Capital Structure Theories

CA Chandni Bhagat
Balance Sheet

Liabilities Assets

Total Total

Financing Decision Investing Decision

 Balance Sheet
Liabilities Assets
Long Term Liabilities Fixed Assets
Current Liabilities Current Assets
Total Total
LTL + CL = Financial Structure
LTL = Capital Structure = Debt + Equity

Debt Capital Equity Capital

Term Loans Equity Sh Capital
Debentures Preference Sh Capital
Leases
Security Premium
Other long term debt
Retained Earnings
Factors determining Capital
Structure
Control & Management
Risk
Income
Tax considerations
Cost of capital
Flexibility
Condition of the economy
Growth rate
Govt policies
Company size
Financing Purpose
What is an optimum capital
structure??
That combination of debt & equity that leads to
maximisation of firms value and minimises the firms
cost of capital.
Understand this !
The use of debt leads to ---increase in EPS --- which
leads to increase in share price.
But higher level of debt leads to --- higher financial
leverage --- which is beneficial till a point but at a later
stage leads to higher cost of capital which --- lowers the
share price.
High debt in adverse condition may lead to inability to
repay --- which adversely affects the goodwill of the co.
Leading to disqualification in getting loans later.
Hence an optimum capital structure should be such that
it leads to increase EPS, profitability and value of firm.
Capital Structure Theories
Net Income Approach
Net Operating Income Approach
Modiglani Miller Approach

BASIC ASSUMPTIONS OF THESE THEORIES

There are only two sources of fund- Debt & Equity
The co. distributes all its earnings as dividend.
No Tax(personal or corporate)
No business Risk
No transaction cost
There will be no change in profits
What will be asked in Exams??

To calculate the VALUE OF FIRM

Calculate the Value of firm ??
Revenue St.
Sales
- VC
=Contb
- FC
= EBIT/ Operating income Value of firm (Ko)
- Intt
Debt (Kd)
= EBT/Net Income
Equity
(Ke)
What is capitalization concept ?
If I say I earned 5 lac Rs. On an amount invested
which is 20% return. What is the amount
invested/capital ?
= 500000 = 25,00,000
20%
We will calculate the value of firm in this chapter based
on the given concept.
Net Income Approach
According to the given approach the Calculation will
start from net income which will be PBT in the above
case (corporate tax is assumed to be nil in this theory)
E = NI & D = Intt & V = E+D
Ke Kd

