CHAPTER 15

CAPITAL STRUCTURE THEORY AND POLICY

Q.1.
A.1.

Explain the assumptions and implications of the NI approach and the NOI
approach. Illustrate your answer with hypothetical examples.
Under the Net Income (NI) approach, the cost of debt and cost of equity are
assumed to be independent to the capital structure. The weighted average cost of
capital declines and the total value of the firm rises with increased use of
leverage.
Under the net operating income (NOI) approach, the cost of equity is
assumed to increase linearly with leverage. The weighted average cost of capital
remains constant and total value of firm also remains constant as leverage is
changed.
Example: Assume that EBIT (i.e., Net Operating Income) is Rs 1,00,000.
The amount of debt employed by firm Rs 7,00,000; the cost of debt 6%; and the
rate of return expected by equity shareholders 10%. ko = 8%.
NI Approach:
Rs
1,00,000
42,000
---------Net income available to shareholders 58,000
---------Market value of equity(S)
5,80,000
Market Value of Debt (D)
7,00,000
---------Total value of firm (S+D)
12,80,000
---------NOI
Less: Interest costs

(58,000/0.10)

NOI Approach:

NOI
Market value of firm
Market value of Debt (D)
Market value of Share (S)

Rs
1,00,000
12,50,000 (1,00,000/0.08)
7,00,000
5,50,000

Now, assume that value of debt increases to Rs 9,00,000

NI approach:
NOI
Less: Interest cost

Rs
1,00,000
54,000 (9,00,000 x 6%)
---------

Equity Earnings
Market value of shares (S)
Market value of debt (D)
Total value of firm

46,000
4,60,000 (46,000/0.10)
9,00,000
--------13,60,000
----------

NOI approach:
NOI
Market value of firm
Market value of debt (D)
Market value of share (S)

Rs
1,00,000
12,50,000
9,00,000
3,50,000

From the above, it is clear that as per NI approach the value of firm
increases as the use of debt increases, i.e., from Rs 12,50,000 to Rs 13,60,000. As
per NOI approach, the value of firm remains constant.
Q.2.
A.2.

Q.3.

A.3.

Describe the traditional view on the optimum capital structure. Compare and
contrast this view with the NOI approach and the NI approach.
According to traditional approach, the cost of capital declines and the value of the
firm increases with leverage up to a prudent debt level and after reaching the
optimum level, leverage cause the cost of capital to increase and the value of the
firm to decline. The optimum capital structure occurs when the cost of capital is at
its minimum or the value of firm is at maximum.
The NI approach indicates that the total value of firm rises with increased
use of leverage, and weighted average cost of capital declines.
The NOI approach assumes that the total value of firm remains constant as
leverage is changed, because the cost of equity increases linearly with leverage
and sets off the benefits of debt capital.
The NI approach is valid, if financing decisions have an important effect
on the value of firm. NOI approach is valid, if the financing decisions is not of
great concern, but overall cost of capital depends on business risk. Traditional
approach is based on the NI approach.
Explain the position of MM on the issue of an optimum capital structure, ignoring
the corporate income taxes. Use an illustration to show how home-made leverage
by an individual investor can replicate the same risk and return as provided by the
levered firm.
The Modigliani-Miller hypothesis is identical with the NOI approach. MM
approach indicates that a firms market value and the cost of capital remain
invariant to the capital structure changes, i.e., any combination of debt and equity
is as good as any other. MM hypothesis indicates that securities are traded in
perfect capital market situation, and firms can be grouped into homogeneous risk
classes. Further, it is also assumed that no corporate income taxes exist, and firms
distribute all net earnings to the shareholders.

