Capital Structure Theory

NI Approach
NET INCOME Approach
NOI 100000
Kd 5%
Ke 10%

Zero Debt Low Debt High Debt

Amount of Debt (D) - 300,000 900,000
NOI 100,000 100,000 100,000
INT= kd*D - 15,000 45,000
NI= NOI- INT 100,000 85,000 55,000

Value of Equity 1,000,000 850,000 550,000

Value of Debt - 300,000 900,000
Value of Firm 1,000,000 1,150,000 1,450,000

WACC= NOI/V 10% 9% 7%

D/V 0% 26% 62%
 Traditional View
Traditional View
NOI 150000 150000 150000 150000
Kd 5% 0.06 0.07 0.09
Ke 10% 0.1056 0.125 0.15

Zero Debt Low Debt High Debt Highest Debt

Amount of Debt (D) - 300,000 600,000 1,000,000
NOI 150,000 150,000 150,000 150,000
INT= kd*D - 18,000 42,000 90,000
NI= NOI- INT 150,000 132,000 108,000 60,000

Value of Equity 1,500,000 1,250,000 864,000 400,000

Value of Debt - 300,000 600,000 1,000,000
Value of Firm 1,500,000 1,550,000 1,464,000 1,400,000

WACC= NOI/V 10.00% 9.68% 10.25% 10.71%

D/V 0.00% 19.35% 40.98% 71.43%
 NOI Approach
CS is irrelevant
NOI 200000
Kd 6%
WACC 10%

Zero Debt Low Debt High Debt

Amount of Debt (D) 0 300,000 900,000
NOI 200,000 200,000 200,000
Valoe of firm 2,000,000 2,000,000 2,000,000

Value of Debt 0 300,000 900,000

Value of Equity 2000000 1700000 1100000

Int 0 18000 54000

NI (EBIT- INT) 200000 182000 146000
Cost of Equity (NI/E) 0.1 0.107058824 0.132727273

D/V 0% 15% 45%

 Arbitrage Opportunity
Unlevered Levered
NOI 10000 10000
INT 0 3000
NI 10000 7000

Ke Traditional View 0.1 0.117

E 100000 60000
D @ 6% 0 50000
Value of Firm 100000 110000

Assuming investors holding is 10% in levered firm

 Arbitrage

Return from Investment= Alpha*(NOI-INT) .10*(10000-3000)

Debt cost @ 6% 700
amount Capital with investors
1 Sell investment in levered firm (60,000) 10% 6000
Borrow on personal account equal to debt
2 in levered firm (50,000) @ 6% 10% 5000
Buy same ownership in Unlevered firm
3 (100,000) 10% 10,000
4 Amount Left= 1000- Interest on Borrowing 6% 1000-5000*.06

Return from this 700