Where E = Value of equity

D = Value of debt
& V = Value of firm
Ke = cost of equity
Kd = Cost of Debt
If Ko is asked to be calculated then
Ko = EBIT X 100
V
Net operating income Approach
According to this approach, the calculation will start
from Operating income which is EBIT and we will
calculate Value of Firm (V) first.
So, V = EBIT
ko
& D = Intt
Kd
or D = (no of debentures x Value of each debenture)
So, E = V- D
Q1.
A Company’s expected net operating income is Rs
50,000. The company has Rs. 2,00,000, 10%
Debentures.The equity capitalisation rate (ke) of the
company is 12.5%. Calculate the value of firm.
Solution:
EBIT = 50000
- Intt= 20000
EBT/NI = 30000
V = NI/Ke = 30000/12.5% = 2,40,000
Q2.
Mehta Company Limited is expecting an annual EBIT of Rs.
2,00,000. The company has Rs. 5,00,000 in 10% debentures.
The cost of equity capital or capitalization rate is 12.5%.
Compute the value of the firm.
Sol – EBIT – 2,00,000
- Intt - 50,000
NI 150000
E = NI /Ke = 150000/0.125 = Rs. 12,00,000
D = =Rs 5,00,000
V = Rs, 17,00,000
Ko = EBIT/V = 2/17 = 11.76%
Q3.
Jupiter ltd has earned a profit before intt & tax Rs. 500000.
The company’s capital structure include 20,000, 14%
debentures of Rs. 100 each. The overall capitalisation rate of
the firm is 16%.Calculate the total value of the firm & Equity
capitalisation rate.
Sol :
V = EBIT/Ko = 5,00,000/16% = 31,25,000
D = 20000x100 = 2000000
E = V-D = 11,25,000
Ke= NI/E = EBIT-Intt/E = (500000-280000)/1125000 =
19.5%
Q4.
An organization expects a net income of Rs. 1,00,000.
It has Rs. 1,50,000, 10 % debentures. The equity
capitalization rate of the company is 12%. Calculate
the value of the firm and overall capitalization rate
according to the Net Income Approach (ignoring
income-tax)
Sol : E = NI/Ke = 100000/0.12 = 8,33,333
D = 1,50,000
V = 9,83,333
K0 = EBIT/V = (NI+Intt)/V = (100000+ 15000)/983333
11.69%
Q4(A)
IN THE ABOVE QUESTION, If the debenture debt
increased to Rs. 2,00,000, what shall be the value of
the firm and the overall capitalization rate ?
Solution : EBIT = 115000
Intt (200000x10%) = 20000
NI = 95000
V = NI/Ke = 95000/ 12% = 7,91,667
Ko = EBIT/V = 115000/791667 = 14.52%
Q5.
A manufacturing company is expecting the Net Operating
Income of is Rs. 200,000. The company has debenture
lending of Rs 6,00,000 at 10% interest payable. The overall
capitalization rate is 20%. Calculate the value of the firm
and the equity capitalization rate as per the NOI approach.
Solution – EBIT = 2,00,000, intt – 60,000, Ko = 20%
V = EBIT/Ko = 200000/20% = 10,00,000
E = V-D = 10,00,000 – 6,00,000 = 4,00,000
NI = EBIT – Intt = 140000
Ke = NI/E = 140000/400000 = 0.35
Q6.
Glamour ltd earned a profit of 20 lakhs before
providing for intt and tax. The company’s capital
structure is as follows:
1) 4,00,000 eq shares of Rs. 10 each and its mkt
capitalistion rate is 16%
2) 25000,14% secured redeemable debentures, of
Rs.150 each.
Calculate the value of firm & overall cost of capital.
Solution:
EBIT = 20lacs
intt on debt = 14% x 37,50,000 = 5.25 lacs
(D = 25000x150 = 37,50,000 )
NI = 14.75 lacs
Ke = 16%
V = NI/Ke = 92.19lacs
Q7.
Operating Income Rs 50,000. Cost of Debt 10% and
outstanding debt is Rs. 2,00,000 of amazon ltd . If the
overall capitalisation rate is 12.5%. What will be the
total value of the firm & Equity capitalisation rate.
Q8.
Assume there are 2 firms identical in all aspects
except that firm L has 10%, Rs. 500,000 debentures.
The EBIT of both the firms are equal that is Rs.
1,00,000. The Ke of firm L is higher (16%) than firm
firm U(12.5%).
Calculate the market values of both the firms.
Sol : L U
EBIT 1,00,000 100000
 Intt 50,000 ---
 NI 50,000 1,00,000
 /Ke 16% 12.5%
 E 3,12,500 8,00,0000
Q9.
Z ltd has EBIT Rs 500000. It also has Rs. 10,00,000
debentures at an intt rate of 12%. If Ke is 15% Calculate
the value of the firm.
 MM Approach/NOI with tax
Value of Unlevered Firm(V)= EBIT (1-tax)
Ke
the value of V and E will be same as there is no debt in the
company
Value of Levered Firm (V) = E + D or
Value of Levered Firm (V) = EBIT (1-tax) + Debt(x)tax
Ke
E will be same as calculated above &
D = Debt(x)tax
Q9.
Company A and B are two similar businesses with
similar business risks. Company A is unlevered
whereas Company B is levered with Rs. 2,00,000
debenture @ 5% interest rate. Both the companies
earn Rs. 50,000 before intt& tax income. The
capitalization rate is 10% and the corporate tax-rate is
40%. Calculate the market value of two firms.
Solution
A(Unlevered) = EBIT (1-tax)
Ke
= 50000(1-0.40)
0.10
= Rs. 3,00,000
B (levered) = Rs. 3,00,000 + 2,00,000 x 0.40
= 3,80,000
Q10.
Company A and B are homogeneous in all respects
except that Company A is levered while Company B is
unlevered. Company A has Rs. 5,00,000 Debentures.
assumptions are met and the tax rate is 50%. EBIT is
Rs. 50,000 and that equity-capitalisation rate for
Company B is 12%. What would be the value for each
firm according to M— M’s approach?
Value of unlevered Firm (Vu)= [EBIT (1-Tc)]/Ke
= [50,000*(1-0.5)]/0.12
                                               = Rs 2,08,333
Value of levered Firm (Vl)= Rs. 2,08,333+ Rs.
5,00,000*0.50
= Rs. 4,58,333
Teachers note
In NI & NOI approach the basic assumption is that
there is no corporate tax.
But in case in exam the question mentions a tax rate
then while calculating the answer in NI approach: after
EBT calculation tax will be deducted and NI will be
EAT (and not EBT).
If in a similar case, Tax is mentioned for calculation of
NOI approach: MM method will be followed.
Q 11. (NI / NOI with tax)
Company A and B are engaged in the same line of
activity with similar business risk. Company A is
unlevered and Company B is levered with Rs. 2,00,000
debentures carrying 5% rate of interest. Both the firms
have income before interest and taxes of Rs. 50,000.
The company’s tax rate is 40% and capitalisation rate
10% for purely equity firms. Compute the value of firm
U and L using the NI and NOI approach.
Solution(NI Approach)
Solution(NOI Approach)
Value of unlevered Firm (Vu)= [EBIT (1-Tc)]/Ke
= [50,000*(1-0.4)]/0.10
                                                            =Rs. 3,00,000
Value of levered Firm (VL)= E+D
= Rs. 3,00,000+ Rs. 2,00,000*0.40
                         = Rs. 3,80,000