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Unit : 1
Cost of Capital & Capital Structure Theories

Meaning of Cost of Capital:

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt
holders) to the business as a compensation for their contribution to the total capital. Cost of capital is also
known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.
In other words, the minimum rate of return that a firm must earn on its investment which will
maintain the market value of share at its current level.

Significance of Cost of Capital:

1. Capital Allocation and Project Evaluation: By comparing the expected returns of a project with the
cost of capital, firms can make investment decisions that align with shareholder value maximization.
2. Financial Performance Measurement: It serves as a yardstick for assessing financial performance.
A company’s ability to generate returns above its cost of capital indicates operational efficiency and
effective resource utilization.
3. Cost of Debt and Equity Balancing: The cost of capital guides the balance between debt and equity
in a firm's capital structure. As companies strive to minimize their overall cost of capital, they navigate
the trade-off between the lower cost of debt and the potential risks associated with increased leverage.
4. Investor Expectations and Market Perception:A company's cost of capital is indicative of the
returns investors require for providing funds. If a company consistently exceeds or falls short of this
benchmark, it can impact investor confidence and influence stock prices.
5. Risk Management: The cost of capital integrates risk considerations. Understanding risk components
aids in strategic decision-making and risk management. Companies can adjust their capital structure
and investment strategies to mitigate risk and align with their cost of capital.
6. Capital Structure Optimization: It facilitates capital structure optimization. Achieving the right mix
of debt and equity is essential for minimizing the cost of capital. Firms aim to find the optimal capital
structure that maximizes shareholder value.
7. Market Competitiveness: The cost of capital impacts a company's competitiveness. In industries
where access to capital is a critical factor, having a lower cost of capital can provide a competitive
advantage.
8. Dividend Policy and Shareholder Returns: Companies consider the cost of capital when determining
whether to distribute profits as dividends or reinvest in the business. This decision affects shareholder
returns and influences the overall attractiveness of the company's stock to investors.

Types of
Cost of
Capital

External Internal Others

Equity Preference Debt Retained Implicit Explicit

Capital Capital Capital Earnings Cost Cost

Mohammed Adnan Shariff, Dept. of Commerce

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Classification of Cost of Capital:
The various relevant costs associated with the measurement of cost of capital are:
1. Marginal Cost of Capital: Marginal cost of capital is the additional cost incurred to obtain additional
funds required by a firm. It is also known as incremental or differential cost of capital.

2. Weighted Average Cost/Overall Cost: It is the average cost of various specific costs of the different
components (equity, preference, debentures, retained earnings) of capital structure at a given time and
this is used as the acceptance criteria for (capital budgeting) investment proposals.

3. Historic Cost (Book Cost): The book cost has its origin in the accounting system. They are related to
the past. It is in common use for computation of cost of capital.
For example, cost of capital may be computed based on the book value of the components of capital
structure. Historical costs act as a guide for future cost estimation.
4. Future Cost: It is the cost of capital that is expected to raise funds to finance an investment proposal.
5. Specific Cost: It is the cost associated with a particular source of finance. It is also known as
component cost of capital. For example, cost of equity (𝐾𝑒 ) or cost of preference share (𝐾𝑝 ), or cost
of debt (𝐾𝑑 ), etc.
6. Spot Cost: These are the costs that are prevailing in the market at a certain time.
For example, a few years back cost of bank loans (house loans) was around 18%, now it is at 12%.
The 12% is the spot cost.
7. Explicit Cost: Explicit cost refer to cost which are direct, measurable & out of pocket expenses
incurred by the business.
8. Implicit Cost: It also known as the opportunity cost. In simple words, the cost of using internal
resources.
For example, the cost of retained earnings is an opportunity cost or implicit cost for a shareholder and
is deprived of the opportunity to invest retained earnings elsewhere.

COMPUTATION OF COST OF SPECIFIC SOURCE

Financial manager has to compute the specific cost of each source of funds needed in the
capitalisation of a company. Company may resort to different financial sources (equity share, preference
share, debentures, retained earnings, public deposits). It may prefer internal source (retained earnings) or
external source (equity, preference and public deposits). Particular ₹
Face value XXX
Note: Floatation Cost refer to the cost involved in issuing & selling securities. + Premium XXX
- Discount (XX)
XXX
- Floatation Cost (XX)
Net Proceeds XXX
I. COST OF DEBT: 𝑲𝒅
Cost of debt capital refers to the total cost or the rate of interest paid by an organization in raising
debt capital. However, in a real situation, total interest paid for raising debt capital is not considered as
cost of debt because the total interest is treated as an expense and deducted from tax. This reduces the tax
liability of an organization. Therefore, to calculate the cost of debt, the organization needs to make some
adjustments.

