Capital Structure Theories

Factors determining capital

structure
Minimisation of risk
a. Business risk
b. Financial risk
A capital structure is called an efficient
capital structure if it keeps the total risk of
the firm to a minimum level
. Control
. Flexibility(the ability of the firm to raise
additional capital funds whenever needed)

 Profitability(to increase the return to

the equity share holders)
Cost of financing

Optimum capital structure

A capital structure will be optimum
when the proper mix of equity and
debt results in maximising the value of
the share. Selection of the right
amount of equity and combining it with
the right amount of debt increases the
market value of the share and helps
the company to attain an optimum
capital structure

Some of the techniques that will help

in achieving an optimal capital
structure are:
1. risk and return
2. Cost of finance
3. Corporate taxes

Capital structure theories

Capital structure theories gives an
understanding of the different approaches
to debt equity mix and the effect on the
value of the share.
The basic theories are:
1. Net Income(NI) approach
2. Net Operating Income(NOI) approach
3. Traditional approach
4. Modigliani Miller(MM) approach

Assumptions of capital structure

theories
That there are only two sources of funds:
equity and debt, which is having fixed
interest
The total assets of the firm are given and
thr would be no change in the investment
decisions of the firm
The firm has a policy of distributing the
entire profits among the shareholders
The operating profits of the company are
given and are not expected to grow

 The business risk complexion of the

firm is given and is constant and is
not affected by the financing mix
There is no corporate or personal
taxes
The following definitions and
notations haveee been used
E = total market value of the equity
D = total market value of the debt
V = total market value of the firm = D
+E
I = total interest payment

NOP = net operating profit i.e. EBIT

NP = net profit or PAT
D0 = dividend paid by the company at
time 0(now)
D1 = expected dividend
P0 = current market price of the
share
P1 = expected market price after
year 1
kd = after tax cost of debt = I/D
ke = after tax cost of equity = D1/P0

WACC = [D/(D+E)]Kd + [E/(E+D)]Ke

since, D+E = value
Therefore, =

Net Income approach

Is given by Durand, states that there is a
relationship between capital structure and the
value of the firm.
The main assumptions are:
Total capital requirement of the firm remains
constant
Kd is less than Ke.
Both Kd and Ke remain constant and
increase in financial leverage does not affect
the risk perception of the investors

Net income approach

According to this approach, there does exist
an optimum capital structure. So firm can
increase its value and change its capital
structure and vice versa
So, higher is the use of debt, lower is the cost
of capital and therefore higher is the value
Value of the firm is maximised at 100%
leverage but equity must be there
According to this approach debt is available
at a very cheap rate and in plenty

and whole of the demand of debt is

meant and it is assumed that the
shareholders do not feel that the
company is at risk by using more and
more debt
Therefore, Kd and ke are constant an
are parallel to each other
(diagram and practical question)

Net Operating Income

Approach
The value of the firm is not affected by the
increase in debt. Ko is constant at all operating
leverage.
Therefore, every capital structure is optimum and
the overall value of the firm is same. So firms
belonging to the same risk class have same value.
As firm goes for more and more debt the
shareholders demand more returns i.e. ke
increases. However, increase in ke is exactly
offset by the cheap availability of funds therefore
Ko is constant.

Assumptions , practical questions ,

diagram done in class

Traditional Approach
According to this approach, a firm should make a
judicious use of both the debt and equity to
achieve a capital structure which may bee called
the optimum capital structure. At this capital
structure, the WACC of the firm will be minimum
and the value of the firm maximum.
The traditional view states that the value of the
firm increases with the increase in financial
leverage but upto a certain limit only. Beyond this
limit, the increase in financial leverage will
increase

Its WACC also and hence the value of the

firm will decline.
Under this approach, Kd is assumed to be
less than Ke. Initially ke remains constant
upto a certain point with the increase in
leverage therefore Ko falls initially. But
this position cannot continue when
leverage is further increased
The increase in leverage beyond a limit
increases the risk of the equity investors
and as a result Ke also starts increasing
and Ko will starts rising.

Assumptions, diagram, practical

question done in class

Modigliani Miller Model: Extension

of the NOI Approach
This model states that the capital structure
and its composition has no effect on the
value of the firm. They have shown that
financial leverage does not matter and the
cost of capital and value of the firm are
independent of the capital structure.
Main assumptions are:
The capital markets are perfect and
complete information is available to all the
investors free of cost

 The securities are infinitely divisible

Investors are rational and well informed
about the risk return of all the securities
There is no corporate tax
The personal and the corporate leverage are
perfect substitute
This model argues that if two firms are alike in
all respect except that they differ in respect of
their financing pattern and their market value,
then the investors will develop a tendency to
sell the shares of the overvalued firm and buy
the shares of the buy the shares of the under
valued firm

This buying and selling pressures

continue till the two firms have same
market values.
The Arbitrage Process:
It refers to undertaking by a person of
two related actions and steps
simultaneously in order to derive some
benefit.
Ex: buying a security in one market at
a lower price and selling the same at a
higher price in the other market.
Practical applicationdone in
class(very important)

Critical Evaluation of MM
Model
Personal and corporate leverage are
not perfect substitutes
Different borrowing rates for the
corporates and the individuals
Inconveniences of personal leverages

MM Model with taxes

Practical application