1. Capital Structure Theory and Policy
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2. Debt-equity Mix and the Value of the Firm
Capital structure theories:
Net operating income (NOI) approach.
Traditional approach and Net income (NI) approach.
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal taxes.
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3. Net Income (NI) Approach
Capital structure decision is relevant to the value of the firm.
A change in capital structure causes a corresponding change in the overall cost of capital as well as the total value of the firm.
According to NI approach both the cost of debt and the cost of equity are independent of the capital structure
They remain constant regardless of how much debt the firm uses.
As a result, the overall cost of capital declines and the firm value increases with debt.
This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
Higher debt content will result in decline in the overall or weighted average cost of debt.
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4. Assumptions There are no corporate taxes.
The cost of debt is less than cost of equity
The debt content does not change the risk perception.
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5. Net Income (NI) Approach
This method is suggested by Durand
Kd and Ke are constant.
As the debt proposition increases, Ko decreases (Kd is lesser than Ke)
This result in the increase in value of the firm.
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6. Use more debt, then cost of capital will reduce, it will increase value of the firm
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7. Calculating the value of a company
Earnings before Interest Tax (EBIT) =
100,000
Bonds (Debt part)
300,000
Cost of Bonds issued (Debt)
10%
Cost of Equity
14%
Calculating the value of a company
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8. Less: Interest cost (10% of 300,000) 30,000
EBIT =
100,000
Less: Interest cost (10% of 300,000)
30,000
Earnings after Interest Tax (since tax is assumed to be absent)
70,000
Shareholders’ Earnings
Market value of Equity (70,000/14%)
500,000
Market value of Debt
300,000
Total Market value
800,000
Overall cost of capital
EBIT/(Total value of firm)
100,000/800,000
12.5%
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9. EBIT/(Total value of firm)
Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.
(EBIT) =
100,000
Less: Interest cost (10% of 300,000)
40,000
Earnings after Interest Tax (since tax is assumed to be absent)
60,000
Shareholders’ Earnings
Market value of Equity (60,000/14%)
428,570 (approx)
Market value of Debt
400,000
Total Market value
828,570
Overall cost of capital
EBIT/(Total value of firm)
100,000/828,570
12% (approx)
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10. Example
X ltd is expecting an annual EBIT of 1 Lac. The company has 4 Lac in 10% debt. The cost of equity capital is 12.5%. You are required to calculate the total value of the firm and Ko.
Financial Management

11. Statement showing value of the firm
Particulars
Amount
EBIT
1,00,000
Less: Interest (10% on 4,00,000)
40,000
Earnings available to the equity holders (NI)
60,000
Equity capitalization rate (Ke)
12.5%
Market value of Equity (NI/Ke)= (60000*100)/12.5
4,80,000
Market value of debt
4,00,000
Total value of the firm (V)
8,80,000
Ko =EBIT/V = (1,00,000/8,80,000) * = 11.36%
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12. Problem
SRE Ltd is expecting an annual EBIT of Rs.1 Lac. The company has Rs.4 Lac in 10% debt. The equity capitalization rate is 12.5%. The co decides to raises Rs.1 lac by issue of 11%debt and use the proceeds thereof to redeem equity shares.
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13. Problem
Two firms L and U are identical in all aspects except for the debt equity mix from L has issued 12% debt of Rs.15,00,000, firm U has no debt. Both L and U earn 30% before interest and taxes on their total assets of Rs.20,00,000. The tax rate is 50% and equity capitalization rate is 20%. Compute the value of firm using Net income approach.
Financial Management