FINANCIAL MANAGEMENT (PART-25)

UNIT - V

THEORIES AND DETERMINANTS OF

CAPITAL STRUCTURE (PART–II)

1. INTRODUCTION

Dear Students, welcome to the lecture series on financial

management. Today in this lecture, we shall cover the topic theories
and determinants of capital structure.

We shall learn about optimum capital structure, various theories

propounded by scholars like
a. Net income approach
b. Net operating income approach,
c. Modigliani Miller approach.

We shall learn about the method of calculation of value of firm under

all these theories and all assumptions related to these theories.

The objective of this lecture is to understand the conceptual

framework of theories highlighting the relationships between capital
structure, cost of capital and value of firm. Broadly these theories are
classified into two heads.

a) Traditional theories and

b) Those theories propounded by Modigliani Miller.

Traditional theories here mean net income approach theory and net
operating income approach theory. We shall also learn what is meant
by optimum capital mix.

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 2. OPTIMUM CAPITAL STRUCTURE

Optimum capital structure means that mix of sources of fund where

weighted average cost of capital comes to minimum and it enhances
the value of firm. If value of firm is increased, wealth of share holder
automatically increases. So optimum capital structure is that structure
where cost is minimum and value is maximum.

Return on capital employed should be more than interest cost. That

means cost of debt should be less than the return we expect from any
investment. This is the basic parameter where we can find out the use
of debt. How much debt can be used in the capital structure is
determined by this parameter. It is same as financial leverage. Its
second name is trading on equity. This way we have learnt what is
optimum capital structure.

3. CAPITAL STRUCTURE PRACTICES IN INDIA

We will learn capital structure practices in India. That means how

Indian incorporations use capital structure. What is more in the use of
capital structure, i.e., debt or what sort of debt, how much is the use
i.e., quantitative and qualitative. So let’s learn it one by one. We will
compare Indian incorporations with the foreign controlled entities to
know how the debt has been managed.
1. Indian corporate employ substantial amount of debt in relation to
debt equity ratio and in relation to the total debt to the total
asset ratio. While the foreign controlled entities use less amount
of debt and they prefer more on their internally generated funds.
2. The corporate enterprises in India seem to use long term funds in
comparison to short term borrowings. Now-a-days, that means
from the mid 90’s there has been a substantial change in the
Indian scenario and they are moving towards short term
borrowings.

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 3. As a result of debt dominating capital structure, the Indian
corporate are exposed to a very high risk related to finance. That
means their total degree of risk is very high. The total degree of
risk includes operating leverage as well as financial leverage.
This amounts to a higher financial distress.
4. We shall learn about the practices is the debts services capacity
of sizeable segment of corporate borrowers are measured by
debt-equity ratio and inter-service ratios. These ratios will tell us
how much is the how much is the revenue we can use for
recovering the interest charges.
5. Retained earnings are the most favored source of finance. The
profitable firms use retained earnings more than the low
profitable firms.
6. In India, the corporations or the corporate entities are using
loans and debts as we have discussed earlier. What happens that
the foreign controlled entities are using those bonds that they
issue in the capital market as a source of finance? We are lagging
a little behind. Indian is not practicing the advanced sources,
i.e., the conversion of bonds, options, derivatives as much as
they are used by the foreign entities.
7. The hybrid securities are the least popular source of finance
among Indian corporations. And they are used by higher
profitable institutes more.

With this we have completed the practices of Indian corporations

using the capital structure.

4. SOME IMPORTANT CONCEPTS LIKE FINANCIAL

LEVERAGE, OPERATING LEVERAGE AND FINANCIAL
STRESS

What do you mean by a financial distress? What do we mean by

operating leverage? And what’s the meaning of financial leverage? We
will learn about them one by one

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FINANCIAL LEVERAGE
Financial leverage means the use of long term fixed income bearing
debt and preferential capital along with equity share capital. This is
known as financial leverage or trading on equity. Now how the
financial leverage will be favorable or unfavorable, let’s learn about it.
Financial leverage is favorable if the earning is more than cost of debt
and it becomes unfavorable when the cost is more than the earnings.