If two identical firms, except for the degree of leverage, have different
market values, arbitrage will take place to enable investors to engage in personal
or home-made leverage as against the corporate leverage, to restore equilibrium in
the market.
Example: Assume that two firms, i.e., unleveraged firm U and leveraged
firm L have identical expected NOI of Rs 10,000. The value of leveraged firm is
Rs 1,10,000 the value of equity shares being Rs 60,000 and the value of debt is
Rs 50,000, and the value of unleveraged firm is Rs 1,00,000. Firm L has
borrowed at the expected rate of return of 6%. Assume that an investor, Mr X,
holds 10% of shares of leveraged firm. How does the arbitrage benefit him?
Mr Xs value of investment in firm L = Rs 6,000 (60,000 x 10%)
Mr Xs return from firm L
= 10% of (EBIT INT)
= 10% (10,000 3,000)
= Rs 700
Now, Mr X will sell his shares of firm L for Rs 6,000 and will borrow Rs
5,000 (Rs 50,000 10%) at 6% interest rate on his personal account. He will
invest Rs 11,000 to purchase shares of firm U (Rs 110,000 10%).
Mr. Xs return from firm U
= 10% x 11,000
=
1100
Less: Interest on personal borrowing
= 6% x 5,000
=
300
----Rs 800
----This strategy pays to Mr X more return at same investment. As a result of
this switching, i.e., arbitrage process, the market value of leveraged firms share
will decrease and that of unleveraged firm will increase. So, equilibrium takes
place when values of both firms, i.e., U and L are identical.
Q.4.
A.4.

Q.5.
A.5.

Assuming the existence of the corporate income taxes, describe the MM

proposition on the issue of optimum capital structure.
When the corporate taxes are assumed, firms can increase earnings of investors
through borrowing which results in interest tax shield. Under the assumption of
infinite stream of constant tax shield, the value of interest tax shield (PVINTS) is
equal to tax rate multiplied by debt (TD).
T ( k d D)
PVINTS =
= TD
kd
where T is the corporate tax rate, kd is the cost of debt and D is the amount
of debt. Thus the market value of levered firm is equal to market value of unlevered firm plus the present value of interest tax shield.
The MM thesis is based on unrealistic assumptions. Evaluate the reality of the
assumptions made by MM.
The MM thesis is based on the assumption of perfect capital market in which
arbitrage is expected to work. The assumption that firms and individuals can

borrow and lend at the same rate of interest may not hold in practice. In reality,
firms are able to borrow at lower rates of interest than individuals. The existence
of limited liability of firms in contrast with unlimited liability of individuals
makes it incorrect to assume that personal leverage is a perfect substitute of
corporate leverage. The existence of transaction costs also interferes with the
working of arbitrage. The existence of number of institutional investors would
make it unfeasible to substitute personal leverage for corporate leverage. The
existence of corporate income tax provide the interest tax shield benefits to firm,
which results in lower cost of borrowed funds than the contractual rate of interest.
Q.6.
A.6.

Q.7.

A.7.

Q.8.

A.8.

Q.9.

How does the cost of equity behave with leverage under the traditional view and
the MM position?
According to the traditional view, the rate at which shareholders capitalize their
net income, i.e., the cost of equity, ke remains constant up to certain level of debt,
(i.e., a certain degree of leverage). Later on, further increase in the leverage
increases the cost of equity due to the added risk (i.e., financial) and offsets the
advantage of low cost of debt, after the acceptable limit of leverage.
On the other hand, according to MM view, the cost of equity increases
with debt; ke, is equal to the constant average cost of capital, ko, plus a premium
for the financial risk, which is equal to debtequity ratio times the spread between
the constant average cost of capital and the cost of debt, (ko kd) D/E. The ke is a
linear function of leverage, measured by the market value of debt to equity, D/E.
Consider two firms, L and U, that are identical except that L is levered where as U
is unlevered. Let Vl and Vu stand respectively, for the market value of L and U. In
a perfect market, would one expect Vu to be less or greater than or equal to Vl?
Explain.
In a perfect market, Vu will be equal to Vl. If Vu is less than Vj then arbitrage
process (as suggested by MM) will take place and value of both firms will
become equal. The arbitrage process is explained above in answer A.3.
When the corporate income taxes are assumed to exist, Modigliani-Miller and the
traditional theorists agree that capital structure does affect value, so the basic
point of dispute disappears. Do you agree? Why or why not?
Two theories are based on different premises. Taxes or no taxes, traditional theory
is based on the assumption that leverage has three-stage effect on value of the
firm (or the firms cost of capital). First, there is a favourable effect on value.
Second, there is no effect. Third, as the use of leverage goes beyond certain level
(undefined level), there is unfavourable effect. The MM theory, on the other hand,
is based on the assumption that there is a linear relationship between leverage and
financial risk. Since the advantage of leverage taken off by the financial risk,
there is no effect on value. When corporate taxes are considered, there is a net
advantage of leverage because of the interest tax shield.
Explain the effect of capital structure on the value of the firm when both corporate
and personal income taxes are considered?

