Capital Structure Theories for CA Intermediate FM

Understand Capital Structure Theories

Key rules to remember

Value of firm (NI approach)

V = S + D, where S = (EBIT − Interest) ÷ Ke

Ke and Kd are constant. S is market value of equity and D is market value of debt.

Overall cost of capital

Ko = EBIT ÷ V

Under NI, Ko falls as debt rises. Use this to show the effect of added debt.

Value of firm (NOI approach)

V = EBIT ÷ Ko, and S = V − D

Ko is constant. First find V, then S by subtraction.

Cost of equity (NOI approach)

Ke = (EBIT − Interest) ÷ S

Ke rises as debt rises. Interest = D × Kd.

MM without taxes: value

V(levered) = V(unlevered) = EBIT ÷ Ko

Capital structure does not affect value. Ko is the same at every debt level.

MM without taxes: cost of equity

Ke = Ko + (Ko − Kd) × (D ÷ S)

Ke rises linearly with the debt-equity ratio.

MM with taxes: value

V(levered) = V(unlevered) + (t × D)

t × D is the tax shield on permanent debt. t is the corporate tax rate.

MM with taxes: cost of equity

Ke(levered) = Ke(unlevered) + (Ke(unlevered) − Kd) × (1 − t) × (D ÷ S)

Kd is the pre-tax cost of debt here. Ke rises with leverage, but less than without tax.

MM with taxes: WACC

Ko(levered) = Ko(unlevered) × (1 − t × D ÷ V)

WACC falls as debt rises, so a firm gains by using more debt.

How to solve Capital Structure Theories questions

1. 1Read the question and note the theory named or implied. NI means Ke is given and constant. NOI means Ko is given and constant. MM means check whether tax is mentioned.
2. 2List the data: EBIT, debt amount, Kd, tax rate and the given Ke or Ko.
3. 3Calculate interest as Debt × Kd. Under NI, deduct it from EBIT to get earnings for equity.
4. 4Find the value: under NI, S = earnings ÷ Ke, then V = S + D. Under NOI, V = EBIT ÷ Ko, then S = V − D.
5. 5Find the missing rate: under NI, Ko = EBIT ÷ V. Under NOI, Ke = (EBIT − Interest) ÷ S.
6. 6Repeat for each debt level in a small table so the trend is visible.
7. 7For MM with tax, find the unlevered value first, then add t × D. Compare levered and unlevered values.
8. 8Write a one or two line conclusion: where Ko is lowest or value is highest, and what the theory says about the best structure.

Quickest way: Constant-rate shortcut and MCQ elimination

Common mistakes in Capital Structure Theories

• Using EBIT instead of EBIT less interest to value equity under the NI approach.

  Students remember that value comes from EBIT and apply it to equity.

  Fix: Equity holders get only what remains after interest. S = (EBIT − Interest) ÷ Ke. Use EBIT in full only for V under NOI or for Ko.

• Mixing up what is constant under NI and NOI.

  Both names look alike and both use the same data.

  Fix: NI: Ke is given, so you compute S first. NOI: Ko is given, so you compute V first. Write the constant at the top of your answer.

• Applying the tax shield formula t × D in MM without taxes, or forgetting it in MM with taxes.

  Students do not check whether the question mentions corporate tax.

  Fix: No tax means V is the same for levered and unlevered. With tax, V(levered) = V(unlevered) + t × D.

• Saying the Traditional approach has no optimal structure.

  It is confused with NOI or MM without taxes.

  Fix: Traditional says Ko falls, reaches a minimum, then rises. The minimum is the optimal capital structure.

• Using book value of debt or equity when market values are intended.

  Balance sheet figures are handy, so students use them.

  Fix: These theories use market values. In NI, S is computed from earnings and Ke, not taken from the balance sheet.

• Writing only numbers with no conclusion.

  Students run out of time and stop after the calculations.

  Fix: Add one line on what the numbers show, for example that Ko falls and value rises with more debt, so more debt is preferred under NI.

Worked examples