OPERATING LEVERAGE
Operating leverage results from the presence of fixed cost that helps in
magnifying net operating income flowing from small operations in
revenue. See the definition of operating leverage in detail. The
changes in sales are related to change in revenue. The fixed costs do
not change with the level of output. An increase in sales or decrease in
sales is irrelevant for fixed cost calculation. Now what happens fixed
cost remaining the same will magnify operating revenue. That means
the fixed cost will impact the change in sales and the change in the
revenue. This impact is calculated with the help of operating leverage.

FINANCIAL DISTRESS
Financial distress means a big spectrum involving minimum liquidity
shortage to huge bankruptcy. That means any change in the liquidity
position will result in financial distress. So our point here is, if properly
not used, that means Indian incorporations or Indian entities are not
using the debts and equity in a good proportion, it will result in high
operating cost and high financial cost, that results in overall higher risk
and which will lead to a financial distress.

5. DIFFERENT THEORIES OF CAPITAL STRUCTURE

We will learn theories relating to capital structure. These theories are

helpful to ascertain value of firm. There are three types of theories.
1. Net Income approach. This is known as NI approach.
2. Net operating income approach, which is popularly known as NOI
approach.
3. Modigliani Miller approach which is known as MM approach.

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 Now we will learn the assumptions which are applicable to all
these theories.
1) There are only two sources of finance. One equity and another
is debt.
2) The total assets are given and there are no changes in those
total assets value.
3) There is no taxation at all.
4) Business risk is constant and is independent of financial risk and
operating risk.
5) The company has infinitive life.
6) The dividend payout ratio is 100%.

6. NET INCOME APPROACH THEORY

First one, we will be taking up the Net Income approach or known as NI

approach.

What’s the principle of this theory?

The one line principle of this theory is – a firm increases its value or
lowers the overall cost of the capital by increasing the proportion of
debt in its capital structure.

That means, more the use of debt, lesser will be the overall cost of the
capital.

There are certain assumptions relating to this theory.

1. This theory says that the cost of debt will be lower than cost of
equity.
2. Cost of debt and cost of equity will be known to us and they will
remain constant.
3. The expectation of the share holders for the revenue by the use
of debt will not change. That means EBIT will remain generally
fixed.
4. Taxation will not be there at all.

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 Now what does it says?
Meaning of the principle is if the degree of financial leverage
increases, the weighted average cost of the capital declines. With
every increase in debt content, the total fund employed that will
result in increasing the value of firm. Now see the formula by which
we can ascertain the value of the firm.

Under NI approach, the formula given is:

V=S+D

Here
V =the value of firm which we need to find out;
S = market value of equity; and
D = market value of debt

Generally market value of debt is given in the question; we need to

find out the market value of equity using the formula as has been given
in the approach. Then we need to add up these two market values,
First market value of equity as calculated, market value of debt as
given, so it will give us value of firm. When value of firm is known,
then we need to find out the overall cost of capital using the formula
given.
So, overall cost of capital will be found out by this formula:

Ko = EBIT

VALUE OF FIRM SO DETERMINED

FLOW OF CALCULATION
Firstly we will calculate the market value of equity.
In second step we will add that calculated cost to value of debt that’s
given in the question.
It will give us value of firm.

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And using value of firm and the formula of EBIT that’s known to us,
i.e., EBIT/Value of firm so determined, we can find out the overall
cost of firm. This is the flow of calculation.

Now see the formula, how do we ascertain the market value of equity.
Market value of equity will be ascertained using formula:

VALUE OF EQUITY SHARES= EBIT-I

KE

EBIT means Earnings before Interest and Tax. From this EBIT we need
to deduct interest (I) which is a fixed financial charge which we need
to pay as we are using debt in our capital mix. When EBIT-I is done, it
will amount to earnings available to equity share holders. As in the
case of NI approach, there are no taxation, so EBT and EAT will be
equal.
So, EBIT-I/KE, KE here means cost of equity, this will give us market
value of equity. And in second step, EBIT/Market value of firm (KO)
shall be ascertained.

7. GRAPHICAL PRESENTATION OF NI APPROACH

Now students, let’s learn this relationship with the help of a graphical
diagram.