A.9.

Investors are required to pay personal taxes on the income earned by them.
Hence, from investors view point, taxes will include both corporate and personal
taxes. So, firms have to aim at minimizing the total taxes while deciding about
capital structure.
The advantage of interest tax shield is offset by the personal taxes paid by
debt holders on interest income. Income on account of interest is tax-exempt at
corporate level while dividend income is not. Interest income is taxed at personal
level while dividend income may largely escape personal taxes. Thus, companies
can induce tax paying investors to buy debt securities if they are offered high rate
of interest. But after a stage it will not be possible to attract investors in the high
tax brackets. This point establishes the optimum debt ratio in the economy.
Thus, the value of leveraged firm will be equal to value of unleveraged
firm plus present value of interest tax shield benefits. The present value of interest
tax shield (PVINTS) is:
1 T )(1 Tpe)
PVINTS = 1
D
(1 Tpb )

where T is corporate tax rate; Tpe is personal tax rate on equity income;
Tpb is personal tax rate on dividend income; and D is the amount of debt.
Vl = Vu + PVINTS
where Vl value of leveraged firm and Vu is value of unleveraged firm.

Q.10. What is financial distress? How does it affect the value of firm?
A.10. The offsetting advantage of debt is grouped under the term financial distress.
Financial distress occurs when the firm finds it difficult to honour the obligations
of creditors, which may lead to insolvency also. The financial distress also
introduces inflexibility of raising funds by firm when needed. The financial
distress reduces the value of the firm, on account of insolvency costs like legal
costs, arranging the funds at higher cost of capital, etc. Hence:
Value of leveraged firm = Value of unleveraged firm
+ PV of tax shield benefit
PV of financial distress.
The costs of financial distress increases as more and more debt is introduced in
the capital structure of the firm.
Q.11.

Define the capital structure. What are the elements of a capital structure? What
do you mean by an appropriate capital structure? What are the features of an
appropriate capital structure?
A.11. Capital structure refers to the mix of long term sources of funds, such as
debentures, long-term debt, preference share capital and equity share capital
including reserves and surpluses.
The appropriate capital structure maximizes the long term market price per
share, also keeping in view the financial requirements of a company.
A sound or appropriate capital structure should have the following
features:

1. It should generate maximum returns to the shareholders.

2. There should not be the use of excessive debt to maintain long-term
solvency.
3. The capital structure should be flexible, to provide funds to finance its
profitable activities in future.
4. The capital structure should involve minimum risk of loss of control of the
company.
Q.12. Briefly explain the factors that influence the planning of the capital structure in
practice.
A.12. In addition to the concerns about EPS, value of firm and cash flow; the other
important considerations are as follows:
The desire to continue control over the company: For example, closely
held companies do not make issues of new shares, while widely-held
companies may make issue of new equity shares.
The firms willingness to venture into new profitable activities as and
when needed, then they may like to have present target debt ratio at lower
end.
Restrictive covenants in loan agreements already executed.
Readiness of the investors to purchase a security in a given period of time
and to demand reasonable return.
Also, study of the market conditions, and internal conditions of a company
from the view point of marketability of securities, etc.
Q.13. Explain the features and limitations of three approaches of determining a firms
capital structure: (a) EBIT-EPS approach, (b) valuation approach, and (c) cash
flow approach.
A.13. The EBIT-EPS approach analyses the impact of debt on EPS. The use of fixed
cost sources of finance, such as debt and preference share capital to finance the
assets of the company, is known as financial leverage. If the assets financed with
the use of debt yield a return greater than the cost of debt, the earnings per share
also increases without an increase in the owners interest. The firm with high level
of the EBIT can make profitable use of the high degree of leverage to increase
return on the shareholders equity. The EBIT-EPS analysis does not reflect the
debt-servicing ability of the firm. This approach does not consider operating and
business risk also.
In the valuation approach, the capital structure is evaluated in terms of its
effect on the value of the firm. According to MM theory, capital structure will
have favourable effect on the value of the firm only because of the interest tax
shield. This advantage reduces because of personal taxes and financial distress
caused by leverage.
In the cash flow approach, a firm is considered prudently financed if it is
able to service its fixed charges, i.e., pay interest and principal, under any
reasonably predictable adverse conditions. At the time of planning the capital
structure, the ratio of net cash inflows of fixed charges (debt-servicing ratio)