Mohammed Adnan Shariff, Dept. of Commerce

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(a) Cost of Irredeemable Debt
Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm till
liquidation. Cost of perpetual debt is the rate of return that lender expects (i.e. fixed interest rate).
Bonds/debentures can be issued at (i) par/face value, (ii) discount and (iii) premium. The following
formulae as used to compute cost of debentures or debt of bond.
I (1−t)
𝑲𝒅 = × 100
NP
Where,
𝐾𝑑 = cost of debt after tax, I = Annual Interest payment, T=Tax rate.
NP = Net proceeds from debt in case of new issue of debt or Current market price in case of existing debt.

Illustration:
1. XYZ Company Ltd., decides to float 12%, perpetual debentures of ₹ 100 each. The tax rate is 50%.
Calculate cost of debenture (pre and post-tax cost).

2. Z Ltd. issues, 12% debenture of ₹ 5,00,000. The tax rate is 30%, floating cost is 2%. Find out the cost
of debt before & after tax for the following cases: a. at par, b. at 10% premium, & c. at 10% discount.

3. A Co., issues 12% redeemable debenture of ₹ 1,00,000 tax rate is 50%. Calculate the cost of debt, if
debenture issued: a. at par, b. at 10% premium. & c. at 10% discount.

4. Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ₹ 103, at ₹ 3 premium to
their par value of ₹ 100. The current market price of these debentures is ₹ 94. If the company pays
corporate tax at a rate of 35 per cent what is its current cost of debenture capital?

(b) Cost of Redeemable Debt:

Redeemable debentures are those having a maturity period or repayable after a certain given period
of time. It can be calculated by using below formula:
RV−NP
I (1−t)+( )
n
𝑲𝒅 = RV+NP × 100
( )
2
Where,
I = Interest payment, t = Tax rate applicable to the company
RV = Redemption value of debentures n = Life of debentures.
NP = Net proceeds from debt in case of new issue of debt or Current market price in case of existing debt.

Illustration:
1. A company issued 10,000, 10% debentures of ₹ 100 each at a premium of 10% on 1.4.2017 to be
matured on 1.4.2022. The debentures will be redeemed on maturity. Compute the cost of debentures
assuming 35% as tax rate.

2. A company issued 10,000, 10% debentures of ₹ 100 each on 1.4.2017 to be matured on 1.4.2022. The
company wants to know the current cost of its existing debt and the market price of the debentures is
₹ 80. Compute the cost of existing debentures assuming 35% tax rate.

Mohammed Adnan Shariff, Dept. of Commerce

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3. A company issues ₹ 10,00,000, 10% redeemable debenture at 5% discount. The cost of commission
amount to ₹ 30,000. Debenture are redeemable after 5 years. Compute Cost of debenture assuming tax
rate at 50%.

4. For 10 Years ₹ 100, 13% debenture of a company sold for ₹ 92, which will be redeemed at 5% premium
on maturity. Compute cost of debt if the tax rate is 50%.

II. COST OF PREFERENCE SHARE CAPITAL (𝑲𝒑 )

The preference share capital is paid dividend at a specified rate on face value of preference shares.
The payment of dividend to the preference shareholders are not charged as expenses but treated as
appropriation of after-tax profit. Hence, dividend paid to preference shareholders does not reduce the tax
liability to the company. Preference share capital can be categorised as redeemable and irredeemable.

a. Cost of Irredeemable Preference Shares

The cost of irredeemable preference shares is similar to calculation of perpetuity. The cost is
calculated by dividing the preference dividend with the current market price or net proceeds from the
issue. The cost of irredeemable preference share is as below:
𝑃𝐷
Cost of Irredeemable Preference Share (𝐾𝑝 ) =
𝑃𝑜
Where,
PD = Annual preference dividend 𝑃𝑂 = Net proceeds in issue of preference shares

ILLUSTRATION:
1. HHC Ltd. issues 12% perpetual preference shares with face value of ₹ 200 each. Compute cost of
preference share.
2. XYZ & Co. issues 2,000, 10% preference shares of ₹ 100 each at ₹ 95 each. Calculate the cost of
preference shares.
3. The co., issues 10,000, 10% preference share of ₹ 100 each. Cost of issue ₹ 2 per share. Calculate cost
of pref. shares if issued: a. at par, b. at 10% premium, c. at 10% discount.

b. Cost of Redeemable Preference Shares

Preference shares issued by a company which are redeemed on its maturity is called redeemable
preference shares. Dividends paid to the preference shareholders are not tax deductible. Cost of preference
capital is calculated as follows:
𝑅𝑉−𝑁𝑃
𝑃𝐷 + ( )
𝑛
𝐾𝑃 = 𝑅𝑉+𝑁𝑃
( )
2
Where,
PD = Annual preference dividend NP = Net proceeds on issue of preference shares
RV = Redemption value of preference shares n = Life of preference shares.

