remain unchanged.
• Higher the cost, lower will be the value
• Therefore the prime objective of financing
decision is to minimize the cost
 Sources of funds
• Equity share capital
• Preference share capital
• Debentures/ loan/ bonds/borrowings
• Retained earnings

• Specific cost of capital: Cost of each source/

components.
• Weighted average cost of capital: Average
cost of entire capital structure.
 Weighted Average cost of capital
• Overall cost of capital
• Weighted average cost of all components of
firm’s capital structure
• WACC=E/V*Ke+D/V*Kdt
• Here,
 E=Value of equity
 V=Value of Firm=Debt+Equity
 D=Debt
 Ke=cost of equity or equity capitalization rate
 Kdt=After tax cost of debt, i.e. Kd(1-tax rate)
 Weights
• Marginal weights
– Weights based on new financing pattern
– For example, in a project of Rs 10 lac, if 20% is debt financing.
Then ,marginal weights of equity is 0.8 and for debt is 0.2.
• Historical weights
– Weights based on historical debt-equity ratio as reflected in
balance sheet.
– Book-value weights
– Mv weights
• Book value weights are generally preferred as
– They reflect long-term perspective
– Also, market value is subject to fluctuation
 To do
Source of capital book value Market value Specific cost
Debt ₹ 4,00,000.00 ₹ 3,80,000.00 5%
Preference share capital ₹ 1,00,000.00 ₹ 1,10,000.00 8%
Equity shares capital ₹ 6,00,000.00 15%
Retained earnings ₹ 2,00,000.00 ₹ 12,00,000.00 13%
 WACC based on BV
Source of capital book value Specific Weight on BV WACC on
cost BV
Debt ₹ 4,00,000.00 5%
0.31 0.02
Preference share ₹ 1,00,000.00 8%
capital 0.08 0.01
Equity shares capital ₹ 6,00,000.00 15%
0.46 0.07
Retained earnings ₹ 2,00,000.00 13%
0.15 0.02
Total ₹ 13,00,000.00 WACC
0.111
 WACC based on MV
Source of capital Market value Specific cost Weight on MV WACC on
MV
Debt ₹ 3,80,000.00 5% 0.01
0.22
Preference share ₹ 1,10,000.00 8% 0.01
capital 0.07
Equity shares capital ₹ 9,00,000.00 15% 0.08
0.53
Retained earnings ₹ 3,00,000.00 13% 0.02
0.18
₹ 16,90,000.00 WACC 0.119
 Cost and value

Lower the cost, higher will be the value

Value
WACC Free cash flows Value 2,50,000.00
5% 10000 2,00,000.00 2,00,000.00
10% 10000 1,00,000.00 1,50,000.00

VALUE
15% 10000 66,666.67 1,00,000.00

20% 10000 50,000.00 50,000.00

25% 10000 40,000.00 -

5% 10% 15% 20% 25% 30%
30% 10000 33,333.33
WACC

Value
 Risk and Cost
• Higher the risk-perception of the investor,
more will be the required rate return expected
by them.
• Thus, higher risk enhance the WACC
 DEBT and Equity
DEBT capital Equity Capital
• Economic • Most expensive
• Risky if earnings are volatile • No risk
• Provides tax advantage
 Optimal capital structure
• Optimal capital structure represent that debt-
equity mix where WACC is minimum.
• It is also known as firm’s target capital
structure
 Key consideration for optimal capital
structure
• Operating and financial leverage
• EBIT-EPS analysis
• Financial Break-even point
• Indifference point
 Leverage
• Use of fixed cost carrying assets and sources
of finance in business is known as leverage.
• Use of fixed cost in operations is known as
operating leverage.
• Use of fixed cost sources of funds in known as
financial leverage.
• Leverage represent risk
• Total risk = Operating leverage +financial leverage
 Operating leverage
• Ability of a firm to use fixed operating cost to
magnify the effects of change in sales on its
earning before interest and taxes.
DOL= Total Contribution (at base level)
Total Sales
DOL=1 implies no risk of operating fixed cost
DOL>1, implies high risk
• Alternatively, DOL = % Change in EBIT
• % Change in Sales
 Example
• Acquafina sells its water bottle for Rs 10 per
unit. It has a variable cost of Rs 5 per bottle
and fixed operating cost of Rs 500,000 per
year. Find the degree of operating leverage, if
sales at base level are of 2 lac bottles.
• What will be the impact on profitability if sales
improve by 50%?
• What will be the profit, if sales declines by
50%?
 DOL
• Sales = Rs 20 lac
• Less VC= 10
• Contribution= 10
• Less Fixed cost = 5
• EBIT 5 lac

