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Capital Structure and
Cost Of Capital Theories
Meaning of Capital Structure

 Capital Structure refers to the combination or mix of debt and

equity which a company uses to finance its long term

 Raising of capital from different sources and their use in

different assets by a company is made on the basis of certain
principles that provide a system of capital so that the
maximum rate of return can be earned at a minimum cost.
This sort of system of capital is known as capital structure.
Total Required Capital

From Shares
(a) Equity Share capital
(b) Preference Share Capital
 From Debentures
Factors Influencing Capital Structure
• Internal Factors
• External Factors
 Internal Factors
 Size of Business
 Nature of Business
 Regularity and Certainty of Income
 Assets Structure
 Age of the Firm
 Desire to Retain Control
 Future Plans Operating Ratio
 Trading on Equity
 Period and Purpose of Financing
Factors Influencing Capital Structure
 External Factors
 Capital Market Conditions
 Nature of Investors
 Statutory Requirements
 Taxation Policy
 Policies of Financial Institutions
 Cost of Financing
 Seasonal Variations
 Economic Fluctuations
 Nature of Competition
Optimal Capital Structure
The optimal or the best capital structure
implies the most economical and safe ratio
between various types of securities.
It is that mix of debt and equity which
maximizes the value of the company and
minimizes the cost of capital.
Essentials of a sound or optimal
Capital structure
 Minimum Cost of Capital
 Minimum Risk
 Maximum Return
 Maximum Control
 Safety
 Simplicity
 Flexibility
 Attractive Rules
 Commensurate to Legal Requirements
Theories of Capital structure
 Net Income (NI) Theory
 Net Operating Income (NOI) Theory
 Traditional Theory
 Modigliani-Miller (M-M) Theory
Net income (NI) Theory
 This theory was propounded by “David Durand” and
is also known as “Fixed ‘Ke’ Theory”.
 According to this theory a firm can increase the
value of the firm and reduce the overall cost of
capital by increasing the proportion of debt in its
capital structure to the maximum possible extent.
 It is due to the fact that debt is, generally a cheaper
source of funds because:
(i) Interest rates are lower than dividend rates due
to element of risk,
(ii) The benefit of tax as the interest is deductible
expense for income tax purpose.
Net Operating Income Theory

 This theory was propounded by “David Durand” and

is also known as “Irrelevant Theory”.

 According to this theory, the total market value of

the firm (V) is not affected by the change in the
capital structure and the overall cost of capital (Ko)
remains fixed irrespective of the debt-equity mix.
Assumptions of NOI Theory
 The split of total capitalization between debt and
equity is not essential or relevant.
 The equity shareholders and other investors i.e.
the market capitalizes the value of the firm as a
 The business risk at each level of debt-equity mix
remains constant. Therefore, overall cost of capital
also remains constant.
 The corporate income tax does not exist.
Traditional Theory
• This theory was propounded by Ezra Solomon.
According to this theory, a firm can reduce the
overall cost of capital or increase the total
value of the firm by increasing the debt
proportion in its capital structure to a certain
limit. Because debt is a cheap source of raising
funds as compared to equity capital.
Modigliani-Miller Theory
This theory was propounded by Franco
Modigliani and Merton Miller.
They have given two approaches.
 In the Absence of Corporate Taxes.
 When Corporate Taxes Exist.
Assumptions of M-M Approach
 Perfect Capital Market
 No Transaction Cost
 Homogeneous Risk Class: Expected EBIT of all the firms
have identical risk characteristics.
 Risk in terms of expected EBIT should also be identical for
determination of market value of the shares
 Cent-Percent Distribution of earnings to the shareholders
 No Corporate Taxes: But later on in 1969 they removed
this assumption.
In the Absence of Corporate Taxes
 According to this approach the ‘V’ and its ‘Ko’ are
independent of its capital structure.
 The debt-equity mix of the firm is irrelevant in
determining the total value of the firm.
 Because with increased use of debt as a source of
finance, ‘Ke’ increases and the advantage of low cost
debt is offset equally by the increased ‘Ke’.
 In the opinion of them, two identical firms in all
respect, except their capital structure, cannot have
different market value or cost of capital due to
Arbitrage Process.
When Corporate Taxes Exist
M-M’s original argument that the ‘V’ and ‘Ko’
remain constant with the increase of debt in capital
structure, does not hold good when corporate taxes
are assumed to exist.
They recognized that the ‘V’ will increase and ‘Ko’
will decrease with the increase of debt in capital
structure. They accepted that the value of levered
(VL) firm will be greater than the value of unlevered
firm (Vu).
Cost of Capital
 The cost of capital is the cost of a company's
funds (both debt and equity) or, from an
investor's point of view "the expected return
on a portfolio of all the company's existing
 It is used to evaluate new projects of a
company as it is the minimum return that
investors expect for providing capital to the
company, thus setting a benchmark that a
new project has to meet.
 “The cost of capital is the minimum required rate of
earnings or the cut-off rate of expenditure”.
 “The cost of capital represents a cut-off rate for the
allocation of capital to investments of projects. It is
the rate of return on a project that will leave
unchanged the market price of the stock.”
 The cost of capital is the rate of return that capital
could be expected to earn in an alternative
investment of equivalent risk.
Importance of Cost of Capital
 Designing the capital structure
 Capital budgeting decisions
 Evaluations of financial performance
 Financing and Dividend Decisions
Cost of Equity Capital
 𝑲𝒆 = × 100
Ke = Equity capitalization Rate or Cost of Equity
I = Interest on Debt
S = Market Value of Equity Capital
Cost of Debt
• Formula
Cost of Debt= I (1- Tax)
I= Interest
Computation of the Overall Cost of
Capital or Capitalization Rate