ILLUSTRATION
1. XYZ Ltd. issues 2,000, 10% preference shares of ₹ 100 each at ₹ 95 each. The company proposes to
redeem the preference shares at the end of 10th year from the date of issue. Calculate the cost of
preference share?
Mohammed Adnan Shariff, Dept. of Commerce
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2. A company issues ₹ 1,00,000, 10% preference shares of ₹ 100 each redeemable after 10 years at face
value. Cost of issue is 10%. Calculate cost of preference share.
3. Shreyas Ltd. issues 9% Preference share of ₹ 100 each at par. Redeemable at 10% premium after 10
years. Calculate the cost of preference share.
4. Bhavani Ltd. issues 8000, 8% Preference share of ₹ 50 each redeemable after 10 years at a premium
of 5%. The cost of issuing preference share is ₹ 2 per share. Calculate the cost of preference share.

III. COST OF EQUITY SHARE: 𝑲𝒆

The cost of equity capital (K), may be defined as the minimum rate of return that a firm must earn
on the equity financed portions of an investment project in order to leave unchanged the market price of
the shares. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders
are not paid dividend at a fixed rate every year.

APPROACHES TO CALCULATE COST OF EQUITY

There are 5 approaches available to calculate the cost of equity capital, they are:
1. Dividend Price Approach 4. Bond Yield Plus Risk Premium Approach
2. Earning/ Price Approach 5. Capital Asset Pricing Model Approach.
3. Dividend Pricing plus Growth Rate Approach

1. Dividend Capitalisation Approach / Dividend Price Approach / Dividend Valuation Model:

According to this approach, the cost of equity capital is calculated on the basis of the required rate
of return in terms of the future dividends to be paid on the shares.
𝐷
Formula: 𝑲𝒆 = 0 × 100
𝑃0

Where, 𝐾𝑒 = Cost of equity

𝐷0 = Current Dividends per share 𝑃0 = Net proceeds or Current market price per share

Limitations of Dividend Capitalisation Approach

• It does not consider future earnings.
• It ignores the earnings on retained earnings.
• It ignores the fact that market price rise may be due to retained earnings and not on account of high
dividends.
• It does not take into account the capital gains.

Illustration:
1. XYZ Ltd., is currently earning ₹ 1,00,000, its current market price per share is ₹ 100, outstanding
equity shares are 10,000. The Company decided to raise an additional capital of ₹ 2,50,000 through
issue of equity shares to the public. It is expected to pay 10% as flotation cost. Equity shares are issued
at a discount of 10%. The company is interested to pay a dividend of ₹ 8 per share. Calculate cost of
equity.
2. A Company has earnings available to ordinary shareholders ₹ 5,00,000. It has equity share of ₹
50,00,000 face value of ₹ 100 each. The co., share is selling at ₹ 200. Compute cost of equity (assuming
100% dividend pay-out ratio).
Mohammed Adnan Shariff, Dept. of Commerce
MAS-AFM Page |6
3. VS International is thinking of raising funds by the issue of equity shares to the public. The current
market price of the firm’s share is ₹ 150. The firm is expected to pay a dividend of ₹ 3.9 next year. At
present the firm can sell the new share for ₹ 140 each & it involves a floatation cost of ₹ 10. Calculate
cost of new issue.

2. Dividend Capitalisation plus Growth Rate Approach

It is the best method over dividend capitalisation approach, since it considers the growth in
dividends. Generally, investors invest in equity shares on the basis of the expected future dividends rather
than on current dividends. They expect increase in future dividend. Growth in dividends will have positive
impact on share prices.
𝐷
𝐾𝑒 = 1 + 𝑔 X 100
𝑃0
Where, 𝑲𝒆 , Cost of equity capital 𝑫𝟏 Dividends per share g = Growth rate (%)
𝑷𝟎 Net proceeds per share or Current market price per share

Illustration:
1. Equity share of a paper manufacturing company is currently selling at ₹ 100. It wants to finance its
capital expenditure of ₹ 1 lakh either by retaining earnings or selling new shares. If Company seeks to
sell share, the issue price will be ₹ 95. The expected dividend for the next year is ₹ 4.75 and it is
expected to grow at 6% perpetually. Calculate the cost of equity capital (internal and external).

2. SS Co., is currently earnings ₹ 10,00,000 & its share is selling at a market price ₹ 160. The firm has
2,00,000 shares outstanding & has no debt. The earnings of the firm are expected to remain stable & it
has a pay-out ratio of 100%. What is 𝐾𝑒 ? If firm’s pay-out ratio is assumed to be 70% & that it earns
15% of return on its investment opportunities, then what would be the firms 𝐾𝑒 ?

3. Woodlands co., share is currently selling at ₹ 134. Current dividend per share is ₹ 3.5 & it is expected
to grow at 8% for the next 4 years & that at a rate of 15% for every year. Calculate co., cost of equity.

