Capital structure ,cost of capital and Value of the firm

Prof. Prapti Paul

Concept of value of firm:

The value of the firm depends on the earnings of the firm and the earnings of the firm depends upon the investment decisions of the firm. The earnings of the firm are capitalized at a rate equal to the cost of capital in order to find out the value of the firm. Thus the value of the firm depends upon 2 factors, i.e. earnings of the firm and cost of capital.

Capital structure theories

Divergent views can been expressed on the relationship between leverage, cost of capital and value of the firm. Establishing the relationship between the 3 is one of the most controversial issue in financial management. Different views in the form of theories of capital structure, can be studied and analyzed by grouping into, i. The capital structure matters for the valuation of the firm, presented by Net Income Approach. ii. The capital structure does not matter for the valuation of the firm. iii. A more pragmatic approach between the two, presented by Traditional Approach. iv. Modigliani- Miller approach which provides justification for NOI approach.

 The relationship between the leverage, cost of capital and value of the firm has been analyzed in terms of the approaches and MM Model. Following assumptions are made to understand this relationship: 1) There are only 2 sources of funds, i.e. the equity and the debt, which is having fixed interest. 2) The total assets of the firm are given and there would be no change in the investment decisions of the firm.
3) The firm has a policy of distributing the entire profits among the sh.hol i.e. there is no retained earnings. 4) The operating profits of the firm are given and not expected to grow. 5) The business risk is given and is constant and not affected by financing mix. 6) No corporate or personal taxes. 7) Investors have the same subjective probability distribution of expected operating profits of the firm.

 The following definitions and notations have been used for discussing capital theories: E= Total market value of equity. D=Total market value of debt. V=Total market value of the firm i.e. D+E I=Total interest payment NOP=Net operating profit i.e. EBIT NP=Net profit or profit after tax (PAT) D0= Dividend paid by the co. at time 0 (i.e. now). D1= Expected dividend at the end of Year 1 (from now). P0=Current market price of the share P1=Expected market price of the share after 1 year. kd= after tax cost of debt i.e. I/D ke= cost of equity i.e. D1 /P0 k0= overall cost of capital i.e. WACC = [D/(D+E)]kd +[E/(D+E)]ke = NOP/V = EBIT/V

Net Income Approach: capital structure matters

Suggested by Durand, this theory states that there is a relationship between capital structure and value of the firm and therefore the firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix. The NI approach makes the foll assumptions: 1) 2) 3) The total capital requirement of the firm is given and is constant. That kd is less than ke. Both kd and ke remain constant and increase in financial leverage i.e. use of more and more debt financing in the capital structure does not affect the risk perception of the investors.

The NI approach starts from the argument that change in financing mix of a firm will lead to change in WACC, ko, of the firm resulting in the change in the value of the firm. As Kd is less than ke the increasing use of cheaper debt (and simultaneous decrease in equity proportion) in the overall capital structure will result in magnified returns available to the shareholders. The increased returns to sh.hol will increase the total value of the equity and thus increase the total value of the firm. The WACC, ko, will decrease and the value of the firm will increase.

 On the other hand, if the financial leverage is reduced by the decrease in debt financing, the WACC , ko of the firm will increase and the total value of the firm will decrease. Under NI approach, the firm will have maximum value capital structure at a point where ko is minimized. A firm can increase its value by increasing the debt proportion in the capital structure. So higher the degree of debt financing, better it is. The optimal capital structure is the one at which WACC, ko is minimum resulting in maximum value of the firm.

illustration 1:
The expected EBIT of a firm is Rs.2,00,000. it has issued equity share capital with ke @ 10% and 6% debt of Rs.5,00,000. find out the value of the firm and the overall cost of capital, WACC. Solution: EBIT Rs.2,00,000 - Interest 30,000 Net Profit 1,70,000 ke 10% Value of equity, E=1,70,000/.10 17,00,000 Value of debt, D, 5,00,000 Total value of the firm, V, 22,00,000 WACC, ko EBIT/V = 2,00,000/22,00,000 = .09 OR 9% The WACC could also be calculated as: [D/(D+E)]kd+[E/(D+E)]ke = [5/(5+17)].06+[17/(5+17)].10 =.09 or 9%

