Theories of Capital Structure

Meaning of an Optimum Capital Structure

One that Makes the EPS maximum or the value of the firm Maximum Reduces the cost at which the capital Raised The objective of the firm therefore should be to select that financing option or the D/E mix that leads to the Maximization of Value or Minimization of the cost of Capital of the firm

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Theories of Capital Structure

Capital Structure Theories

Relevant Theories
There exists an OPTIMAL CAPITAL STRUCTURE Net Income Approach

Irrelevant Theories
There is nothing such as Optimal Capital Structure Any capital structure is as good as any other capital structure Net Operating Income Approach

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Capital Structure

Assumptions
1. Firm Employs only 2 sources of Capital
1. Debt and Equity. There is no preference Shares

2. 3. 4. 5. 6.

There are no corporate tax( removed later) The Dividend payout ratio is 1. Firms total assets dont change EBIT does not change The firms total financing remains constant. The firm can change its capital structure by
1. Redeeming the debenture by issuing shares 2. Raising more debt and buy back equities thus Financial reducing shares. Management Lectures by JPS

Capital Structure
Net Income Approach
Given By David Durand Total value of the firm changes with the change in the capital structure of the firm As per this approach the cost of debt< Cost of Equity Total Value of the firm = Market Value of Debt+ Market Value of Equity V= S+B S = Market Value of Equity(Shares) S= EATES/Ke B = Market Value of Debt ( Borrowings) Overall Cost of Capital = EBIT/Total Value of the Firm
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Capital Structure

How to calculate the Market Value of the Firm Example

A Ltd is expecting an EBIT of RS 1 Lakhs. The capital structure of company consists of 4 lakhs debentures @ 10%.The cost of equity capitalization ke is 12.5%.Calculate the total value of the firm and also the overall cost of capital.

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Earnings Statement of the COMPANY 3 4 5 6 7 Earning Before Interest and Tax (EBIT) Less Interest on the Debentures(10% on 4 lakhs) EBT (Earnings before Tax) Less Tax Earnings after Tax Or Profit After Tax (PAT) Less Dividend to Pref. Share Holders Earnings Available to Equity Share Holders (EATES) Market Value of Equity (EATES/Ke) Rs 1,00,000 40,000 Rs 60,000 NIL RS 60,000

8 9 10

NIL RS 60,000 60,000/.125= Rs 4,80,000

11
12

Market Value of Debt

Total Value of the Firm(10+11) Ko
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4,00,000
8,80,000 1,00,000/8,80,000

Capital Structure
How to calculate the overall cost of Capital? Earnings/Total Value of the firm

EBIT/Total Value of the Firm

Ko = 1,00,000/8,80,000
= 11.3%

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Capital Structure

Effect of change in the D/E ratio on the Market value of the firm and on the overall cost of capital
The same company decides to raise 1 lakh Rs by issuing debentures @10% and reducing the share capital by an equal amount. Calculate the total value of the firm and also the overall cost of capital. Debt has Increased and Equity has decreased

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Earnings Statement of the COMPANY 3 4 5 6 7 8 9 10 11 12 31 Earning Before Interest and Tax (EBIT) Rs 1,00,000

Less Interest on the Debentures(10% on 5 50,000 lakhs) EBT (Earnings before Tax) Less Tax Profit After Tax (PAT) Less Dividend to Pref. Share Holders Earnings Available to Equity Share Holders (EATES) Market Value of Equity (EATES/Ke) Market Value of Debt Total Value of the Firm(10+11) Ko (EBIT/Total Value of the firm)
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Rs 50,000 NIL RS 50,000 NIL RS 50,000 50,000/.125= Rs 4,00,000 5,00,000 9,00,000 11.1%

Capital Structure

The same company decides to raise 1 lakh Rs by issuing equity shares and redeem the debentures with the amount received by raising the equity shares. Calculate the total value of the firm and also the overall cost of capital. Debt has Decreased and Equity has Increased