4. Smitha Ltd. wants to issue 10,000 equity shares of ₹ 1,100 each @ par. The floatation cost is expected
to be 5%. The company has paid dividend of ₹ 20 per share in the last year & is expected to grow by
8%. Compute cost of equity share capital:
i. In case of new equity shares.
ii. For existing shareholders assuming market price of the share is ₹ 2,250 per share. QP-2024

3. Earnings Capitalisation Approach (OR) Earning/ Price Approach:

According to this approach, cost of equity (𝐾𝑒 ) is the discount rate that equates the present value
of expected future earnings per share with the net proceeds (or current market price) of a share. The
advocates of this approach establishes a relationship between earnings and market price of share. They
say that it is more useful than the dividend capitalisation approach, due to two reasons,
• One, it acknowledge that Earning available to Equity share holder legally belongs to equity
shareholders whether they are paid as dividends or retained for investment.
• Secondly, and the most importantly, determining the market price of equity shares is based on
earnings and not dividends. Computation of retained earnings cost separately leads to double the
company’s cost of capital. This approach is employed under the following conditions, they are:

Mohammed Adnan Shariff, Dept. of Commerce

MAS-AFM Page |7
(a) Constant earnings per share over the future period
(b) There should be either 100% retention ratio or 100% dividend pay-out ratio and
(c) Company satisfies the requirements with equity shares and does not employ debt.
Cost of equity can be calculated with the following formula:
𝐸𝑃𝑆
𝑲𝒆 = x 100
𝑀𝑃𝑆 𝑜𝑟 𝑁𝑃
Where, 𝐾𝑒 = Cost of equity CMP = Current market price per share
E = Earnings per share NP = Net proceeds per share

Limitations of Earnings Capitalisation Approach:

• All earnings are not distributed to the equity shareholders as dividends.
• Earnings per share may not be constant.
• Share price also does not remain constant.

Illustration:
1. Well Do Company Ltd is currently earning 15% operating profit on its share capital of ₹ 20 lakhs (FV
of ₹ 200 per share). It is interested to go for an expansion programme for which the company requires
an additional share capital of ₹ 10 lakhs. The Company is raising this amount by issue of equity shares
at 10% premium and the expected flotation cost is 5%. Calculate cost of equity.

2. A firm is currently earning ₹ 1,00,000 and its share is selling at a market price of ₹ 90. The firm has
10,000 shares outstanding and has no debt. Compute cost of equity.

3. P&G Co., current earnings per share is ₹ 6 & its share is currently selling at ₹ 25 per share. Compute
cost of equity capital.

4. Bond Yield Plus Risk Premium (BYRP) Approach:

According to this approach the rate of return required by the equity shareholder of a company is
equal to 𝑲𝒆 = Yield on long-term Bonds + Risk Premium

The logic of this approach is very simple, equity investors bear a higher risk than bond investors,
hence their required rate of return should include a premium for their higher risk.
The problem involved in this approach is the addition of premium, should it be 1%, 2%, 3% or
'n'%. There is no theoretical basis for estimating the risk premium.

Illustration 1: XYZ Company is planning to sell equity shares. Mr. A is requesting planning to invest in
XYZ Company equity shares. Bond yield of XYZ Company is 12%. Mr. A an investor is requesting you
to calculate his required rate of return on equity with 3% risk premium.

5. Capital Asset Pricing Model Approach (CAPM)

Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe. It explains the
relationship between the required rate of return, and the non- diversifiable or relevant risk, of the firm as
reflected in its index of non-diversifiable risk that is beta (β). It shows the relationship between risk and
return for efficient and inefficient portfolios.

Mohammed Adnan Shariff, Dept. of Commerce

 MAS-AFM Page |8
The risk can be classified into 2 group:
a. Unsystematic Risk: The risk which is related to company performance.
b. Systematic Risk: It a market risk under which company operates.

Symbolically,
𝑲𝒆 = 𝑅𝑓 + (𝑅𝑚𝑓 − 𝑅𝑓 )β
Where, 𝐾𝑒 = cost of equity capital.
𝑅𝑓 = Rate of return required on a risk-free security (%).
β = Beta coefficient.
𝑅𝑚𝑓 = Required rate of return on the market portfolio of assets, that can be viewed as the average rate of
return on all assets.

Illustration
1. The Capital Ltd., wishes to calculate its cost of equity capital using the Capital Asset Pricing Model
(CAPM). Company’s analyst found that its risk-free rate of return equals 12%, beta equals 1.7 and the
return on market portfolio equals 14.5%.

2. Calculate the cost of equity capital of H Ltd., whose risk-free rate of return equals 10%. The firm beta
equals 1.75 & the return on the market portfolio equals to 15%.

IV. WEIGHTED AVERAGE COST OF CAPITAL (WACC):

WACC is the also known as overall cost of capital of having capitals from the different sources.