 Now if the firm has issued 6% Debt of Rs. 7,00,000 instead of Rs. 5,00,000, the position would have been as follows: EBIT Rs. 2,00,000 - Interest 42,000 Net profit 1,58,000 ke 10% Value of equity, E=1,58,000/.10 15,80,000 Value of debt, D, 7,00,000 Total value of the firm, V, 22,80,000 WACC, ko, EBIT/V =2,00,000/22,80,000 =.087 or 8.7%
So when the 6% debt is increased from Rs.5,00,000 to Rs. Rs.7,00,000 the value of the firm increases from Rs.22,00,000 to Rs. 22,80,000 and the WACC decreases from 9% to 8.7%.

 Now suppose the firm has issued 6% debt of Rs.2,00,000 only instead of Rs.5,00,000, the position would be as follows:
EBIT Rs.2,00,000 - Interest 12,000 Net Profit 1,88,000 ke 10% Value of equity, E=1,88,000/.10 18,80,000 Value of debt, D, 2,00,000 Total value of the firm, V 20,80,000 WACC, k0 EBIT/V = 2,00,000/20,80,000 = .096 or 9.6% So when the proportion of 6% debt is reduced to Rs.2,00,000 only, the value of the firm reduces to Rs.20,80,000 and the WACC increases from 9% to 9.6%. Thus as per the NI approach, a firm is able to increase its value and decrease its WACC by increasing the debt proportion in the capital structure.

 The effect of changing proportions of debt on the market price of the share can also be analyzed. Initially the value of equity, E is Rs.17,00,000 and the firm has 1,00,000 shares outstanding. So the market price of the share would be Rs.17. now if the firm increases its debt proportion from Rs.5,00,000 to Rs.7,00,000 and uses its proceed to retire 11,764.70 shares (i.e. Rs.2,00,000/Rs.17) of the firm. In this case, the total value of equity is Rs. 15,80,000(already calculated) represented by 88,235.30 shares or the market price of Rs. 17.90 per share (Rs.15,80,000/88,235.30). The EPS in this case would be Rs.1.79 (i.e.Rs.1,58,000/88,235.30) giving 10% yield on the market price of Rs.17.90. However if the firm wishes to reduce the debt from Rs.5,00,000 to Rs.2,00,000 it will be required to issue additional shares at the market price of Rs. 17. the no. of new shares to be issued is Rs.3,00,000/17 = 17,647.05 , making total no. of outstanding shares to be 1,17,647.05. in this case the total market value of the equity shares is Rs.18,80,000 and the market price of the share would be Rs.15.98 and the EPS would be Rs. 1.59 giving a yield of 10% on the market price. Thus the market price of the share also moves in line with the value of the firm in response to the variations in debt proportions of the capital structure.

 Under NI Approach, the value of the firm can be defined as: Value of firm= value of equity + value of debt Conclusion: easy to understand and its too simple to be realistic. It ignores, perhaps the most important aspects of leverage, that the market price depends upon the risk which varies in direct relation to the changing proportion of debt in the capital structure.

Net Operating Income Approach: capital structure does not matter

According to NOI approach, the market value of the firm depends upon the net operating profit or the EBIT and the overall cost of capital, WACC. The financing mix or the capital structure does not affect the value of the firm. The NOI approach makes the following assumptions: 1) The investors see the firm as a whole and thus capitalize the total earnings of the firm to find out the value of the firm. 2) k0 of the firm is constant and depends upon the business risk which also is assumed to be unchanged. 3) kd is taken as constant. 4) The use of more and more debt in the capital structure increases the risk of the sh.hol and thus results in the increase in the cost of the equity capital, i.e., ke. The increase in ke is such as to completely off set the benefits of employing cheaper debt. 5) There are no taxes.