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Earnings Statement of the COMPANY 3 4 5 6 7 8 9 10 11 12 31 Earning Before Interest and Tax (EBIT) Less Interest on the Debentures(10% on 3 lakhs) EBT (Earnings before Tax) Less Tax Profit After Tax (PAT) Less Dividend to Pref. Share Holders Earnings Available to Equity Share Holders (EATES) Market Value of Equity (EATES/Ke) Market Value of Debt Total Value of the Firm(10+11) Ko (EBIT/Total Value of the firm)
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Rs 1,00,000 30,000 Rs 70,000 NIL RS 70,000 NIL RS 70,000 70,000/.125= Rs 5,60,000 3,00,000 8,60,000 11.6%

Capital Structure
Before changing the D/E mix.
MV of Firm = 8,80,000 Over all Cost of Capital = 11.3%

After changing the D/E mix. ( Increasing the Debt Component)

MV of Firm = 9,00,000 Over all Cost of Capital = 11.1%

After changing the D/E mix. ( Decreasing the Debt Component)

MV of Firm = 8,60,000 Over all Cost of Capital = 11.6%

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Net Income Approach

Cost of Capital

Kd Ko Ke

D/E Ratio ( Gearing Ratio)

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Net Operating Income Approach

Other Extreme of the Capital Structure theories As per this approach there is nothing as Optimal Capital Structure Increasing the debt content in the capital Structure does not change the Overall cost of capital of the firm and the value of the firm does not change Thus Over all cost of Capital and MV of Firm Does not change Additional Assumptions of NOI
Overall Cost of Capital of the company remains constant irrespective of the D/E mix in the capital structure The market value of the equity is calculate by deducting the value of debt from the total value of the firm The increase in the low cost debt increase the riskiness of the company and thus there is a corresponding increase in the cost of equity so that the total coast of capital remains constant Financial Management There are no corporate taxes Lectures by JPS

Net Operating Income Approach

As per this approach Overall Cost of Capital of the company remains constant irrespective of the D/E mix in the capital structure Market Value of the firm will remain constant , irrespective if any capital structure In NUT SHELL we can say that there is nothing as OPTIMAL CAPITAL STRUCTURE Steps in NOI Value of the Firm = EBIT/ Ko Value of Equity = Total Value of the firm-Total Value of Debt S = V-B

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Capital Structure

Example
A Ltd is expecting an EBIT of RS 1 Lakhs. The capital structure of company consists of 4 lakhs debentures @ 10%.The overall cost of capital ko is 12.5%.Calculate the total value of the firm and the total value of equity. Also find Ke Total value of Firm = EBIT/ ko V = Rs 8,00,000 B= 4,00,000 S = V-B = 4,00,000
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Capital Structure

How to find Ke Ke = EATES/Market Value of Equity = 60,000/4,00,000 = 15% So for this firm
V= 8,00,000 Ko = 12.5% Ke = 15% Kd = 10%

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Capital Structure

The same company decides to raise 1 lakh Rs by issuing debentures @10% and reducing the share capital by an equal amount. Calculate the total value of the firm .Overall cost of capital remains same at 12.5%.Find market value of the firm and Equity capitalization Rate. Debt has Increased and Equity has decreased

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Capital Structure

Since as per this approach the Ko and MV of the firm remains constant MV of Firm = EBIT/Ko = 1,00,000/.125 = RS 8,00,000
MV of Debt = Rs 5,00,000 MV of Equity = RS 3,00,000 ( 8,00,00-5,00,000) Ke = EATES/MV of Equity = 50,000/3,00,000 = 16.67% So the effect of increasing the debt component is No Change in the overall value of the firm No change in Ko (Overall cost of Capital is constant) Ke increases from 15% to 16.67 %
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Capital Structure

Ko (Overall cost of Capital is constant) why? It is the weighted average of Kd and Ke Ko = wd Kd + we Ke

