CHAPTER EIGHT

Capital Structure Theories

Learning Objectives:
After studying this chapter, you should be able to-
 Define capital structure with reference to the basic typical-types.
 Analyze the effects of capital structure on financial risk with business
risk assumed constant.
 Pin-point the linkage of capital structure, risk, return and value, and
 Describe the important factors to be considered in determining the
capital structure.

Introduction
Planning the capital structure is one of the complex areas of financial
decision making because of the interrelationships among components of the
capital structure and also its relationship to risk, return and value of the firm.
The term “capital” denotes the long-term funds of the firm.

Two basic classes of capital are:

- Debt capital, and

- Equity capital.

Let as us recapitulate the characteristics of each of these.

Equity capital comprises equity share capital and retained earnings.

Preference share capital is yet another distinguishing component of capital.

Debt capital consists of the long term funds obtained by borrowing. When a
business firm raises money by borrowing it promises to repay the principal
plus interest. The distinction of the cost of various types of capital, to be
discussed in detail latter in the next chapter, will show that the cost of debt is
less than that of equity capital because the holders of debt instruments or
creditors take less risk than providers of equity funds to the company.

First, the creditors have a higher priority of claims against any earnings or
assets available for payment.

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Secondly, as per the conditions included in the debt agreement regarding
mortgage, etc, they can exert greater legal pressure on the company to
make repayments than equity or preference shareholders would be able to do.

Thirdly, the interest payments are tax deductible expenses. Hence, the after
tax or effective cost of debt comes down considerably.

Finally, equity includes the long term funds provided by the shareholders who
are the firm’s owners. Borrowed funds should be repaid within a specified
limit of time. The equity capital is expected to remain for the life of the firm.

The three basic components of owners’ capital, are preference shares, equity
(ordinary) shares, and retained earnings. Many financial analysts and
managers tend to think of preference shares as a substitute of debt, as the
amount of dividend to be paid is fixed. The difference is that the preference
dividend unlike debt interest is not a tax-deductible expense. It does not have a
fixed maturity date. Preference shareholders have a prior claim to receive
income from the firm’s earnings through dividends. Convertible debentures
have the features of both debt and equity capital.

Because of its secondary position relative to debt, suppliers of equity capital

take greater risk, and therefore must be compensated with higher expected
returns.

Optimal Capital Structure: Traditional View/Approach

The theory of capital structure is related to the firm’s cost of capital. The
debate regarding the Capital Structure has been around the issue “Whether
an Optimal Capital Structure Exists?”
The debate began in the late 1950’s and is yet unresolved.
Those who assert that an Optimal Capital Structure Exists are known as
take a “Traditional View.”
While the supporters of what is called “MM Approach” (named after
Modigliani and Miller) who advocated this approach), maintain that the
“Optimal Capital Structure does not Exist.”

What is an Optimal Capital?

In the Traditional Approach to the capital structure, the value of the firm is
maximized when the cost of capital is minimized.

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Using the simple “Zero Growth Valuation Model” for determining the value of
the firm:

V = EBIT
K0

Where:

V = Value of the firm

EBIT = Earnings Before Interest and Taxes
K0 = Weighted Average Cost of Capital
If the EBIT are constant, the value of the firm is maximized by minimizing the
Weighted Average cost of Capital (K0/ WACC) or overall cost of capital of the
firm. We will discuss WACC/k0 latter on.
We may, however, state that “maximization of value of the firm (V) is achieved
when K0 (WACC), is at a minimum, and that “specific mix of capital” at which
the WACC is minimized and value of the firm maximized is called “Optimal
Capital Structure”.
The basic relationship between WACC and the value of the firm may be stated
as:
“The lower the firm’s overall or weighted average cost of
capital, the higher the returns to the shareholders”.
“For a given capital budget of the firm, lesser the costs of required funds or the
greater the difference between the returns of the project and the costs of the
required funds, greater the profits from the projects:.
Reinvesting these increased profits will increase the firm’s future earnings and
therefore its value.

Risk and Capital Structure: Critics

The firm capital structure should be developed with the consideration of risk,
because the risk affects the value of the firm. Risk can be considered in two
ways:
(a) The capital structure should be consistent with the business risk of the
firm,
(b) The capital structure results in a certain level of financial risk to the
firm.

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Thus, on one hand, the business risk determines the capital structure
decision of the firm; while on the other hand, the capital structure decision
gives rise to certain financial risk.

MM-Analysis of a Tax Factor

MM- have analyzed the impacts of corporate taxes. They found that debt
provides a benefit to the firm because of the tax deductibility of interest
payments.
The results of the MM-Analysis are”
(1). The only benefit of debt financing relative to equity financing is the
reduction in Corporate Taxes due to the tax deductibility of debt interest.
(2). There is no disadvantage of debt financing relative to equity financing.
The implication of MM-Analysis is that if a firm is not paying Corporate
Income Taxes, then the financing decision and consequently choosing of the
optimal capital structure, is “irrelevant”. It does not matter whether debt is
used or not.
“A company paying corporate income taxes uses dent as it is superior to
all other financing sources”.
However, the MM Model assumes away many factors that imply that an
optimal capital structure with a certain blend of debt and equity exists.
Example: MM assumes that there are no costs if debt repayments’ are
defaulted or the company goes bankrupt.

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