INTRODUCTION

 The capital structure of a company

refers to a combination of the long-
term finances used by the firm.
 It is composed of long term debt,
preference share capital & equity
shareholders’ funds


Optimal capital structure

 Maximum value of firm

 Avoid undue financial/business risk
 Minimise cost of financing
 Flexible
Factors determining capital
structure
 Financial leverage
 Growth & stability of sales
 Cost of capital
 Risks
 Cash flow ability to service debt
 Nature & size of firm
 Net Income Approach

 As suggested by David Durand, this

theory states that there is a
relationship between the Capital
Structure and the value of the firm.
 The cost of capital declines as higher-
cost equity is replaced with lower-cost
debt.
Net income approach

Ke
value

Ko
Kd

Degree of leverage
Illustration

vCompany X ltd. has EBIT=2,00,000. It is a no

debt company Cost of Equity is 12%. Find
out value of firm(v) and overall cost of
capital by net income approach.
vIf it issues 10% debt of Rs. 5,00,000, find out
the new value of firm(v) and overall cost of
capital.
Net Operating Income
Approach
vThis theory is extremely opposite to net income
approach.
vAccording to this approach, change in capital
structure of a company does not affect the
market value of the firm and overall cost of
capital remains constant irrespective of the
method of financing.
 Assumptions

ü There are no corporate taxes.

ü Cost of debt and cost of equity are constant.
ü Only two sources of finance i.e. debt and equity
shares.
ü Dividend payout ratio is 100%.
ü Life of firm is perpetual.
ü Increase in debt leads to repayment and equity
share capital, so company is in no growth
situation.
ü
ü
Illustration

vCompany X ltd. has EBIT=1,00,000 if uses

10% debt of Rs 2,00,000. overall cost of
capital(Ko) is 20%. Find out value of firm(v)
and cost of equity (Ke) by Net operating
income approach.
a) If amount of debt increases to 3,50,000, then
what is the V and Ke.
Traditional Approach :

 It takes a mid-way between the NI

approach and the NOI approach. It
has 3 stages
 Stage 1
 In the first stage the overall cost of
capital falls and the value of the
firm increases with the increase in
leverage
 Stage 2
 A stage is reached when increase in
leverage has no effect on the value
or the cost of capital of the firm.
This is the stage wherein the value
of the firm is maximum
 Stage 3
 Beyond a definite limit of leverage
the cost of capital increases and the
value of the firm decreases with
leverage.
Illustration

 Find the value of firm & Ko in

following cases using traditional
approach
1. EBIT of Rs. 40,000 & 10% debt of Rs.
1,00,000. Ke is 16%.
2. EBIT of Rs. 40,000 & 11% debt of Rs.
1,50,000. Ke is 17%.
3. EBIT of Rs. 40,000 & 12.5% debt of
Rs. 2,00,000. Ke is 20%.

MODIGLIANI- MILLER
APPROACH
 In the absence of taxes
 This theory proves that the cost of
capital is not affected by the
changes in the capital structure.
 Arbitrage process ensures that
investors will buy shares of under-
priced firm & sell those of over-
priced firm

Assumptions

 Perfect Capital Market.

 100% dividend payout ratio
 Homogeneous risk class
 Investors act rationally
 No taxes.
MM approach Proposition 1
illustration

 EBIT of L ltd & U ltd is Rs. 1,00,000.

they are alike in all respects, except
that firm L uses 10% debt of Rs. 5
lakh. Firm U does not have debt.
The cost of equity of both the firms
are 16% and 12.5% respectively.
Find the market values of the firms.
When taxes are assumed to
exist
 This theory proves that the value of
firm will increase or cost of capital
will decrease with the use of debt
MM Approach Proposition 2
Illustration

 EBIT of L ltd & U ltd is Rs. 10,00,000.

they are alike in all respects, except
that firm L uses 15% debt of Rs. 20
lakh. Firm U does not have debt. Tax
rate is 35%. Show the impact of tax
shield of interest acc. To MM
Approach