Unit
iii 04 : Capital Structure &
i
ii.fi iiliiesi'p
Leverages
i is ill
if
capital structure
A capitalstructure refers tothe combination ofthe structure ofliabilitiesof afirm
it is the composition of thelongtermfinancingofan enterprise including debt
preferredstock andequity
it IEtjpetg ites ma
is Anoptimumcapitalstructure is one thathas a mixofdebtandequity in such a
manner that the of capitalis minimum andreturnto shareholde
weighted averagecost
is maximum
Capital TotalAssets Total liabilities
Factorsaffectingcapitalstructure
control
Typeofcompany
toFunds
Access
IndustryLifeCycle
requirement
Market competition
Taxbenefitondebt
Optimum capital structure
Profitability
offirmdependsuponwaceearnings
value
solvency
assetsefficientlytoobtainhigh
things
Flexibility
of
earningsareafunction investment
decisions operatingefficiences
control
WACis afunction capitalstructure
of totalearnings firm
capitalstructuresa ffect of conservatism
Valueof a firm is directly correlated with manimisation of shareholders wealth
, CapitalstructureTheories
Assumptions firmuses 2sourcesoff unds debt equity
nochangeininvestmentdecisions totalassets
100 dividendpayout no retainedearnings
risknotaffectedbyfinancemix
business
notaxes
investorsexpectfuture profitability
1 Netincome Approach
definite relationship bw capitalstructure value
of thefirm
met capitalstructure influences cost ofcapital Nacc thusdirectlyaffecting thevalue
jiffy of afirm
gagging p
as per NIapproach high useof debt capital leadstoreduction in WACC as a
consequence value offirm increases
cost
valueoffirm
Egg D
Keko ke
no no earnings beingconstant as WACCis reduced value offirmincreases
Debt Afirm willthushavemaximum value at a pointwhereYA.ge is minimum i.efirm
is almost debtfinanced
11 Net operating Income Approach
o nrisk
depends
If
Assumptions
aigginente ofnetincome approach
exact opposite
asperNota pproach valueof a firm is not dependent upon itscapitalstructure
itproposesthatthe higheruseof debt component borrowings in the capital
cost ke structure increases therisk
ofthe shareholders
Konka
increase in shareholders risk causes equitycapitalization rate i.e costofequity
ke to increase
Debt
highercostofequity nullifies the advantage gaineddueto cheapercostof debt
, doesnotaffect the value
thusstatingthat thefinance minis irrelevant of a
firm
111 ModiglianiMiller Model MMM
Assumptions rootdividend
payout
thisapproach supports the NOIa pproach iethe capitalstructure debtequitymin
if
hasno effect on thevalueof afirm
itormed
it adds a behaviouraljustification infavourof theNotapproach called as
personal leverage
itproposesthatthe value of afirm is independentof capital structure It is
equal tothecapitalized value ofoperating income EBIT bythe appropriate rate
NACC
Value
offirm MVofEquity MVofDebt
ExpectedEBIT
WACC
asperMMModel identical
firms exceptcapital structure will have the same leve
ofearnings
ifthemarketvalues ofidenticalfirms are different arbitrageprocess willtakepla
in which investors switchtheirsecurities between identical
firms from levered to
unlevered
firms andreceivethesamereturnsfrombothfirms
IV Traditional Approach
NI andNOIapproach holdextreme views on the relationship between capitalstructu
cost cost
ofcapitalandvalueoffirm
theTraditionalapproach or intermediate approach is a compromise betweenthese two
Ko
extreme approaches
it confirms the existence of an optimalcapital structure where WACC is minimum
Kd
Debt
value
ofthefirm is maximum
equity will maximise
thus as
perthisapproach the bestpossible minofdebt the
iii 04 : Capital Structure &
i
ii.fi iiliiesi'p
Leverages
i is ill
if
capital structure
A capitalstructure refers tothe combination ofthe structure ofliabilitiesof afirm
it is the composition of thelongtermfinancingofan enterprise including debt
preferredstock andequity
it IEtjpetg ites ma
is Anoptimumcapitalstructure is one thathas a mixofdebtandequity in such a
manner that the of capitalis minimum andreturnto shareholde
weighted averagecost
is maximum
Capital TotalAssets Total liabilities
Factorsaffectingcapitalstructure
control
Typeofcompany
toFunds
Access
IndustryLifeCycle
requirement
Market competition
Taxbenefitondebt
Optimum capital structure
Profitability
offirmdependsuponwaceearnings
value
solvency
assetsefficientlytoobtainhigh
things
Flexibility
of
earningsareafunction investment
decisions operatingefficiences
control
WACis afunction capitalstructure
of totalearnings firm
capitalstructuresa ffect of conservatism
Valueof a firm is directly correlated with manimisation of shareholders wealth
, CapitalstructureTheories
Assumptions firmuses 2sourcesoff unds debt equity
nochangeininvestmentdecisions totalassets
100 dividendpayout no retainedearnings
risknotaffectedbyfinancemix
business
notaxes
investorsexpectfuture profitability
1 Netincome Approach
definite relationship bw capitalstructure value
of thefirm
met capitalstructure influences cost ofcapital Nacc thusdirectlyaffecting thevalue
jiffy of afirm
gagging p
as per NIapproach high useof debt capital leadstoreduction in WACC as a
consequence value offirm increases
cost
valueoffirm
Egg D
Keko ke
no no earnings beingconstant as WACCis reduced value offirmincreases
Debt Afirm willthushavemaximum value at a pointwhereYA.ge is minimum i.efirm
is almost debtfinanced
11 Net operating Income Approach
o nrisk
depends
If
Assumptions
aigginente ofnetincome approach
exact opposite
asperNota pproach valueof a firm is not dependent upon itscapitalstructure
itproposesthatthe higheruseof debt component borrowings in the capital
cost ke structure increases therisk
ofthe shareholders
Konka
increase in shareholders risk causes equitycapitalization rate i.e costofequity
ke to increase
Debt
highercostofequity nullifies the advantage gaineddueto cheapercostof debt
, doesnotaffect the value
thusstatingthat thefinance minis irrelevant of a
firm
111 ModiglianiMiller Model MMM
Assumptions rootdividend
payout
thisapproach supports the NOIa pproach iethe capitalstructure debtequitymin
if
hasno effect on thevalueof afirm
itormed
it adds a behaviouraljustification infavourof theNotapproach called as
personal leverage
itproposesthatthe value of afirm is independentof capital structure It is
equal tothecapitalized value ofoperating income EBIT bythe appropriate rate
NACC
Value
offirm MVofEquity MVofDebt
ExpectedEBIT
WACC
asperMMModel identical
firms exceptcapital structure will have the same leve
ofearnings
ifthemarketvalues ofidenticalfirms are different arbitrageprocess willtakepla
in which investors switchtheirsecurities between identical
firms from levered to
unlevered
firms andreceivethesamereturnsfrombothfirms
IV Traditional Approach
NI andNOIapproach holdextreme views on the relationship between capitalstructu
cost cost
ofcapitalandvalueoffirm
theTraditionalapproach or intermediate approach is a compromise betweenthese two
Ko
extreme approaches
it confirms the existence of an optimalcapital structure where WACC is minimum
Kd
Debt
value
ofthefirm is maximum
equity will maximise
thus as
perthisapproach the bestpossible minofdebt the
