Financial Management

Course content to be used by: BMS Sem 4

Faculty: Neha Gosain
E-mail: [email protected]
Capital structure
• Every business requires an investment, and it requires a capital structure to raise a profitable investment
for that particular business.
• It determines the ratio between the debt and equity of the company. It should be planned so that the
company can attain the maximum profit with minimum risk factors.
• Several factors affect the capital structure, including the market conditions, nature of investors, taxation
policies, etc.
• There are several competing capital structure theories, each of which explores the relationship
between debt financing, equity financing, and the market value of the firm slightly differently.
• Combination of various component of capital is called capital structure.
• The over all cost of capital may reduce as the proportion of debt increases in the capital structure
because cost of debt is less than cost of equity, while on the other hand risk of the firm increases with the
increase in the fixed contractual obligation, which again increases the weighted average cost of capital.
• The firm may use only equity, or only debt, or a combination of equity +debt, or a combination of equity
+ debt + preference shares or may use other similar combinations to form capital structure.
• Several capital structure theories provide different approaches; the four most important ones are the net
income theory, net operating income theory, traditional theory, and Modigliani-Miller theory.
• Total capital needed for a company is Rs. 2000. Company has 2
options 1) Issue 20 Equity shares of Rs. 100 2) Issue 10 Equity shares
of Rs. 100 and 10% Debt for Rs. 1000. Assume that total return
earned in both is Rs.1000. Calculate the return for shareholders (EPS)
• It means when capital structure is changing the cost of capital will
change and also it will effect the value of the firm
Net Income Approach
• David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change
in financial leverage results in a change in capital costs. In other words, if a company takes on more debt to leverage
investments, its capital structure increases in size and the weighted average cost of capital (WACC) decreases, which results in
higher firm value.
• It postulates that the market analyzes a whole firm, and any discount has no relation to the debt-to-equity ratio. If tax
information is provided, it states that WACC decreases with an increase in debt financing, and the value of a firm will increase.
• In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It's important to remember,
however, that this approach assumes an optimal capital structure. Optimal capital structure implies that at a certain ratio of debt
and equity, the cost of capital is at a minimum, and the value of the firm is at a maximum.
• According to NI approach capital structure decision is relevant for the value of the firm.
• • Change in the capital structure will corresponding bring change in the overall cost of capital
• According to this approach, “a high debt equity ratio in the capital structure (called financial leverage) will result in decline in
the overall cost of capital (WACC) of the firm and increase value of firm.”
• According to NI Approach, change in the financial leverage (debt/equity ratio) of a firm will lead to a corresponding change in
the WACC and also the value of the firm.
• • The NI Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm
increases and vice versa.
Assumptions
• (i) There are no corporate taxes.
• (ii) The cost of debt is less than the cost of equity (Kd < Ke ) i.e. the
capitalization rate of debt is less than the capitalization rate of equity. This
prompts the firm to borrow.
• (iii)The debt capitalization rate and the equity capitalization rate remain
constant over the time.
• (iv)The proportion of the debt does not affect the risk perception of the
investors. Investors are only concerned with their desired return.
• (v) The cost of debt remains constant at any level of debt.
• (vi) Dividend pay out ratio is 100%.
• Value Of The Firm(V) = S+B S= Value of share B = Value Of Debt
• Market Value Of Equity = NI/Ke x100
• NI = Net Income for E-Share holders Ke = Cost of Equity
• Case 1. XYZ Ltd Earned a profit of Rs. 25 Lakhs before providing interest
and tax. The company’s capital structure is as follows 4,50,000 E/S of Rs.
10 each and its market capitalization rate is 16% 26,000 14% secured
redeemable debentures of Rs. 150 each You are required to calculate
Value of firm by using NI Approach and Overall cost of capital of the firm.
Net operating income approach (NOI)
• Proposed by Durand.
• This theory is just opposite to NI approach. As per NOI approach the capital structure decision is irrelevant and the degree of
financial leverage does not affect the WACC and market value of the firm. Ke increases with increase in leverage. To
compensate for increased financial risk, shareholders expect higher rate of return on their investment.
• Assumptions
(i) There are no corporate taxes.
(ii) Cost of debt remains constant at all level of debt.
(iii)Overall cost of capital remains constant.

Cost of debt has two parts: Explicit – rate of interest paid on debt ; implicit or hidden – increased cost of equity due to increase in
debt
Optimum capital structure under NOI Approach:
As per NOI approach the cost of debt, market value of the firm and the market value of the equity shares remain constant
irrespective of change in the financial leverage and the benefit of low cost of debt is offset by the increased rate of return on equity
with the increase in debt in the capital structure Therefore, the overall all cost of capital remains the same at any level of debt;
hence, the capital structure is optimum at any level of debt-equity mix. There is nothing as an “optimum capital structure”
Residual value of equity
Q1. The XYZ Ltd. has earned a profit before interest and tax Rs. 7 lakhs. The
company’s capital structure includes 30,000 14% Debenture of Rs. 100 each. The
overall capitalization rate of the firm is 16%. – Calculate the Total value of firm
and the equity capitalization rate?

Q2. A company expects a net operating income of 100000. it has Rs.5,00,000 6%

Debentures. The overall capitalization rate is 10%.
a. Calculate the value of the firm and the equity capitlization rate (Cost of
equity) according to the Net Operating Income Approach.
b. If the debenture debt is increased to Rs.700000 what will be the effect on the
value of the firm?
c. If the debenture debt is decreased to Rs. 300000 what will be the effect on the
value of the firm?
Traditional Approach
• The traditional approach was propounded by Ezra Soloman in 1963 .
• This approach is the compromise between NI approach and NOI approach.
• The traditional approach rejects both extreme prepositions of relevance approach of NI theory and irrelevance approach of
NOI theory.
• This approach neither assumes constant cost of equity (ke) and declining Weighted Average Cost of Capital (WACC) like NI
approach nor increasing cost of equity and constant cost of debt (kd) and over all cost of capital (ko) like NOI approach.
• Under traditional approach wacc decreases only up to a certain level of financial leverage and starts increasing beyond this
level. At the judicious mix of debt and equity as of optimum capital structure weighted average cost of capital is minimum
and the market value of the firm is maximum.
• At optimum capital structure, the marginal real cost of debt both implicit and explicit, will be equal to real cost of equity. For
a debt-equity ratio before that level, marginal real cost of debt would be less than that of equity capital while beyond that level
of leverage, marginal real cost of debt would exceed equity.
• Three stage of capital structure under traditional approach
• Stage 1: The value of the firm may first increase with moderate leverage when WACC is decreasing.
• Stage 2: Reach the maximum value when WACC is minimum.
• Stage 3: Then starts declining with higher financial leverage when WACC start increasing.
Assumptions Under Traditional Approach
• Cost of debt (kd) remains stable with an increase in the debt ratio to a
certain limit after which it begins to grow.
• Cost of equity (ke) remains stable or grows slightly with an increase in the
debt ratio to a certain limit after which it begins to grow rapidly.
• Weighted average cost of capital decreases to some degree with an increase
in the debt ratio and then begins to grow.