CAPITAL STRUCTURE : Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions)

1. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
Affiliated to Institution of G.G.S.IP.U, Delhi
FINANCIAL
MANAGEMENT
BBA – 309

2. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
UNIT 2- OUTLINE
• Capital Structure Theories
 NI Approach
 NOI Approach
 Traditional Approach
 MM Approach
• Cost of Capital
• Leverage

3. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
CAPITAL STRUCTURE
• CAPITAL STRUCTURE : Capital structure can be
defined as the mix of owned capital (equity,
reserves & surplus) and borrowed capital
(debentures, loans from banks, financial
institutions)
• Maximization of shareholders’ wealth is prime
objective of a financial manager. The same may be
achieved if an optimal capital structure is designed
for the company.

4. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
CAPITAL STRUCTURE THEORIES
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no change
in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.

5. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
Capital Structure Theories –
A) Net Income Approach (NI)
ke
ko
kd
Debt
Cost
kd
ke, ko
 As per NI approach, higher use
of debt capital will result in
reduction of WACC. As a
consequence, value of firm will
be increased.
Value of firm = Earnings
WACC

6. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
Capital Structure Theories –
B) Net Operating Income (NOI)
ke
ko
kd
Debt
Cost
 Cost of capital (Ko) is
constant.
 As the proportion of debt
increases, (Ke) increases.
 No effect on total cost of
capital (WACC)
 Value of firm remains
constant.

7. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition –
• Value of a firm is independent of the capital structure.
• In this process, investors will switch their securities
between identical firms (from levered firms to un-
levered firms) and receive the same returns from both
firms.
• Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
= Expected EBIT
Expected WACC

8. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
Capital Structure Theories –
D) Traditional Approach
ke
ko
kd
Debt
Cost
 Traditional approach
(‘intermediate approach’) is a
compromise between these two
extreme approaches.
 Traditional approach confirms
the existence of an optimal
capital structure; where WACC
is minimum and value is the
firm is maximum.

9. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
COST OF CAPITAL
• It is the minimum rate of return that a firm must
earn on its investment for the market value of the
firm to remain unchanged. It is also known as
minimum required rate of return.
• SPECIFIC COST OF CAPITAL :
Cost of Debt (Kd)
 Cost of Preference Capital (Kp)
Cost of Equity Capital (Ke)
 Cost of retained earnings (Kr)

10. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
LEVERAGE
• Leverage refers to a relationship between
two interrelated variables.
• Leverage = % in independent variable
% in dependent variable

11. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
TYPES OF LEVERAGE
• OPERATING LEVERAGE : It means the use of
fixed operating cost by the firm. Due to which
firm’s profit increases with every increase in
Sales. It is measured by ----
• DOL (Degree of Operating Leverage) =
% in EBIT
% in Sales

12. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
TYPES OF LEVERAGE
• FINANCIAL LEVERAGE : It means the use of
fixed financing cost by the firm. As a result,
the value of EPS either increases or decreases
with every change in EBIT. It is measured by ---
• DFL ( Degree of Financial Leverage) =
% in EPS
% in EBIT

13. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
TYPES OF LEVERAGE
• COMBINED LEVERAGE : It is ascertained to
measure the effect of change in Sales on
change in EPS.
• DCL (Degree of Combined Leverage)
= DOL X DFL
= % in EPS
% in Sales

14. TRINITY INSTITUTE OF PROFESSIONAL STUDIES
Sector – 9, Dwarka Institutional Area, New Delhi-75
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