CAPITAL STRUCTURE AND

COST OF CAPITAL

1
Introduction

• Capital structure represents long-term sources of funds used to

finance the operations of a firm.

• Optimum capital structure is that capital structure for which the

market value of the firm is maximum and cost of capital is minimum.

• Optimum capital structure keeps the balance between debt capital

and equity capital.

• There are conflicting views and theories on this subject of the

relationship between capital structure and market value of the firm.
Capital Structure Has Significance: The Net Income
(NI) Approach and Traditional Approach

• The moot question is that whether a change in debt equity mix

would alter the market value of the firm.

• The traditional approaches are of the view that capital structure has
significance and impacts the value of the firm.

• Traditional views under two subheadings are:

1. Net income (NI) approach

2. Traditional approach
Capital Structure Has Significance: The Net Income
(NI) Approach and Traditional Approach

• The Net Income (NI) Approach

– The net income approach was proposed by David Durand.

– As per this approach, relationship exists between capital structure of a

firm and value of the firm.

– If the debt proportion in capital structure increases, the WACC

decreases and value of the firm increases.

– The cost of equity of the unlevered firm is same as its WACC.

– The value of unlevered (pure-equity) firm is discounted value of net

operating income.
Capital Structure Has Significance: The Net Income
(NI) Approach and Traditional Approach
• The Traditional Approach

– Traditional approach does not assume the cost of equity to be constant.

– This approach states that the firm can lower its cost of capital and raise
the value of the firm by increasing financial leverage.

– Under the traditional approach, the value of a firm increases with

increase in financial leverage at lower levels of the leverage. It reaches
a peak value after which it declines.

– WACC first decreases with increase in financial leverage, reaches a

minimum level and then rises.

– In the traditional approach, there are three distinct stages of relationship

between the value of a firm and its capital structure.
Capital Structure Has no Significance: NOI
Approach and MM Hypothesis without Taxes
• The theories under this section state that capital structure has no
significance or relevance and does not impact the value of the firm.

• The two main theories of this view are:

• Net Operating Income (NOI) Approach

– Net operating income (NOI) approach is in principle the opposite of NI

approach.

– As per NOI approach, the value of a firm is dependent upon net

operating profit and the firm’s overall cost of capital WACC.

– In the NOI approach, the capital structure does not matter for value of
the firm.
Capital Structure Has no Significance: NOI
Approach and MM Hypothesis without Taxes
• Modigliani Miller (MM) Approach

• MM Theory was put forward by Franco Modigliani and Merton Miller

in 1958.

• This approach is similar to the Net Operating Income (NOI)

approach.

• The MM Theory is based on strong assumptions.

• If MM assumptions are correct, it does not matter how the financing

takes place and capital structure decision would be irrelevant.
Capital Structure Has no Significance: NOI
Approach and MM Hypothesis without Taxes

• MM Theory has been expressed in the form of two propositions:

• Proposition I

– The Proposition I states that in perfect markets for firms in the same risk
class, the market value of the firm and cost of capital are independent of
debt equity proportion.

– Value of levered firm is equal to value of unlevered firm.

– To provide behavioural justification of how the value of a levered and

unlevered firm remains same, MM suggested an arbitrage mechanism
Capital Structure Has no Significance: NOI
Approach and MM Hypothesis without Taxes
• Proposition II

• The Proposition II states that financial leverage introduces two

opposing effects.

• It increases shareholders’ return due to deployment of debt which is

cheaper source of finance, but it also increases the financial risk.

• The Proposition II gives justification for the levered firm’s opportunity

cost of capital remaining constant with different proportions of debt
in the capital structure.

• MM states that when cost of debt increases, cost of equity will

increase at reducing rate and may eventually reduce.
MM Hypothesis with Corporate Taxes

• MM proposed another theory in 1963 in which they included

corporate taxes.

• MM stated that value of a levered firm is same as the value of

identical but unlevered firm plus value of any side effects.

• Only side effect MM considered was the interest tax shield.

• Present value of interest tax shield is corporate income tax rate

multiplied by amount of permanent debt and it is independent of the
cost of debt.

• MM under its tax-corrected view, states that a firm can increase its
value with leverage due to tax-deductibility of interest charges.
MM Hypothesis with Corporate Taxes

• The announcement of a share issue is generally the signal that the

firm’s prospects in the views of its management are not good.

• On the other hand, a debt issue is considered as a positive signal.

• Based on the signaling theory we find that issuing new shares would
send negative signals to investors.

• It is prudent for the firm to reserve a part of its borrowing capacity

which can be utilised in case a really good opportunity arises.
MM Hypothesis with Corporate Taxes

• In normal times the firm may use more equity and less debt
compared to the optimal capital structure based on tax benefit–
bankruptcy cost trade-off.

• Other reasons for the firms not to use extreme level of debt in real
life practice are:

1. The impact of corporate income tax and personal income tax on the
firm’s borrowings.

2. Borrowing may involve cost of financial distress.

Miller’s Model

• Miller introduced the impact of personal taxes of investors on the

valuation of a firm.

• The assumption for the Miller’s Model is that the personal income
tax rate for equity income is zero.

• Debt can easily be issued to those investors who do not pay taxes.

• There are two significant implications of Miller’s Model:

– There is an optimum debt equity ratio for all firms in the economy
considered together.

– For any single firm there is no optimum debt equity ratio.

The Trade-Off Theory

• In real life bankruptcy can be quite expensive.

• Bankruptcy costs discourage a firm to use excessive debt in the

capital structure.

• Bankruptcy costs have the following two elements:

1. The probability of financial distress.
2. The costs related to the distress actually occurring.

• Trade-off theory involves the trade-off between the benefit of debt

financing against the higher interest rates and bankruptcy costs.
Agency Costs

• In a firm conflict of interest usually exists amongst shareholders,

debt-holders and managers of the firm.

• These conflicts are referred to as agency problems and addressing

agency problems involves costs, called agency costs.

• Typical agency problems are:

1. Shareholders-Managers Conflict
2. Shareholders-Debt-holders Conflict

• Agency costs influence the capital structure of a firm by diminishing

the impact of present value of interest tax shield