𝐾0 =
Ko = Overall Cost of Capital or Capitalization
V = Value of the firm
Value of Unlevered Firm
 𝑽𝒖 =
Value of Levered Firm
 VL =𝑽𝒖 + 𝑫𝒕
Vu : Value of Unlevered Firm
VL :Value of Levered Firm
D : Amount of Debt
t : tax rate
Computation of the Total Value of the
 V=
Ko = Overall cost of capital

 Market Value of Equity Capital

S = Market Value of Equity Capital
V = Value of the Firm
D = Market value of the Debt
Weighted Average Cost of Capital
 A calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.
WACC = × 𝟏𝟎𝟎
Effects of Changes in Capital Structure on ‘Ko’ and
 First Stage: The use of debt in capital structure increases the
‘V’ and decreases the ‘Ko’.
 Because ‘Ke’ remains constant or rises slightly with
debt, but it does not rise fast enough to offset the advantages
of low cost debt.
 ‘Kd’ remains constant or rises very negligibly.
 Second Stage: During this Stage, there is a range in which
the ‘V’ will be maximum and the ‘Ko’ will be minimum.
 Because the increase in the ‘Ke’, due to increase in
financial risk, offset the advantage of using low cost of debt.
 Third Stage: The ‘V’ will decrease and the ‘Ko’ will increase.
Because further increase of debt in the capital structure,
beyond the acceptable limit increases the financial risk.
Capital Budgeting
Categories of Capital Budgeting
Capital budgeting techniques under certainty;
 Capital budgeting techniques under
Capital Budgeting Techniques Under
 Risk can be defined as the chance that the actual
outcome will differ from the expected outcome.
Uncertainty relates to the situation where a range of
differing outcome is possible, but it is not possible to
assign probabilities to this range of outcomes.
 Conventional Techniques for Risk Analysis:
(a) Pay Back Period(PBP)
(b) Risk-adjusted Discount Rate
(c) Certainty Equivalent
Pay Back Period(PBP)
 Meaning: It is the number of years required to
recover the original cash outlay invested in a
Methods to compute PBP:
A ) The first method can be applied when the
CFAT is uniform. In such a situation the initial cost of
the investment is divided by the constant annual
cash flow: For example, if an investment of
Rs.100000 in a machine is expected to generate
cash inflow of Rs.20,000 p.a. for 10 years.
• Its PBP will be calculated using following formula:
• PBP=Initial Investment/ constant annual cash inflow = 1,00,000
/20,000=5 yrs
B) The second method is used when a project’s CFAT are not
equal. In such a situation PBP is calculated by the process of
cumulating CFAT till the time when cumulative cash flow
becomes equal to the original investment outlays.
For example, A firm requires an initial cash outflow of Rs. 20,000
and the annual cash inflows for 5 years are Rs. 6000, Rs. 8000, Rs.
5000, Rs. 4000 and Rs. 4000 respectively.
Calculate PBP. Here, When we cumulate the cash flows for the
first three years, Rs. 19,000 is recovered. In the fourth year
Rs.4000 cash flow is generated by the project but we need to
recover only Rs.1000 so the time required recovering Rs. 1000
will be (Rs.1000/Rs.4000)× 12months = 3 months. Thus, the PBP
is 3 years and 3 months (3.25 years).
Decision Rule
 The PBP can be used as a decision criterion to
select investment proposal. If the PBP is less
than the maximum acceptable payback
period, accept the project. If the PBP is greater
than the maximum acceptable payback
period, reject the project.
Risk Adjusted Discount Method
• To allow for risk, the businessmen required a premium
over and above an alternative which is risk free. It is
proposed that risk premium be incorporated into the
capital budgeting analysis through the discount rate.
i.e. If the time preference for the money is to be
recognized by discounting estimated future cash flows,
at some risk free rate, to there present value, then, to
allow for the riskiness of the future cash flow a risk
premium rate may be added to risk free discount rate.
Such a composite discount would account for both
time preference and risk preference.
Risk Adjusted Discount Method
RADR= Risk free rate + Risk Premium OR
k = Rf + Rp
The RADR accounts for risk by varying discount rate depending
on the degree of risk of investment projects. The following figure
portrays the relationship between amount of risk and the
required k.
The following equation can be used:-
NPV = ΣNCFt / ( 1+k )t – CO
Where k is a risk-adjusted rate.
Decision Rule
 The risk adjusted approach can be used for both
 If NPV method is used for evaluation, the NPV
would be calculated using risk adjusted rate. If
NPV is positive, the proposal would qualify for
acceptance, if it is negative, the proposal would
be rejected. In case of IRR, the IRR would be
compared with the risk adjusted required rate of
return. If the ‘r’ exceeds risk adjusted rate, the
proposal would be accepted, otherwise not.
Decision Rule
 For example, if an investment project has following cash flows,
its NPV using RADR will be as follows:
Risk free rate is 6% and Risk adjusted rate is 10%.