 The NOI Approach is based on the argument that the market values the firm as a whole for a given risk complexion. Thus for a given value of EBIT, the value of the firm remain same irrespective of the capital composition and instead depends upon the overall cost of capital. The value of the equity maybe found out by deducting the value of debt from the total value of the firm i.e. V=EBIT/ko and E= V-D and ke= EBIT-Interest V-D Thus the financing mix is irrelevant and does not affect the value of the firm. The value remains the same for all types of debt-equity mix. Since there will be change in risk of the sh.hol as a result of a change in debt-equity mix, therefore, the ke, will be changing linearly with change in debt proportions.
The NOI Approach considers ko to be constant and therefore there is no optimal capital structure; rather every capital structure is as good as any other.

illustration 2:
A firm has an EBIT of Rs. 2,00,000 and belongs to the risk class of 10%. What is the value of the cost of equity capital if it employs 6% debt to the extent of 30%, 40% or 50% of the total capital fund of Rs. 10,00,000. Solution:
Particulars 30% debt 40% debt 50% debt

EBIT ko Value of the firm, V

2,00,000 10% 20,00,000

2,00,000 10% 20,00,000

2,00,000 10% 20,00,000

Value of 6% debt, D Value of equity, E=(V-D)

ke, NP/E

3,00,000 17,00,000
10.7%

4,00,000 16,00,000 1,76,000

11%

5,00,000 15,00,000 1,70,000

11.33%

Net profit(EBIT-Interest) 1,82,000

 The ke of 10.7%, 11% and 11.33% can be verified for different proportions of debt by calculating WACC, ko, as follows: For 30% debt, ko = [D(D+E)]kd+[E(D+E)]ke =[ 3(3+17)].06+[17(3+17)].107 =10% For 40% debt, ko= [D(D+E)]kd+[E(D+E)]ke =[ 4(4+16)].06+[16(4+16)].107 =10% For 50% debt, ko= [D(D+E)]kd+[E(D+E)]ke = [ 5(5+15)].06+[15(5+15)].107 = 10% The calculations of WACC testify that the benefit of employment of more and more debt in the capital structure is offset by the increase in equity capitalization rate ke. The above analysis shows that under the NOI approach, the value of the firm is found by capitalizing the EBIT at the rate ko and from this value, the value of debt is deducted to find out the value of the equity.
Value of equity = value of firm value of debt

Traditional Approach: a practical view point

In practical situation both NI and NOI Approach are extreme in view and seem to be unrealistic. The traditional approach takes a compromising view between the two and incorporates the basic philosophy of both. It takes midway between the NI approach ( that the value of the firm can be increased by increasing leverage) and the NOI approach (that the value of the firm is constant irrespective of the degree of financial leverage).

As per the traditional approach, a firm should make judicious use of both debt and the equity to achieve a capital structure which maybe called the optimal capital structure. At this capital structure, the overall cost of capital, WACC of the firm will be minimum and value of the firm maximum. The traditional viewpoint states that the value of the firm increases with increase in financial leverage but upto a certain limit only. Beyond this limit, the increase in financial leverage will increase its WACC also and hence the value of the firm will decline. Under traditional approach, kd is assumed to be less than ke.

 Thus as per the traditional approach, a firm can be benefitted from a moderate level of leverage when the advantages of using debt (having lower cost) out weigh the disadvantages of increasing ke (as a result of higher financial risk). The overall cost of capital ko, therefore is a function of the financial leverage. The value of the firm can be affected by the judicious use of debt and equity in the capital structure.

illustration 3:
ABC Ltd. having a EBIT of Rs.1,50,000 is contemplating to redeem a part of the equity by introducing debt financing. Presently its a 100% equity firm with ke of 16%. The firm is to redeem the capital by introducing debt financing upto Rs.3,00,000 i.e.30% of the total funds or upto Rs.5,00,000 i.e. 50% of total funds. It is expected that for the debt financing upto 30% the rate of interest will be 10% and the ke will increase to 17%. However if the firm opts for 50% debt financing then the interest will be payable at the rate of 12% and the ke will be 20%. Find out the value of the firm and its WACC under different levels of debt financing.