FACTORS AFFECTING WACC

Weighted average cost of capital is affected by a number of factors. They are divided into two categories
such as: Controllable Factors (Internal factor) & Uncontrollable Factors (External factor)

(A) Controllable Factors: Controllable factors are those factors that are within the control of the firm.
They are:
(i) Capital Structure Policy: If firm can change its capital structure or proportions of components of
capital that affect its WACC.
For example, a firm decides to use more debt and less equity, which will lead to reduction of
WACC. At the same time increasing proportion of debt in capital structure increases the risk of both debt
and equity holder, because it increases fixed financial (commitment) charges.

(ii) Dividend Policy: The required capital may be raised by equity or debt or by combination of both the
sources. Equity capital can be raised by issue of new equity shares or through retained earnings.
Sometimes companies may prefer to raise equity capital by retention of earnings, because it involves no
flotation costs.

(iii) Investment Policy: While estimating initial cost of capital, generally, we use the starting point for
the required rates of return on the firm's existing stock and bonds. Therefore, we implicitly assume that
new capital will be invested in assets of the same type and with the same degree of risk. But it is not
correct as no firm invests in assets similar to what they currently operate, when a firm changes its
investment policy. For example, investment in diversified business.
Mohammed Adnan Shariff, Dept. of Commerce
MAS-AFM Page |9
(B) Uncontrollable Factors: The factors that are not possible to be controlled by the firm that mostly
affects the cost of capital. This type of factors are known as external factors.

(i) Tax Rates: Tax rates that are beyond the control of a firm, have an important effect on the overall cost
of capital. Computation of debt involves consideration of tax. In addition to lowering capital gains tax rate
on ordinary income makes stocks more attractive and that reduces cost of equity and it would lower the
overall cost of capital.

(ii) Level of Interest Rates: Cost of debt is interest rate. If interest rates increases, automatically cost of
debt also increases. On the other hand, if interest rates are low then the cost of debt is less. The reduced
cost of debt reduces WACC and this will encourage an additional investment.

(iii) Market Risk Premium: It is determined by the risk in investing proposed stock and the investor's
aversion to risk. Market risk is out of control risk, i.e., firms have no control on this factor.

Steps involved in computation of WACC

1. Determination total capital of the firm from all the source of funds,
2. Computation of cost of specific source of funds,
3. Assignment of weight to specific source of funds,
4. Multiply the cost of each source by the appropriate assigned weights, and
5. Add individual source weight cost to get cost of capital.

Assignment of Weights:
The weights to specific funds may be assigned based on the following:
(1) Book Values: These weights are based on the values found on the balance sheet. The weight applicable
to a given source of fund is simply the book value of the source of fund divided by the book value of total
funds.
(ii) Market Value Weights: Under this method, assigned weights to a particular component of capital
structure is equal to the market value of the component of capital divided by the market value of all
components of capital and capital employed by the firm.

Illustration:
1. XYZ Company supplied the following information to you and requested to compute cost of capital
based on book values as well as market values.
Source of Finance Book Value ₹ Market Value ₹ After Tax Cost (%)
Equity Capital 10,00,000 15,00,000 12
Long term debt 8,00,000 7,50,000 7
Short term debt 2,00,000 2,00,000 4
Total 20,00,000 24,50,000

2. From the following particulars relating to X Ltd., calculate the WACC: Book & Market Value weights:
Particular Book Value Market Value Cost of Capital
Equity share capital 10,00,000 16,00,000 16%
Preference Share capital 4,00,000 6,00,000 10%
Debenture 6,00,000 8,00,000 8%
Retained Earnings 5,00,000 - 10%
Total 25,00,000 30,00,000
Mohammed Adnan Shariff, Dept. of Commerce
MAS-AFM P a g e | 10
3. A Ltd co., has the following capital structure.
• Equity Share capital (1,00,000 share of ₹ 10 each) ₹ 10,00,000
• 10% Preference Share capital ₹ 8,00,000
• 12% Debenture ₹ 12,00,000
Total ₹ 30,00,000
The market price of E.S is ₹ 10. Expected dividend is ₹ 5 per share & growth rate is 8% forever.
Assume tax rate at 30%. You are required to compute:
a. WACC based on existing capital structure.
b. New weighted average cost of capital if the company raises an additional ₹ 10,00,000 in the form
of 13% Debenture.
This would result in increasing the expected dividend to ₹ 6 & growth rate unchanged but
the share price will fall to ₹ 8 per share.

4. A Ltd as following capital structure:

Particular ₹
16% Debenture 40,00,000
12% Preference Share capital 18,00,000
Equity share capital 10,00,000
Total 68,00,000
The market price of Equity share is ₹ 18. The company is expected to pay a dividend of ₹ 6 per share
which grow at 10% forever. Assuming tax rate of 30% compute:
a. WACC based on existing capital structure.
b. A new WACC if co., increased additional ₹ 40,00,000 debt by issuing 20% debenture.
This would result in increasing the expected dividend to ₹ 8 & the growth rate remains
same. However, the price of share will fall to ₹ 15 per share.