Year CFAT (TK.) PV @10 PV( TK.)

1 50000 0.909 45450

2 40000 0.826 33040

3 45000 0.751 33795

LESS ∑PV 112285

Investment 150000
Other Techniques
 Sensitivity Analysis
 Scenario Analysis
 Simulation Analysis
(A)The sensitivity analysis helps in identifying how sensitive are the
various estimated variables of the project. It shows how sensitive is a
project’s NPV or IRR for a given change in particular variables.
Steps : The following three steps are involved in the use of
sensitivity analysis.
1. Identify the variables which can influence the project’s NPV or
2. Define the underlying relationship between the variables.
3. Analyze the impact of the change in each of the variables on the
project’s NPV or IRR.
Sensitivity Analysis
 The Project’s NPV or IRR can be computed under following
three assumptions in sensitivity analysis.
1. Pessimistic (i.e. the worst),
2. Expected (i.e. the most likely)
3. Optimistic (i.e. the best)
For example,
A company has two mutually exclusive projects for process
improvement. The management has developed following
estimates of the annual cash flows for each project having a life
of fifteen years and 12% discount rate.
Sensitivity Analysis
Net investments 90000

CFAT Estimates PVAIF12%,15yrs PV NPV

Pessimistic 10000 6.811 68110 (21890)
Most likely 15000 6.811 102165 12165
Optimistic 21000 6.811 143031 53031

Net investments 90000
CFAT Estimates PVAIF12%,15yrs PV NPV
Pessimistic 13500 6.811 91948.5 1948.5
Most likely 15000 6.811 102165 12165
Optimistic 18000 6.811 122598 32598
Sensitivity Analysis
• The NPV calculations of both the projects suggest that the
projects are equally desirable on the basis of the most likely
estimates of cash flows.
However, the Project– A is riskier than Project – B because its
NPV can be negative to the extent of TK. 21,890 but there is no
possibility of incurring any losses with project B as all the NPVs
are positive. As the two projects are mutually exclusive, the
actual selection of the projects depends on decision maker’s
attitude towards the risk. If he is ready to take risk, he will select
Project A, because it has the potential of yielding NPV much
higher than (TK. 53031) Project B. But if he is risk averse, he will
select project B.
Scenarios Analysis
• The another way to examine the risk of investment is to
analyze the impact of alternative combination of variables ,
called the scenarios , on the project NPV.
EXAMPLE:- In the expected scenario, it may be possible to
increase the sales volume of 1 lac units to 1,25000 units . If the
company reduces the selling price from TK. 15 to TK. 13.50,
resorts to aggressive advertisement campaign, their by
increasing unit variable cost to TK. 7.1( 5% increase) & fixed cost
is TK. 44,000.
Calculate the NPV.
OPTIMISTIC :-1,25,000
NEUTRAL:- 1,00,000
Scenarios Analysis
REVENUE = 1250 *!6.50=20625(TK)
Variables Base value Pessimistic Optimistic
Sales volume 1000 750 1250

Selling 15 13.50 16.50

Variable 7.1 7.43 6.75
Fixed cost 4400 4840 4400
Simulation Analysis
 Sensitivity analysis and Scenario analysis are quite useful to
understand the uncertainty of the investment projects. But
both the methods do not consider the interactions between
variables and also, they do not reflect on the probability of
the change in variables.
 Monte simulation considers the interaction among variables
& probabilities of change in variables & its impact on NPV of
cash inflows . In this a computer generates a very large no. of
scenarios according to the probability distribution of
Simulation Analysis
 Steps:-
 1) Identification of the variables , which influences the cash
inflows. Initial investment ,Market size ,Fixed cost & variable
cost , market growth rate
 2) Specify the formula which relates the variables.
 3) Assign the probabilities to each variables
 4) Develop a computer program, that randomly selects 1
value from the probability with each variable & uses these
values, to calculate projects NPV.
Thanks To All