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Here the graph represents, the blue line represents in the graph as KE,
i.e., cost of equity, which shall remain constant. So it is represented
by a straight line or a parallel line to the Y-axis. Now KD, KD shall also
be constant because the basic assumption of this theory is KE and KD
are constant. So they are parallel lines. With the use of cost of debt,
means, with the use of debt, KO will constantly decline. So this
declining line is known as line of KO or overall cost of capital. This
way, their relationship is depicted in this graph.

8. PRACTICAL QUESTION BASED ON NI APPROACH

Now let’s see an example to learn this approach in a much better

fashion. Now students, we will learn this theory with the help of a
practical example so that the fashion in which it is calculated will be
clear to us. See the example given on the screen

PARTICULAR FIRM A FIRM B

EBIT 5,00,000 5,00,000

INTEREST 0 1,00,000

EBT 5,00,000 4,00,000

KE 25% 25%

MARKET VALUE OF 20,00,000 16,00,000

EQUITY

MARKET VALUE OF 0 10,00,000

DEBT

VALUE OF FIRM 20,00,000(GIVEN) 26,00,000

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 ko= 25% 19.23%
There are two firms having EBIT as Rs.5 lakh each.
One is using debt, another is not using the debt. And debt here is
Rs.10,000 at 10% interest rate.
Now we will calculate the equity value and overall cost of firm and KO
using the formulas.
Firm A has EBIT of Rs.5 lakh and firm B also has an EBIT of Rs.5 lakh.
Interest will be deducted from EBIT. Firm A has no interest because it
is not using debt. So it will be zero.
Firm B will subtract Rs.1 lakh from EBIT as interest will be Rs.1 lakh
i.e., Rs.10 lakh multiplied by 10%. So it will give us Rs. 1 lakh. So now
the EBT will be Rs.5 lakh-Rs.1 lakh. For firm B, EBT will be Rs.4 lakh,
while EBT for firm A will be Rs.5 lakh. Now K is given in the question
i.e., 25%. So we know the formula to ascertain the market value of
equity that is:

VALUE OF EQUITY = EBIT-I

KE

In firm A VALUE OF EQUITY =

Rs.500000
25%

i.e., 50000
0.25

It will give the market value of equity as Rs.20,00,000.

Now we know that in firm A there are no debts. So the market value of
debt will be zero. Value of firm will be market value of equity +
market value of debt. Here it will come as 20,00,000 + 0 = 20,00,000.

So KO can be ascertained now because we have market value of firm

with us which is Rs.20,00,000. So it will come as (5,00,000 which is
EBIT divided by 20,00,000) * 100 i.e.,

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500000 * 100 = 20%
2000000

So the KO will come as 20%.

In second case, i.e., in firm B, when we have used debts, EBIT-I is
Rs.4,00,000 and we divide 4,00,000 by KE, we can ascertain market
value of equity which is coming as 16,00,000. Market value of debt we
know is 10,00,000 because it’s using the debt. 16,00,000 market value
of equity as determined + market value of debt as given which is
10,00,000 will give us the result as 26,00,000 which is value of firm.
Now we have to find out overall cost of capital. We know the formula
i.e., EBIT/Value of firm. EBIT is 5,00,000 divided by 26,00,000.

KO= 500000 *100

2600000

It will give the value as 19.23%.

So we can see that with the use of debt, overall cost of the firm has
declined. From 25% it is coming as 19.23% when EBIT is same and KE is
also same. The only difference is the use of debt.

This is what NI approach is suggesting us that use the debts so that cost
comes down and value of firm increases.
In first case the cost is 25% while value is 20,00,000. In second case
cost is lower, i.e., 19.23% while value is higher, i.e., 26,00,000.
So with this we have completed NI approach.

9. NET OPERATING INCOME APPROACH

We will learn another approach that is Net Operating Income approach

relating to capital structure.

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The basic principle of NOI approach is that market value of firm is
independent of cost of capital. That means with the use of debt in the
capital structure, the overall cost of capital will remain fixed.
Why it is so? The benefit which has been accrued by the use of debt
gets offset by the increasing cost of equity.

Thus decline in the overall cost of capital by the use of debt will be
offset and the overall cost shall be same. This is called implicit cost of
equity where with the use of debt expectation of the shareholders
increases which in turn increases the cost of equity nullifying the
benefit, so overall cost shall be the same.