5. Naren Co. decided to raise finance by issuing following:

Particular Book Value (₹) Market Value (₹)
Equity Share 6,00,000 7,00,000
Preference Share 4,00,000 4,00,000
Debenture 5,00,000 5,00,000
Total 15,00,000 16,00,000

Additional Information:
a. Current Selling price of equity is ₹ 100 per share
b. The co. pays dividend of ₹ 5 per share & the cost incurred for raising shares is ₹ 6 per share.
c. 10% preference share with face value of ₹ 100 is issued at ₹ 140 per share. Underwriting
commission being ₹ 7 per share.
d. 10% debenture with face value of ₹ 100 is redeemable after 10 years, 3% underwriting fee is
incurred on issue price of debentures.
e. Tax rate is 40%.

Calculate weighted cost of capital using:

i. Book value weights
ii. Market value weights. QP-2024

Mohammed Adnan Shariff, Dept. of Commerce

 MAS-AFM P a g e | 11
CAPITAL STRUCTURE
Capital structure is the combination of capitals from different sources of finance. The capital of a
company consists of equity share holders’ fund, preference share capital and long-term external debts.

Value of the firm: It assume that the firm only has two sources of funds riskless debt & equity. So, the
value of the firm (V) equals to the market value of equity plus market value of debt. V = E + D
𝐸𝐵𝐼𝑇
Value of the firm =
𝐾𝑜 𝑜𝑟 𝑊𝐴𝐶𝐶

𝐾𝑜 = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)

𝐾𝑜 = [{𝐾𝑑 × D / (D+S)} + {𝐾𝑒 × S / (D+S)}]

Where:
𝐾𝑜 is the weighted average cost of capital (WACC)
𝐾𝑑 is the cost of debt, S is the market value of equity
D is the market value of debt 𝐾𝑒 is the cost of equity.

CAPITAL STRUCTURE THEORIES

The total capital structure theories can be categorised into two: Relevant and Irrelevant theories.
The following are the main theories/Approaches of capital structure:
1. Net Income (Theory) Approach (Relevant) 3. Modigliani and Miller Approach (Irrelevant)
2. Net Operating Income Approach (Irrelevant) 4. Traditional Approach (Neutral).

However, the following assumptions are made to understand this relationship:

• There are only two kinds of funds used by a firm i.e. debt and equity.
• The total assets of the firm are given. The degree of average can be changed by selling debt to purchase
shares or selling shares to retire debt. (Investment Decision is assumed to be constant).
• Taxes are not considered.
• The pay-out ratio is 100%. (No Retained Earnings)
• The firm’s total financing remains constant. (Total Capital is the same, but proportion of debt and
equity may be changed).
• Business risk is constant over time.
• The firm has perpetual life.

I. NET INCOME (NI) APPROACH:

This approach has been developed by Durand. It is a
relevant theory. According to the approach, capital
structure decision is relevant to the valuation of the firm.

In other words, a change in debt proportion in

capital structure will lead to a corresponding change in
cost of capital (𝐾𝑜 ) well as total value of the firm.

Mohammed Adnan Shariff, Dept. of Commerce

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Assumptions
Net income approach is based on the following assumptions:
(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(in) Use of debt in capital structure does not change the risk perception of investors.

Net Income Approach can be ascertained as follows: Particular Amt ₹

➢ Value of Firm (V) = S + D Net operating income (EBIT) XXX
Where, Less: Interest on Debenture XXX
Earnings available to equity holder (NI) XXX
V=Value of the firm D=Marketvalue of debt
Equity capitalisation rate (𝐾𝑒 ) XXX
S = Market value of equity Market value of equity (S) (NI ÷ 𝐾𝑒 ) XXX
𝑁𝐼 Market value of Debt (D) XXX
➢ Market value of equity (S) = Total value of the firm (V = S+D) XXX
𝐾𝑒 Overall cost of capital (𝐾𝑜 = EBIT ÷ V) XX%
Where,
NI = Earnings available for equity shareholders 𝐾𝑒 = Equity Capitalisation rate.
EBIT
➢ Overall cost of capital (𝐾𝑜 ) =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚

Illustration:
1. Rupa Ltd.’s EBIT is ₹ 5,00,000. The company has 10%, ₹ 20 lakh debentures. The equity
capitalization rate i.e. 𝐾𝑒 is 16%. You are required to calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital.

2. ABC Company, is expecting an EBIT of 1,00,000 whose equity capitalisation rate (𝐾𝑒 ) is 12.5%.
Currently the company has a debt capital of 4,00,000 at 8 per cent. Calculate the value of the firm (V)
and cost of capital (𝐾𝑜 ).
Case (i): When the company increases debt by 2,00,000, uses proceeds to repurchase equity shares.
Case (ii): When company reduces debt to 2,00,000 by issue of equity shares, of the same amount.