• DOL= Contribution/ EBIT

• = 10/5= 2 times
 DOL= 10/5= 2 times
Units sales 200000 300000 100000
+50% -50%
sales ₹ 20,00,000.00 ₹ 30,00,000.00 ₹ 10,00,000.00

variable cost ₹ 10,00,000.00 ₹ 15,00,000.00 ₹ 5,00,000.00

Contribution ₹ 10,00,000.00 ₹ 15,00,000.00 ₹ 5,00,000.00

Fixed operating
cost ₹ 5,00,000.00 ₹ 5,00,000.00 ₹ 5,00,000.00

Earnings before
Interest and tax ₹ 5,00,000.00 ₹ 10,00,000.00 ₹ -
 Financial leverage
• Ability of firm to use fixed cost sources of finance
to magnify impact of change in EBIT on its
earnings per share.
• FL is also known as trading on equity.
• Degree of Financial leverage (DFL)
• = % Change in EPS
• % Change in EBIT
• Alternatively, EBIT
• EBIT-INT-(PD/(1-taxrate))
 Example
• Liabilities
• 5% Bonds Rs 400,000
• 10% Preference shares Rs 200,000
• Equity share capital Rs 100,000
(1000 shares @Rs 100)
Total External liabilities Rs 700,000
Current income statement shows the EBIT of Rs
100,000; tax rate 35%.
Compute degree of financial risk; compute the
impact of EPS, if EBIT moves up by 40%
 DFL
• DFL= EBIT/ EBIT-INT-PD/(1-tax)

EBIT Rs 100000
INT 20000
EBT 80000
Tax 28000
EAT 52000
PD 20000
EAT-PD 32000
EPS Rs 32 per share
DFL= 100,000/(100,000-20000-(20000/.65))
=2.03
EBIT 100000 60000 40%
INT 20000 20000
EBT 80000 40000
Tax 28000 14000
EAT 52000 26000
PD 20000 20000
EAT-PD 32000 6000
EPS 32 6 81.25%
 EBIT-EPS Analysis
• It is method to study the impact of leverage.
• It involves assessing the impact on EPS with
same level of EBIT under different financial
plans to identify the best financial alternative.
 To do
• Supernova Limited capital structure comprises of
equity share-capital of Rs 10 lac (10,000 ordinary
shares @Rs 100 each).
• For expansion, it is planning to raise Rs 10 lac more. It
has following alternatives under consideration.
– A. Entire equity
– B. 50% equity and 50% through 5% Debt
– C. 50% equity and 50% through 5 % preference share
capital
– D. Entire capital through 6% Debt capital.
• If EBIT is Rs 120,000 and tax rate is 35%, which
alternative should the firm select.
 Financial break-even point
• Financial break event is a level of EBIT, where
EPS is zero.
• Level of EBIT which is equal to fixed financial
cost, i.e
 Interest+ Preference dividend/(1-tax rate)
 It implies minimum Earnings required to meet
fixed financial cost.
 Any level of EBIT above Financial break-even
will produce favourable impact on EPS.
 Example
• Liabilities
• 5% Bonds Rs 400,000
• 10% Preference shares Rs 200,000
• Equity share capital Rs 100,000
(1000 shares @Rs 100)
Total External liabilities Rs 700,000
Current income statement shows the EBIT of Rs
100,000; tax rate 35%.
Compute degree of financial risk; compute the
impact of EPS, if EBIT moves up by 40%
• Interest =5%* 400,000= Rs 20000
• PD= 10% *20000/.65=30769.23

• Financial BEP= Rs 50769.23

• It implies if EBIT is Rs 50769.23 than EPS will
be zero
 Proof
EBIT 50,769.23
INT 20,000.00
EBT 30,769.23
Tax 10,769.23
EAT before PD 20,000.00
PD 20,000.00
EAT after PD -0.00
 Indifference point
• Level of EBIT, where EPS will be same under
two alternatives financial plans.
• Below indifference point, equity will be
favourable and beyond that leverage will be
beneficial to magnify EPS
 Indifference point
• EPS in equity plan
• = X(1-tax rate)
• N1

• EPS in Equity and Debt plan

• =(X-INT)*(1-tax rate)
• N2

• EPS in Equity, Preference and Debt plan

• =(X-INT)*(1-tax rate)-PD
• N3
 Theories of capital structure
• Optimum capital structure is the optimal mix of
debt and equity that lead to maximization of
firms value.
• There exists different opinions on the relationship
of leverage and value of the firms.
• Prominent theories are:
– Net income approach
– Net operating income approach
– Traditional approach
– Modigliani and Miller (MM) approach
 Key assumptions
1. No taxes
2. 100% dividend payout
3. Perfect capital market
4. No growth rate
5. Asset base remains the same
6. Debt and equity are only means of financing.
7. Business risk remains constant and independent of its capital
structure
8. Perpetual life of the firm
 Key Symbols