 Solution:
Total debt Rate of interest EBIT -interest PBT ke Value of equity, E Value of debt Total value

0% debt
---------------1,50,000 .16 9,37,500 ----9,37,500

30% debt
Rs.3,00,000 10% 30,000 1,20,000 .17 7,05,882 3,00,000 10,05,882 .149

50% debt
Rs.5,00,000 12% 1,50,000 60,000 90,000 .20 4,50,000 5,00,000 9,50,000 .158

Rs.1,50,000 1,50,000

ko (EBIT/Total value) .16

With the increase in leverage from 0% to 30%, the firm is able to reduce its WACC from 16% to 14.9% & the value of the firm increases from Rs. 9,37,500 to Rs.10,05,882. This happens as the benefits of employing cheaper debt are available and ke does not rise too much. Thereafter when the leverage is increased further to 50%, the cost of debt as well as equity both rise to 12% and 20% resp. The eq. investors have increased the eq. capitalization rate to 20% as they are now finding the firm to be more risky (as a result of 50% leverage).

 The increase in cost and debt and the eq. capitalization rate has increased the ko and hence as a result the value of the firm has reduced from Rs.10,05,882 to Rs.9,50,000 and the ko has increased from 14.9% to 15.8%. Thus the above example shows that that the value of the firm increases upto a particular level of leverage only and further increase would reduce the value of the firm . So by judicious use of financial leverage the firm can optimize its value.
Thus the traditional approach seems to a workable position on the theoretical grounds. The kd and ke both maybe expected to increase beyond a particular level of leverage. However the traditional approach is criticized on the point that the value of the firm is a factor of its profitability rather than its financial mix.

Modigliani-Miller Model: extension of the NOI approach

The MM model maintains that under a given set of assumptions, the capital structure and its composition has no effect on the value of the firm. The model shows that the financial leverage does not matter and the cost of capital and the value of the firm are independent of the capital structure. There is nothing which maybe called the optimal capital structure. Assumptions of MM Model: 1. The capital markets are perfect and complete information is available to all the investors free of cost. The implication of this assumption is that investors can borrow and lend funds at same rate and can move quickly from one security to another without incurring any transaction cost. 2. The securities are infinitely divisible. 3. Investors are rational and well informed about the risk return of all the securities. 4. All the investors have same probability distribution about expected future earnings. 5. There is no corporate income tax. 6. The personal leverage and corporate leverage are perfect substitutes.

 On the basis of these assumptions, the MM Model derived that : a) The total value of the firm is equal to the capitalized value of the operating earnings of the firm. The capitalization is to be made at a rate appropriate to the risk class of the firm. b) The total value of the firm is independent of the financing mix i.e. the financial leverage. c) The cut off rate for the investment decision of the firm depends upon the risk class to which the firm belongs and thus is not affected by the financing pattern of these investments.
The MM Model argues that if 2 firms are alike in all respects except that they differ in respect of their financing pattern and their market value, then the investors will develop a tendency to sell the shares of the over valued firm (creating a selling pressure) and to buy the shares of the under valued firm (creating a demand pressure). This buying and selling pressure will continue till the two firms have the same market value.

 There are 2 firms, LEV &Co. and ULE & Co. These firms are alike and identical in all respects except that the LEV &Co. is a levered firm and has 10% debt of Rs.30,00,000 in its capital structure. On the other hand, the ULE &Co. is an unlevered firm and had raised funds only by the issue of equity sh.cap. Both these firms have an EBIT of Rs. 10,00,000 and the equity capitalization rate ,ke of 20%. Under these parameters, the total value and the WACC of both the firms will be ascertained as follows:
LEV & Co. ULE &Co. EBIT -Interest Net profit Equity capitalization rate Value of equity Value of debt Total value, V WACC, ko= EBIT/V 10,00,000 3,00,000 7,00,000 .20 35,00,000 30,00,000 65,00,000 15.38% 10,00,000 Nil 10,00,000 .20 50,00,000 Nil 50,00,000 20%

