1. The document discusses various capital structure theories including the net income approach, net operating income approach, Modigliani-Miller approach, and traditional approach. 2. The net income approach states that a firm's cost of capital and value are impacted by its capital structure, while the net operating income approach argues they are independent. 3. The Modigliani-Miller approach also argues a firm's value is independent of capital structure under certain assumptions, but value increases with tax benefits of debt under more realistic assumptions.

1. Chapter 12Chapter 12
CAPITAL STRUCTURECAPITAL STRUCTURE
AND FIRM VALUATIONAND FIRM VALUATION

2. LEARNING OBJECTIVESLEARNING OBJECTIVES
• Give the capital structure equation
• Define optimum capital structure and list its features
• Name the capital structure theories
• List out the general assumptions of capital structure theories
• Discuss the NI approach
• Explain the NOI approach
• Critically evaluate MM Theory of capital structure
• Say why is Traditional Theory is called Neutral structure

3. Capital Structure TheoriesCapital Structure Theories
• The total capital structure theories can be categorised into two
relevant and irrelevant theories.
The following are the main theories/Approaches of capital
structure:
1. Net income (theory) Approach (Relevant)
2. Net operating income Approach (Irrelevant)
3. Modigliani and Miller Approach (Irrelevant)
4. Traditional Approach (Neutral)

4. Assumption of Capital Structure TheoriesAssumption of Capital Structure Theories
1. Firm uses only two sources of funds: perceptual riskless debt and
equity;
2. There are no corporate or income: or personal tax;
3. The dividend payout ratio is 100% [There are no retained earnings];
4. The firm’s total assets are given and do not change [Investment
decision is assumed to be constant].
5. The firm’s total financing remains constant. [Total capital is same, but
proportion of debt and equity may be changed];
6. The firm’s operating profits (EBIT) are not expected to grow;
7. The business risk is remained constant and is independent of capital
structure and financial risk;
8. All investors have the same subject probability distribution of the
expected EBIT for a given firm; and
9. The firm has perpetual life;

5. Definitions used in Capital StructureDefinitions used in Capital Structure
E = Total market value of equity
D = Total market value of debt
V = Total market value of the firm
I = Annual interest payment
NI = Net income or equity earnings
NOI = Net operating income
Ki = pre-tax cost of debt
Cost of debt (Ki) = ×100
Cost of equity (Ke) = or Ko+ [Ko–Ki] D
E
Cost of Capital (Ko) = WdKi + WeKe or [EBIT V] ×100
Value of the Firm (V) = EBIT Ko
NI
E
I
D
÷

6. Net Income ApproachNet Income Approach
• NI Approach: A change in the proportion in capital structure
will lead to a corresponding change in Ko and V.
• Assumptions
(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(iii) Use of debt in capital structure does not change the risk
perception of investors.
(iv) Cost of debt and cost of equity remains constant;

7. E = NI ÷ KeE = NI ÷ Ke
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E
D
Degree Of Leverage
N I Approach (Contd…..)N I Approach (Contd…..)

8. Net Operating Income Approach (NOI)Net Operating Income Approach (NOI)
NOI Approach: Says that there is no relation between capital structure and
Ko and V.
Assumptions
(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of
leverage. (See Fig. 11.2)
(ii) The market capitalises the total value of the firm as a whole and no
importance is given for split of value of firm between debt and equity;
(iii) The market value of equity is residue [i.e., Total value of the firm minus
market value of debt)
(iv) The use of debt funds increases the received risk of equity investors, there
by ke increases
(v) The debt advantage is set off exactly by increase in cost of equity.
(vi) Cost of debt (Ki) remains constant
(vii) There are no corporate taxes.

9. NOI (Contd.)NOI (Contd.)
V = EBIT Ko
E = V-D
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E
D
Degree Of Leverage

10. Modigliani-Miller ApproachModigliani-Miller Approach
MM Approach: Total value of firm is independent of its capital
structure
Assumptions
a.Information is available at free of cost
b.The same information is available for all investors
c.Securities are infinitely divisible
d.Investors are free to buy or sell securities
e.There is no transaction cost
f.There are no bankruptcy costs
g.Investors can borrow without restrictions as the same terms on
which a firm can borrow
h.Dividend payout ratio is 100 percent
i.EBIT is not affected by the use of debt

11. MM Approach (Contd.)MM Approach (Contd.)
Proposition:
I. Ko and V are independent of capital structure
II. Ke = to capitalisation rate of the pure equity plus a premium
for financial risk.
Ke increases with the use of more debt. Increased Ke off set
exactly the use of a less expensive source of funds (debt)
III.The cut of rate for investment purposes is completely
independent of the way in which an investment is financed.

12. MM Approach [Proposition: I]
• Arbitrage Process: Refers to an act of buying an asset or security in
one market at lower price and selling it is an other market at higher
price.
• Steps in working out Arbitrage Process
Students need to keep in mind the following three steps in working of
arbitrage process.
Step 1: Investors Current Position: In this step there is a need to find
out the current investment and income (return).
Step 2: Calculation of Savings in Investment by moving from levered
firm to unlevered firm. Savings in investment is equals to total funds
[Funds raise by sale of shares plus funds raised by personnel
borrowing] minus same percentage of investment. Here the income
will be same which was earning in previous firm.
Step 3: Calculation of Increased Income, by investing total funds
available.

13. Limitations of MM ApproachLimitations of MM Approach
• Investors cannot borrow on the same terms and conditions of a
firm
• Personal leverage is not substitute for corporate leverage
• Existence of transaction cost
• Institutional restriction on personal leverage
• Asymmetric information
• Existence of corporate tax

14. MM Approach: with Corporate Taxes
• MM Approach with tax says affects value of the firm
VL = VU+ Dt
Where VL = Value of levered firm
VU = Value of unlevered firm,
D = Amount of Debt
t = Tax rate
• In other words value of levered firm (VL) is equal to the market
to the market value of unlevered firm VU plus the discounted
present value of the tax saving resulting from tax -
deductibility a interest payments.(7
) Symbolically
• VL = VU + pv of tax shield

15. Traditional ApproachTraditional Approach
• Traditional Approach is midway between NI and NOI theories
• Traditional approach says judicious use of debt helps increase
value of firm and reduce cost of capital

16. Traditional ApproachTraditional Approach (Contd.)(Contd.)
Main propositions
The following three are the main propositions of traditional approach(11)
1. The pretax cost of debt (Ki) remains more or less constant up to a certain
degree of leverage and /but rises thereafter of an increasing rate
2. The cost of equity capital (Ke) remains more or less constant rises slightly
up to a certain degree of leverage and rises sharper there after, due to
increased perceived risk.
3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost
of debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I
increasing firm value];
(b) Remains more or less unchanged for moderate increase in leverage
thereafter [stage II optimum value of firm], and
(c) Rises sharply beyond certain degree of leverage [stage III decline in
firm value].

17. Traditional approachTraditional approach (contd.)(contd.)
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E
D