Even though the cost of equity rises with increased

•
Even though the cost of equity rises with increased
debt the advantages of debt would outweigh the
increased cost of equity.
•
Beyond a certain level of leverage the cost of equity
starts rising disproportionately, more than offsetting
the advantage of debt, raising the overall cost of
capital for the firm.
•
Since cost of capital falls initially and then starts rising
there exists a point where cost of capital would be
least.
•
This point of least cost of capital would maximise the
value of the firm and is the optimal capital structure.
18
Capital Structure - Theory

TRADITIONAL APPROACH
Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate
Debt 10% 11% 12%
Equity 20% 20% 30%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 55.00 108.00
EBT 490.00 445.00 392.00
19
Capital Structure - Theory

TRADITIONAL APPROACH
EBT 490.00 445.00 392.00
Taxes Assumed no taxes
Earnings available to 490.00 445.00
392.00
shareholders (EAT)
Market value of debt 100.00 500.00 900.00
(I/r
d
)
Market value of Equity 2,450.00 2,225.00 1,307.00
(EAT/r
e
)
Value of the Firm, V 2,550.00 2,725.00 2,207.00
Capitalisation rate, WACC 19.61% 18.35% 22.65%
(EBIT/V)
20
Capital Structure - Theory

Traditional Approach
k e
k o
k d
D e b t
C o s t
With increasing level of
debt the overall cost of
capital falls initially
because cost of debt is
less than the cost of
equity, thereafter it
rises because equity
holders expect greater
returns due to
increasing perceived
risk from the debt
holders.

NET OPERATING INCOME
APPROACH
Net Operating Income (NOI)
approach
- assumes that value of the firm remains
constant because overall capitalisation rate
remains constant
‘
Net operating income approach states
that value of the firm is determined by
the earning capacities of the assets and
not by how are they acquired.
12

NET OPERATING INCOME
APPROACH
Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalization Rate
Debt 10% 10% 10%
Overall 20% 20% 20%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 50.00 90.00
EBT 490.00 450.00 410.00

NET OPERATING INCOME
APPROACH
EBT 490.00 450.00 410.00
Taxes Assumed no taxes
Earnings available to 490.00 450.00
410.00
shareholders (EAT)
Market value of debt 100.00 500.00 900.00
(I/r
d
)
Market value of firm 2,500.00 2,500.00 2,500.00
(EBIT/r)
Value of equity (E) 2,400.00 2,000.00 1,600.00
Equity capitalisation rate 20.42% 22.50% 25.63%
(EAT/E)
14
Capital Structure - Theory

NET OPERATING INCOME
APPROACH
‘
Under net operating income approach
the cost of equity rises so as to
compensate the reduced cost of debt
keeping the overall capitalisation rate
constant.
D
r = r + (r - r )
e 0 0 d E
Scenario A : r
e
= 20 + (20 - 10) x 100/2400 = 20.42%
Scenario B : r
e
= 20 + (20 - 10) x 500/2000 = 22.50%
Scenario C : r
e
= 20 + (20 - 10) x 900/1600 = 25.63%
15
Capital Structure - Theory

NET OPERATING INCOME APPROACH
k e
k o
k d
D e b t
C o s t
Under net
operating income
approach no
capital structure
is optimal,
alternatively all
capital structures
are optimal.

MODIGLIANI AND MILLER (MM)
THEORY - WITHOUT TAXES
MM Proposition I without taxes
‘
Capital structure is irrelevant.