 Though, both LEV &Co. and ULE& Co. have the same EBIT of Rs.10,00,000 and the same ke of 20% and still the LEV &Co.., the levered firm has a lower ko and a higher value as against the ULE & Co.., which is an unlevered firm. MM argue that this position cannot persist for long and soon there will be equality in the values of the two firms. MM Model proves the above point by the arbitrage mechanism.
The arbitrage process: refers to undertaking by a person of two related actions simultaneously in order to derive some benefit. Continuing with the above example suppose an investor is holding 10% equity sh.cap of LEV &Co. The value of his ownership right is Rs.3,50,000 i.e.10% of Rs.35,00,000. further out of the total net profit of Rs.7,00,000 of LEV &Co. he is entitled to 10%, i.e.Rs.70,000 p.a. and getting a return of 20%, his ke , on his worth. In order to avail the opportunity of making a profit he decides to convert his holdings from LEV &Co. to ULE & Co.,. He disposes off his holdings in LEV &Co. for Rs.3,50,000, but in order to buy 10% holdings of ULE &Co. he needs total funds of Rs.5,00,000, whereas his proceeds are only Rs.3,50,000. So he takes a loan @10% of an amount equal to Rs.3,00,000 ( i.e. 10% debt of the LEV & Co.) and now he is having total funds of Rs. 6,50,000 (i.e. proceeds of Rs.3,50,000 and the loan of Rs.3,00,000).

Out of the total funds of Rs.6,50,000 he invests Rs.5,00,000 to buy 10% holdings of ULE &Co. still he has funds of Rs. 1,50,000 available with him. Assuming that the ULE &Co. continues to earn the same EBIT of Rs. 10,00,000 the net returns available to the investor from ULE &Co. are: Profit available from ULE &Co. Rs.1,00,000 (being 10% of net profit) - Interest payable@ 10% on Rs.3,00,000 loan 30,000 Net return 70,000

So the investor is able to get the same return of Rs.70,000 from ULE &Co. also, which he was receiving as an investor of LEV &Co.., but he has funds of Rs.1,50,000 left over for investment else where. Thus his total income maybe more than Rs.70,000 (inclusive of some income on investment of Rs.1,50,000). Moreover his risk is the same as before. Though his new outlet i.e. ULE &Co. is an unlevered firm (hence no risk) but the position of the investor is levered because of his borrowing of Rs.3,00,000 from the market. He has replaced corporate leverage by his personal leverage. Thus an investor who originally owns a part of the levered firm and enters into an arbitrage process as above, will be better off selling the holding in levered firm and buying the holding in unlevered firm using his homemade leverage.

 The MM Model argues that this opportunity to earn extra income through arbitrage process, will attract many investors. The gradual increase in sales of the shares of the levered firm, LEV& Co. will push its prices down and the tendency to purchase the shares of the unlevered, ULE &Co. will drive its prices up. The selling and purchasing pressure will continue until the market value of the 2 firms are equal. At this stage, the value of the levered firm and unlevered firm and also their cost of capital are same; thus the overall cost of capital, ko, is independent of the financial leverage.

 The arbitrage process described above involves a transfer of investment from a levered firm to unlevered firm. The arbitrage process will work in the reverse direction also, when the value of the levered firm is less than the value of the unlevered firm. Say the total value of LEV &Co. is Rs.45,00,000 (consisting of Rs.30,00,000 debt capital and Rs. 15,00,000 equity sh.cap) and the value of ULE &Co. is same as before i.e. Rs.50,00,000. Now the investor holding 10% sh.cap of ULE &Co. sells his ownership right for Rs.5,00,000. Out of these proceeds he buys 10% of share capital of LEV &Co. for Rs. 1,50,000 and invests Rs.3,00,000 (i.e. 10% of Rs.30,00,000) in 10% government bonds. Still he would be having funds of Rs.50,000 with him and his position in respect of incomes from the 2 firms would be as under:
ULE &Co. 10% profits 10% interest on bonds Total income 1,00,000 ---1,oo,ooo LEV &CO. 70,000 30,000 1,00,000

Thus by performing the arbitrage process, the investor will not be able to maintain his income level, but also be having additional cash flows of Rs.50,000 at his disposal. The prices of the share of ULE &Co. and LEV &Co. must adjust until the values of both the firms are equal.