3. ABC Co., expects EBIT of ₹ 80,000. The co., has ₹ 2,00,000, 8% Debenture, the equity capitalisation
rate of the co., is 10%. Calculate the value of the firm & overall cost of capital according to net income
approach (ignore tax).
If debt is increased to ₹ 3,00,000 or decreases to ₹ 1,00,000, then what would be the value of the firm
& overall cost of capital.
Conclusion: The above analysis shows that increasing the debt financing in capital structure leads to
increases the value of the firm due to decrease in overall cost of capital. On the other hand, decreasing net
financing in capital structure leads to decreasing the value of the firm due to increase in overall cost.

II. NET OPERATING INCOME (NOI) APPROACH

This is another approach, which has been suggested by Durand. It is just-opposite to the net income
approach. According to this approach, the capital structure decisions of a firm are irrelevant. It says that
any change in debt proportion in capital structure (leverage) will not lead to any change in the value of
the capital (𝐾𝑜 ). They (V, 𝐾𝑜 , and share price) are independent of financial leverage.
Mohammed Adnan Shariff, Dept. of Commerce
 MAS-AFM P a g e | 13
Assumptions:
NOI approach is based on the following assumptions:
a. Overall Cost of Capital (𝐾𝑜 ) remains unchanged for all degrees of
leverage;
b. The market capitalises the total value of the firm as a whole and no
importance is given for split of value of firm between debt and equity;
c. The market value of equity is residue (i.e., Total value of the firm
minus market value of debt);
d. The use of debt funds increases the received risk of equity investors,
thereby (𝐾𝑒 ) increases,
e. The debt advantage is set off exactly by an increase in cost of equity;
f. Cost of debt (𝐾𝑑 ) remains constant;
g. There are no corporate taxes.

EBIT 𝑁𝐼
NOI is calculated as follows: V = , 𝐾𝑒 = , Market value of equity (S) = V-D
𝐾𝑜 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
Where: NI= EBIT - Interest

Optimum Capital Structure: According to NOI approach, there is no optimum capital structure because
the total value of the firm (V), market price of equity share and cost of capital (𝐾𝑜 ) remains unaffected
with the change in financial leverage (change in debt proportion).

ILLUSTRATION:
1. Venkat Intel Company Ltd., expects an operating income of ₹ 1,00,000. The company has 12% debt
of 3,00,000. The company’s overall cost of capital is 13%. Calculate the total value of the firm and
the equity capitalisation rate (𝐾𝑒 ).
2. ABC company’s cost of capital is 12.5% is expecting an operating profit at ₹ 1,00,000 whose cost of
capital is 12.5%. The company has a debt capital of ₹ 4,00,000 at 8%. You are required to calculate
the total value of the firm and equity capital cost (𝐾𝑒 ).
Case (i): The company increases debt from 4,00,000 to 6,00,000 and uses the proceeds for repurchase
of equity shares.
Case (ii): The company reduces debt to 2,00,000 by fresh issue of equity shares of the same amount.
3. ABC Co., expected EBIT is ₹ 1,00,000. It has ₹ 5,00,000, 6% Debenture. The overall cost of capital
is 10%. Calculate the value of the firm & cost of equity under NOI Approach, if the debt increased to
₹ 7,50,000 & decreased to ₹ 4,00,000.

III. TRADITIONAL APPROACH:

This approach favours that as a result of financial leverage
up to some point, cost of capital comes down and value of firm
increases. However, beyond that point, reverse trends emerge.
The principle implication of this approach is that the cost of
capital is dependent on the capital structure and there is an optimal
capital structure which minimises cost of capital.

Mohammed Adnan Shariff, Dept. of Commerce

MAS-AFM P a g e | 14
Optimum Capital Structure occurs at the point where value of the firm is highest and the cost of capital
is the lowest.
According to net operating income approach, capital structure decisions are totally irrelevant.
Modigliani-Miller supports the net operating income approach but provides behavioural justification. The
traditional approach strikes a balance between these extremes.

Main Highlights of Traditional Approach:

(a) The firm should strive to reach the optimal capital structure and its total valuation through a judicious
use of the both debt and equity in capital structure. At the optimal capital structure, the overall cost
of capital will be minimum and the value of the firm will be maximum.
(b) Value of the firm increases with financial leverage up to a certain point. Beyond this point the increase
in financial leverage will increase its overall cost of capital and hence the value of firm will decline.

Criticism of the Traditional View

MM do not agree with traditional approach, they criticise the assumption that cost of equity (𝐾𝑒 )
remains unaffected by use of debt up to some limit. They assert that there is no sufficient justification for
such assumption.

Note: Formula for ascertain Value of firm in traditional method is same as in the Net Income Approach.

1. Tirumala Steel Company Ltd., is expecting a net operating income (EBIT) of 1,00,000. The equity
capitalisation rate is 12.5 per cent. The company has used 8 per cent debt of 3,00,000. You are required
to determine the value of the firm (V) and cost of capital (𝐾𝑒 ).
Case 1: The company is planning to increase debt (leverage) by ₹ 2,00,000, and uses these funds to
retire equity capital to that extent. Cost of debt is 10% and cost of equity is 15%.
Case 2: The company plans to increase debt by ₹ 4,00,000 by issue of debentures of the same amount.
The cost of debt is 12% and cost of equity is 17%.