should be examined carefully. It focuses on the liquidity and solvency of the firm
over a long-period of time.
Q.14. .the analysis of debt to equity ratios alone can be deceiving, and an analysis of
the magnitude and stability of cash flow relative to fixed changes is extremely
important in determining the appropriate capital structure. Give your opinion.
A.14. The cash flow analysis indicates firms ability to service debt obligations even
under the adverse conditions, by examining the debt-servicing ratio. It indicates
the number of times the fixed financial obligations are covered by the net cash
inflows generated by the company. The greater the coverage, the greater is the
amount of debt a company can use. The impact of debtequity ratio should be
evaluated in terms of value, rather than EPS. It is possible for a high-growth
profitable company to suffer from cash shortage if its liquidity management is
poor. Hence, the debt capacity should be thought in terms of cash flows rather
than debt ratios.
Q.15. What are the implications of growth opportunities for the financial leverage?
A.15. To exploit growth opportunities, a firm needs funds. Hence, firms with growth
opportunities will tend to borrow more debt in addition to utilizing internal funds.
Q.16. What is meant by financial flexibility? Is a flexible capital structure costly?
A.16. Flexible capital structure means firms ability to adapt its capital structure to the
needs of the changing conditions. The company should be able to raise funds,
without undue delay and cost, whenever needed, to finance the profitable
investments. The financial plan of the company should be flexible enough to
change the composition of capital structure as warranted by operating needs. It is
costly on account of restrictions imposed by loan covenants, pre-maturity
repayment charges in case of retirement of loan or early redemption of
debentures, flotation costs, etc.
Q.17. What is the importance of marketability and flotation costs in the capital structure
decision of a company?
A.17. The internal conditions of a company dictate the marketability of securities in
addition to readiness of investors to purchase a security in a given period of time
and to demand reasonable return. Due to changing market sentiments, the
company has to decide whether to raise funds with an equity issue or debt issue.
Flotation cost is not a very important factor influencing the capital
structure of a company. Flotation costs occur only when the funds are externally
raised. Generally, the flotation cost of debt is less than cost of equity issue. The
flotation costs can be an important consideration in deciding the size of a security
issue. Generally, the flotation costs as a percentage of funds raised will decline
with larger amount of funds.
Q.18. How do the considerations of control and size affect the capital structure decision
of the firm?

A.18. Capital structure decision is governed by desire of management to continue

control over the company. The ordinary (equity) shareholders elect the directors
of the company. This may result into dilution of control by present management
or owner. In the case of a widely-held company, the shares of such company are
widely scattered, and by issues of new shares, there is a risk of dilution of control.
The risk of loss of control can be reduced by distribution of shares widely and in
small lots.
A closely-held small company would like to maintain control. Because of
fear of sharing control and being interfered by others, the closely held company
would like to raise debt capital instead of equity issue. To avoid the risk of loss of
control, small companies may slow down their rate of growth or issue preference
share capital or raise debt capital. A very excessive debt capital can also cause
serious liquidity problem, and render the company sick, which means complete
loss of control.
The size of company may influence its capacity and availability of funds
from different sources. A small company finds it difficult to raise long term debt
or long term loan at acceptable rate of interest and convenient terms. If small
companies are able to approach capital markets, the cost of issuing shares is
generally more than larger companies.