 Critical evaluation of MM Model: theoretically the MM Model and its emphasis of no relationship between the leverage and the value of the firm seems to be good enough in the light of the assumptions underlying the model. However most of the assumptions are unrealistic and untenable. Moreover, the arbitrage process which provides behavioral justification for the model, is itself questionable in real life as perfect competition is never found and the transaction costs are inevitable.
1. 2. 3. 4. 5. Non substitutability of personal and corporate leverages Transaction costs Institutional investor Availability of complete information Corporate taxes MM also agreed in their later analysis that the leverage may increase the value of the firm . The effect of corporate tax on the firm can be explained with an example. Say A Ltd. and B Ltd. both alike in all respect, except that out of total capital fund of Rs. 10,00,000, B Ltd raised Rs. 5,00,000 by the issue of 10% deb. Both the firms have to pay tax @ 30%. The position of their EBIT and its appropriation under two types of economic conditions is:

Eco. condition
EBIT -Interest PBT -Tax@ 30% PAT Total cash flow for debt & eq. sh.hol

A Ltd. Avg. 50,000 ----50,000 15,000 35,000

A Ltd. Good 1,50,000 -----1,50,000 45,000 1,05,000

B Ltd. Avg. 50,000 50,000 --------------

B Ltd. Good 1,50,000 50,000 1,00,000 30,000 70,000

35,000

1,05,000

50,000

1,20,000

A Ltd (unlevered firm) had a tax liability of Rs.15,000 and Rs.45,000 incase of average and good economic conditions respectively; whereas B ltd (levered firm) having the same EBIT of Rs.50,000 and Rs. 1,50,000 has to pay only zero or Rs.30,000 taxes in average and good economic conditions respectively. So for B Ltd., having 50% leverage in its capital structure, the tax liability becomes smaller under both types of eco. conditions. Similarly the debt holders and the sh.hol of the firm, who collectively determine the total value of the firm, also receive a larger share of EBIT in case of leverage firm than their share in the unlevered firm. This is because of the fact that the interest is tax-deductible in case of the levered firm.

 The excess cash flow available to the investors of a levered firm can be calculated as interest charged*tax rate i.e. Rs.50,000*.30= Rs.15,000. This is the difference between the cash flows from the levered firm and unlevered firm (i.e. Rs.1,20,000-Rs.1,05,000). This difference of Rs. 15,000 is also known as Interest tax- shield.
VU= EBIT(1-t) ko In the above equation value of EBIT will be equal to PBT because in an unlevered firm there would be no interest liability. VL= VU+ PV of interest tax shield

Thus VL = VU +Debt *(t) The value of the levered firm under MM Model (after incorporating the corporate tax) will be higher than the value of unlevered firm.

Pecking order theory

This theory is based on the assertion that managers have more info about their firms than investors. This disparity of info is referred to as asymmetric information. Other things being equal, because of asymmetric info, managers will issue debt when they are positive about their firms future prospects and will issue equity when they are unsure. A commitment to pay a fixed amount of interest and principal to debt- holders implies that the co. expects steady cash flows. On the other hand, an equity issue would indicate that the current share price is over valued. Therefore, the manner in which managers raise capital gives a signal of their belief in their firms prospects to investors. This also implies that the firm always use internal finance when available and choose debt over new issue of equity when external financing is required. Myers has called it the pecking order theory since there is not a well defined debt equity target and there are 2 kinds of equity, internal and external, one at the top of the pecking order and the other at the bottom. Debt is cheaper than the costs of internal and external equity due to interest deductibility. Internal equity is cheaper and easier to use than external equity.

 internal equity is cheaper because (1) personal taxes might have to paid by shareholders on distributed earnings, and (2) no transaction costs (issue costs) etc, are incurred when earnings are retained. Managers avoid signaling adverse information about their companies by using internal finance. The profitable cos. have lower debt ratios not because they have lower targets but because they have internal funds to finance their activities. They will issue equity sh. cap when they think that the shares are over valued. Because of this, it has been found that the announcement of new issue of shares generally causes share prices to fall. Thus, the pecking order theory implies that the managers raise finance in the foll order: 1. Managers always prefer to use internal finance. 2. When they do not have internal finance, they prefer issuing debt. They first issue secured debt and then unsecured debt followed by hybrid securities such as convertible debentures. 3. As a last resort, managers issue shares to raise finances.