2. Compute the market value of the firm & overall cost of capital from the following:
Total investment ₹ 10,00,000, Net Operating Income ₹ 2,00,000. Equity capitalisation rate is follows:
a. If the firm use No debt, 10%
b. If the firm uses 5% debt of ₹ 4,00,000, 11%.
c. If the firm uses 6% debt of ₹ 6,00,000, 13%.

3. From the following information, determine optimal capital structure by calculation of cost of capital.
Particular Plan 1 Plan 2 Plan 3 Plan 4 Plan 5 Plan 6 Plan 7
Debt as a percentage of Total Capital 0 0.10 0.2 0.3 0.4 0.5 0.6
Debt Cost (%) 6 6 6 6.5 7 7.5 8.5
Equity Cost (%) 14 14 14.5 15 16 18 19

4. From the following information calculate value of the firm and cost of capital. EBIT ₹ 20,000 required
capital ₹ 2,00,000.
Debt as a % of Capital Employed 0 10 20 30 40
Cost of Debt % 6 6 6 6.8 7
Cost of Equity % 10 10 10.5 11 12

Mohammed Adnan Shariff, Dept. of Commerce

 MAS-AFM P a g e | 15
IV. MODIGLIANI-MILLER APPROACH (MM)
The NOI approach is definitional or conceptual and lacks behavioural significance. It does not
provide operational justification for irrelevance of capital structure. However, Modigliani-Miller approach
provides behavioural justification for constant overall cost of capital and therefore, total value of the firm.

MM Approach-1958 without tax:

This approach describes, in a perfect capital market where there is no transaction cost and no taxes,
the value and cost of capital of a company remain unchanged irrespective of change in the capital structure.
The approach is based on further additional assumptions like:
• Capital markets are perfect. All information is freely available and there are no transaction costs.
• All investors are rational.
• Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
• Non-existence of corporate taxes.

Arbitrage refers to buying asset or security at lower price in one market and selling it at a higher price
in another market. As a result, equilibrium is attained in different markets.
This is illustrated by taking two identical firms of which one has debt in the capital structure while
the other does not. Investors of the firm whose value is higher will sell their shares and instead buy the
shares of the firm whose value is lower. They will be able to earn the same return at lower outlay with the
same perceived risk or lower risk. They would, therefore, be better off.

MM Approach- 1963 with tax

In 1963, MM model was amended by incorporating tax, they recognised that the value of the firm
will increase or cost of capital will decrease where corporate taxes exist.
Unlevered Firm: The capital structure of co., is full of Equity. (No Debt)
Levered Firm: The capital structure of the co., combined both Equity & Debt.

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

Formula: Market value of Unlevered Firm (𝐾𝑢𝑔 ) = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

Market value of Levered Firm (𝐾𝑒𝑔 ) = M.V of Unlevered Firm + (Debt x Tax rate)

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝐸. 𝑆. 𝐻
𝐾𝑒 = × 100
𝑀. 𝑉 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦

ILLUSTRATION:
1. The firms A & B are identical in all respects expect the degree of leverage. Firm A does not use any
debt in its financial. Firm B has 9% debentures of ₹ 5,00,000.
EBIT of the firms ₹ 2,50,000, Equity capitalisation rate 12%, Tax rate 40%.
Calculate the value of the firm using MM Approach.

2. The following information relates to ABC Ltd.

a. The co., is an all equity co., c. No corporate taxes,
b. EBIT is ₹ 25,00,000 d. Pay-out ratio is 100%
e. If the co., desire, it can raise debt of ₹ 80,00,000 @ 12%.
f. Shareholders require rate of return is 10%.
Mohammed Adnan Shariff, Dept. of Commerce
MAS-AFM P a g e | 16
Using MM Model, you are required to calculate:
i. The firm market value, ii. The firm value of equity,
iii. The firm leverage cost of equity.

3. The values for 2 firms X & Y in accordance with the traditional theory are given below:
Particular X Y
Expected Operating Income (EBIT) 50,000 50,000
Less: Interest - 10,000
Net Income 50,000 40,000
Cost of Equity 𝐾𝑒 0.10 0.11
Market value of shares (S) 5,00,000 3,60,000
Add: Market value of Debt (D) - 2,00,000
Total value of firm (V = S+D) 5,00,000 5,60,000
Average cost of capital (𝐾𝑒 ) 0.10 0.09
Debt-equity ratio - 056

Compute the values for the firms X & Y as per the MM Hypothesis. Assume that:
a. Corporate taxes do not exist &
b. The equilibrium value of 𝐾𝑒 is 12.5%.

Mohammed Adnan Shariff, Dept. of Commerce