Capital Structure Theory

COURSE INSTRUCTOR PROF. SAROJ KR. ROUTRAY

Background of the theory

Under favourable economic conditions, the earnings

per share increase with financial leverage. But leverage also increases the financial risk.
Therefore it cannot be stated definitely whether or

not the firms value will increase with leverage.

There exist conflicting theories on the relationship

between capital structure and the value of a firm.

Traditional Views and MM Theroy

The traditionalists believe that capital structure

affects the firms value while Modigliani and Miller(MM), under the assumptions of perfect capital markets and no taxes, argue that capital structure decision is irrelevant.

Net Income Approach

Levered Firm i.e., Capital Structure consisting of Debt and Equity Unlevered firm i.e., Capital structure consisting of only Equity

*Net income approach says that the capital structure affects the firm value
According to NI approach

both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

Continued.

Cost

ke, ko

ke

kd

ko kd

Debt

Example
Firm L is a levered firm and it has financed its assets by

equity and debt. Its expected EBIT or NOI is Rs.1000 and the interest on debt is Rs.300. The firms cost of equity, ke,is 9.33% and the cost of debt, kd, 6 percent. The value of the firm(V) is the sum of the values of all of its securities.
Value of firms Equity(E) = Net Income(NI)/Cost of equity(Ke) = 700/0.0933 =Rs. 7500

Value of debt(D) = Interest/Cost of debt(kd) = 300/0.06 = Rs.5000 Value of the firm(V) = E + D = 7500 + 5000 = Rs.12500.

Continued
Firms cost of capital =
Net operating income /Value of the firm = NOI/V = 1,000/12,500
=0.08 or 8% Or, Weighted Average Cost of Capital(WACC) = Cost of Equity x Equity Weight + Cost of Debt x Debt Weight = Ke x E/V + Kd x D/V = 0.0933 x 7500 + 0.06 x 5000 = 0.08 = 8% 12500 12500

Value of the Firm

Capital structure(a) Capital structure(b)

NOI Less: Interest NI

Value of Equity, E = NI/Ke Value of Debt, D= Int/Kd
Value of the firm (V) = E + D Debt/ Total value, D/V WACC, NOI/V = Ke x E/V + Kd x D/V

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