• B= Market value of debt

• S=Market value of equity
• V=Market value of firms (B+S)
• Ki: Cost of debt =I /B
• Ke=Equity capitalization rate =Earning
available to equity shareholders (E or NI)/S;
• Ko= Capitalization rate= Ki*B/V+Ke*S/V or
EBIT/V
 Net income (NI) approach
• This approach is suggested by Durand.
• Capital structure decisions are relevant
decisions that affect the value of firm.
• Change in financial leverage affects the
weighted average cost of capital and value of
the firm.
• Increase in debt-equity ratio reduces overall
cost of capital and enhances the firm’ value
and its market price.
 Key arguments
• Debt capital is less expensive source of
financing compared to equity, i.e. Ki<Ke.
• There are no taxes
• Risk perception of investors do not change
with the increase in leverage; i.e. Ki and Ke
will remain same with any degree of leverage;
• Thus, incorporating more debt reduced overall
capitalization rate.
 Example
Operating profit (EBIT) ₹ 50,000
10% Debentures ₹ 2,00,000
Ke 0.125
EBIT ₹ 50,000
Interest 10% on 200000 ₹ 20,000
EBT or NI ₹ 30,000
Ke 0.1250
MV of equity(S)= NI/Ke ₹ 2,40,000
MV of Debt 2,00,000
V of Firm 4,40,000
Ko= Ki*B/V+Ke*NI/V 11.364
Thus, incorporating debt has reduced the WACC
 Net operating income approach
• This is also proposed by Durand.
• It is diametrically opposite to Net income
approach.
• As per the theory, Ko and Ki remains
independent of the degree of financial
leverage; however, ke increases
proportionately with increase in leverage.
• Ke=Ko+(Ko-ki)*B/S
 N0I approach
Operating profit (EBIT) ₹ 50,000
10% Debentures ₹ 2,00,000
EBIT ₹ 50,000
Ko 0.125
V of Firm ₹ 4,00,000
B 2,00,000
S= V-B ₹ 2,00,000
Ki 10%
Ke=Ko+(Ko-Ki)*B/S 15
WACC=Ke*s/v+Ki*B/S 0.125
 Modigliani and Miller approach
• Cost of capital is independent of degree of
leverage at any level of debt and equity.
• Value of firm and cost of capital is not
influenced by debt-equity ratio.
• Provide behavioural justification for Net
operating income approach.
 Basic prepositions
I. Overall cost (Ko), Value (V) are independent of firm’s capital
structure.

I. Ke is equal to capitalization rate of pure equity stream plus a

premium of financial risk equal to difference in capitalization rate
(Ke) and cost of debt (Ki) times to debt-equity ratio.
 Ke= Ko+ (ko-Ki)*B/S
 Ko= Return on assets; Operating income/B+S
 For zero debt company the component is zero; as debt increases, the
equity shareholders’ are to be compensated for it.

II. Cut off rate for investment purposes is totally independent of the
way in which an investment is financed.
 Assumptions
• Perfect capital market.
• Perfect information and rational investor.
• Business risk is similar among all firms in
within similar operating environment.
• The dividend pay-out is 100%.
• No taxes
 Key arguments
• MM have given behavioural justification in
terms of arbitrage and home-made leverage.
– Arbitrage: Balancing operation; selling the
securities of overvalued firms and investing in the
undervalued firm.
– Home-made leverage: Replication of firm capital
structure by using debt in personal investment.
 MM Hypothesis
• Value of homogenous firms can’t be different.
• Value of the firms could be different due to leverage. If
the value differs, this temporary disequilibrium would
be setoff by the arbitrage process.
• The investors will start selling the shares of a
overvalued firms and invest in the shares of under-
valued firm; the process will act as balancing
operation, bringing the share-prices of homogenous
firms at same plate-form.
• The investors gain would remains unaffected due to
the leverage of the firm.
 In the world of taxes
• Value of L firm would be more than UL firm to
the extent of tax advantage on debt
• VL=VUL + B*tax rate
• Two firms L and UL have identical EBIT of Rs
100,000; Firm L has Rs 500,000 10% Debentures;
The Ke of firm L is 16 % (higher) and for UL is 12.5
%.
Levered Firm Unlevered Firm
EBIT ₹ 1,00,000 ₹ 1,00,000
Less interest 50000 0
EBT ₹ 50,000 ₹ 1,00,000
Ke 0.16 0.125
Value of equity (S) ₹ 3,12,500 ₹ 8,00,000
Value of Debt (B) 5,00,000 0
MV of Comany (V) ₹ 8,12,500 ₹ 8,00,000
Capitalization rate (K0) 0.123076923 0.125
Debt-equity ratio 1.60 -
• The arbitrage began by selling thee shares of overvalued firm and investing in
undervalued firm. The process will continue until the value of the firms equate.
 Effect of Arbitrage
• Position of Mr X having 10% equity holding in L
– Dividend = 5000
– Investment=32150
Position if he sell his holdings to purchase 10% stake in UL
Sales proceed of 10% stake in L 31250
Borrowings 50000
10 % investment in in UL 81250
Gain in UL 81250*12.5% 10156.25
Interest on loan 10% on 50000 5000
Net Benefits 5156.25
 In the world of taxes
• As per MM approach,
• VL= VUL+ Debt charges*tax rate