Now what’s the method of computation of value of firm? First of all we

have to find out the value of firm by capitalizing net operating income
with the cost of capital i.e., overall cost of the capital KO. So formula
will be EBIT/KO, it shall give us value of firm. When value of firm is
known, we will subtract cost of debt which is known to us so we will
get value of equity. Now when value of equity is known we need to
find out cost of equity which is represented by Ke. So its formula will
be:
Earnings available to equity shareholders or EBIT-I divided by market
value of equity which has been determined using the formula V=S+D,
we need to interpolate this formula as S=V-D in this approach.

10. PRACTICAL QUESTION BASED ON NOI APPROACH

Now let’s see this with the help of an example.

It’s coming up

Debt 0 5 lakh 10 lakh 20 lakh

EBIT 5,00,000 5,00,000 5,00,000 5,00,000

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Interest 0 50,000 1,00,000 2,00,000

EBT 5,00,000 4,50,000 4,00,000 3,00,000

Ke 20% 22.5% 26.67% 60%

Market value 25,00,000 20,00,000 15,00,000 5,00,000

of equity

Market value 0 5,00,000 10,00,000 20,00,000

of debt

Value of firm 25,00,000 25,00,000 25,00,000 25,00,000

Ko 20% 20% 20% 20%

Now there are four situations with us. First there is no debt. Second
situation when debt is 5,00,000. Third situation when debt is
10,00,000. And the fourth one is when the debt is 20,00,000 and the
cost of debt is constant i.e., 10%.

If the interest rate, now see how does it work. EBIT is given as
5,00,000 which is same under all scenarios. Now we need to subtract
interest element.

In Case 1, there will be zero, in case 2, it will be 50,000. It is

calculated as 10% of 5,00,000. Its coming 50,000.

Second case we will find out interest as 10% of 10,00,000 because debt
is 10,00,000 in second case and the interest will be 1,00,000.

And in the last one, 20,00,000 is the debt 10% is the rate so interest
comes out to be 2,00,000.

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So EBT will be ascertained i.e., EBIT-Interest which we have calculated
right now. So the table is showing EBT under third row as

Case 1, 5,00,000;
Case 2, 4,50,000;
Case 3, 4,00,000
last one 3,00,000.

Now Ke, it’s given in first step as 20%. Since in first part, there are no
debts, so KE and KO will be the same.

So here KO is known to us as 20%. And it will be KE also.

So when we know KO, we know the EBIT, the first step will be finding
out value of firm. So we will use the formula

EBIT/KO.

EBIT is 5,00,000. We need to divide it by 20%. So value of firm will be

known to us. That will come out to be 25,00,000.

Now this is very important feature of NOI approach. The value of firm
which is found out, the first step will remain same for all the
situations. That means whether the debt is 5,00,000; 10,00,000;
20,00,000 and so on , this value of firm will be 25,00,000 in all the
cases. So we will put 25,00,000 in all the rows for the respective
columns.

Now what happens that, we take the second step. Here we need to
find out the value of equity which is ascertained by the formula S=V-D.

V is 25,00,000. D is zero (0) in first case. So equity shall come out to be

25,00,000.

Now the last step is calculation of KE which will be (EBIT-I)/Value of

equity. EBIT in the first case is 5,00,000 and value of equity is
25,00,000. So it is giving us the KE as 20% which is same as KO.

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In the first step even if you don’t find KE its ok but for the rest of the
cases the set procedure is to be followed.

So now when it comes for second case, we know the value of firm
which is fixed and is 25,00,000.

Now we need to subtract debt. In case one, its 5,00,000. So 25,00,000-

5,00,000 will give us market value of equity which is coming as
20,00,000.

Using the formula (EBIT-I)/Value of equity, will give us the value of KE.
So 450000/2000000, it will give us KE as 22.5%.

And in the similar fashion for the rest two cases, we need to find out
KE. So from this example, we can see that the KE constantly increases.
The more the debt, the more the KE. At 5,00,000 KE is coming to be
22.5%.

At 10,00,000 of debt it is coming to be 26.67%.

When 20,00,000 debt is used, KE is coming to be 60%.

So the value of firm is remaining same i.e., 25,00,000 and KO is also

the same i.e., 20%.

With this we have completed the NOI approach.

Thank You !

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