Traditional theory of capital structure

Capital structure of a company refers to the composition or make-up of its capitalization and it includes all long term capital resources viz :- loans, reserves, shares and bonds.

The capital structure is made up of debt and equity securities and refers to permanent financing of a firm.

Capitalization, capital structure, financial structure Capitalization refers to the total amount of

securities issued by a company while capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization.

Financial structure refers to all the financial resources marshaled by the firm, short term as well as long term and all forms of debt as well as equity.

Thus, financial structure generally is composed of a specified percentage of short term debt, long term debt and shareholder’s funds.

Illustration : Information about a certain company is given as follows:• Liabilities:• Equity share capital 10,00,000• Preference share capital 5,00,000• Long term loans and debentures 2,00,000• Retained earnings 6,00,000• Capital surplus 50,000• Current liabilities 1,50,000 25,00,000 Solution Here, capitalization would mean the total amount of securities issued by

a company:• Equity share capital 10,00,000• Preference share capital 5,00,000• Long term loans and debentures 2,00,000• Capitalization 17,00,000

Capital structure refers to the proportionate amount that makes up the capitalization.

proportion

• Equity share capital 1,00,000 58.82%• Preference share capital 5,00,000 29.41%• Long term loans and debentures 2,00,000 11.77%• 17,00,000 100%

Financial structure refers to all the financial resources short as well as long term and is:

proportion Proportionate amount

• Equity share capital 10,00,000 40%• Preference share capital 5,00,000 20%• Long term loans and debentures 2,00,000 8%• Retained earnings 6,00,000 24%• Capital surplus 50,000 2%• Current liabilities 1,50,000 6% 25,00,000 100%

Theories of capital structureThe important theories of capital structure are:Net income approachNet operating income approachThe traditional approachModigliani and Miller approach 

Net income approach According to this approach, a firm can minimize the

weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent.

A company can increase its value and decrease its overall cost of capital by increasing the proportion of debt in its capital structure.

The proportion of debt financing in capital structure increases due to which the proportion of a less expensive source of funds increases. This results in the decrease in overall cost of capital leading to an increase in the value of the firm.

Total market value of a firm on this basis : V=S+D Where, V = total market value of the firm S = market value of equity shares = earnings available to equity share

holders Equity capitalization rate And D = market value of debtOverall cost of capital :- K0 = EBIT V

Illustration: X ltd is expecting an annual EBIT of 1,00,000. The company has 4 lakh in

10% debentures. The cost of equity capital or the capitalization rate is 12.5%. you are required to calculate the total value of the firm according to the net income approach.

Solution:- • Net income (EBIT) 1,00,000• Less : interest on 10% debentures of 4,00,000 40,000• Earnings available to equity shareholders 60,000• Market capitalization rate 12.5% • Market value of equity shares(s) 4,80,000 60,000 * 100/12.5• Market value of debentures(D) 4,00,000• Value of the firm (S+D) 8,80,000

Net operating income approachIt is another extreme of the effect of leverage

on the value of the firm. It is opposite to the net income approach.

According to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains constant whether the debt-equity mix is 50:50 or 0:100.

The reasons for such assumptions are that the increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases.

On the other hand, the cost of debt remains constant with the increasing proportion of debt as the financial risk of the lenders is not affected. Thus, the advantage of using the cheaper source of funds i.e. debt is exactly offset by the increased cost of equity.

The net operating income approach shows the effect of leverage on the overall cost of capital and has been presented as :-

V = EBIT KO

Where, V = value of the firm ko = overall cost of capitalmarket value of equity here is the residual value

which is determined by deducting the market value of debentures from the total market value of the firm.

S = V – D Where, S = market value of equity shares,

V= market value of the firm, D = market value of debt.

Illustration: A company expects a net operating income of 1,00,000. It has 5,00,000,

6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate(cost of equity) according to the net operating income approach.

Solution:-• Net operating income = 1,00,000• Overall cost of capital = 10%• Market value of the firm (V) = EBIT(net operating income)/overall cost of

capital(ko) 1,00,000* 100/10 = 10,00,000• Market value of the firm = 10,00,000• Less : market value of debentures = 5,00,000• Total market value of equity = 5,00,000 Equity capitalization rate ( cost of equity ) :- (ke) Earnings available to equity shareholders/ Total market value of equity

shares = (1,00,000-30,000)/ (1,00,000-5,00,000) *100 = 14%

Traditional approachThe traditional approach also known as

intermediate approach, is a compromise between the two extremes of net income approach and net operating income approach.

. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity.

Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity.

After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt. Thus, overall cost of capital, according to this approach, decreases up to a certain point, remains more or less unchanged and increases or rises beyond a certain period.

Illustration : Compute the market value of a firm, value of shares and the average

cost of capital from the following information :• Net operating income 2,00,000• Total investment 10,00,000• Equity capitalization rate

• If the firm uses no debt 10%• If the firm uses 4,00,000 debt 11% • If the firm uses 6,00,000 debt 13%

Assume that 4,00,000 debentures can be raised at 5% rate whereas 6,00,000 debentures can be raised at 6% rate of interest.

Solution: Computation of market value of firm, value of shares & average cost of capital (a) No debt (b)4,00,000 deb @ 5% (c) 6,00,000 deb @ 6% • Net operating income 2,00,000 2,00,000 2,00,000• Less : interest 20,000 36,000 (cost of debt) • Earnings 2,00,000 1,80,000 1,64,000 available to equity shldr. equity capitalization rate 10% 11% 13%• Market value of shares 2,00,000*100/10 1,80,000*100/11 1,64,000*100/13 = 20,00,000 = 16,36,363 = 12,61,538

• market value of debt NIL 4,00,000 6,00,000• market value of the firm 20,00,000 20,36,363 18,61,538• average cost of capital or: 2k/20k 2k/20,36,363 2k/18,61,538• Earnings/value of the firm *100 *100 *100 • EBIT/V 10% 9.8% 10.7%