Wd = Proportion of Debt in total capital ( B/V) We= Proportion of Equity in total capital (S/V) Wd + We=1 Kd = After tax cost of capital. = Kd (before tax) (1-t) Ke = Cost of Equity

Verify this Ko = 10% X ( 5,00,000/8,00,000) + 16.67% ( 3,00,000/8,00,000)

= 12.5%

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NOI Summary

As debt component increases the cost of Equity increases so that the overall cost of capital remains constant.Why? As per NOI as the proportion of the debt in the capital Structure increases the company becomes more risky in the eyes of the investors and thus they require more return on the equity., while in case of NI approach the company can go on borrowing without having any impact on the cost of equity. This is the basic difference in the two approaches.
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Net Operating Income Approach

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MM Approach
Kd 8.0 8.0 8.6 9.0 12 15 Ke 10 10 11 12 15 18 B/V 0 .1 .2 .3 .5 .6

Determine the which capital structure is suitable for the firm.Tax rate is 50%

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Modigiliani Miller Approach

Similar to NOI Approach, In fact a Behavioural Explanation of the NOI approach Basic difference between NOI and MM is that NOI is purely Definitional /Conceptual while MM is the explanation of that concept As per this approach also there is nothing as Optimal Capital Structure and thus one firm can not have a value greater than the other , just because it has a different capital structure

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MM Approach
Assumptions of MM Approach Capital Markets are perfect Investors are free to buy and sell securities Investors can buy without restrictions on the same rate as corporate ( This concept is called the Home made Leverage) Investors are well informed Investors behave rationally No Transaction costs Firms can be grouped in to RISK CLASSES, which means all firms in the same risk class have the same business risk DP ratio is 1 No Corporate Taxes
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MM Approach
Basic premise of the approach No Matter how you divide up the capital structure of a firm in debt and equity it does not impact the valuation of the firm It tries to explain the above mentioned statement by a process Called ARBITRAGE

Arbitrage process is called the operational justification of MM What is Arbitrage

Selling the security of overvalued firm and buying the security of undervalued firm , which are other wise identical in nature
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MM Approach
Effect of Arbitrage Process It restores Equilibrium Basically it implies that if two firms are similar in all respect except there capital structure then the market price of their shares can (Values of the firms) not remain different for long The Investors sell the overvalued firm and start buying the undervalued firm .why? Because they see an opportunity to make abnormal profits by doing this This process continues till their prices become equal They are brought to the same level by the process of Arbitrage Thus it is based on the concept of arbitrage MM explain that the valuation of the two firms, who are same in all respect Financial Management Lectures by JPS ,other than D/E ration, will always be same.

MM Approach
How Arbitrage Works Example
Let two firms A and B are identical in all respects except for the D/E ratio. Firm A has 10% debentures of Rs 50,000 debentures while firm B is an all equity firm. The EBIT for both companies is Rs 10,000 .Equity Capitalization Rate for A is 16% while for B is 12.5 %.Calculate the MV of Each of the firms

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MM Approach
Firm A(D+E) EBIT interest EATES Ke MV of Equity MV of Debt Total Value of the firm Ko (Overall cost of capital) EBIT/Total Value of Firm 10,000 5000 5,000 16% 31,250 50,000 81,250 10,000/81250= 12.3% B( All Equity) 10,000 Nil 10,000 12.5% 80,000 Nil 80,000 10,000/80000 = 12.5%

Overvalued firm

Under Valued firm

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MM Approach
Working of the Arbitrage Process An investor has 10% stake in Company A Equity Share for the investor = 10% 31250m = RS 3125 His return on investment from A = 16% of 3125= Rs

500

Risk Exposure is also 10% = Rs 5000 He decides to invest 10% in company B In order to invest in B total money needed = Rs 8000 Investor wants the risk exposure in firm B should not be more than Rs 5000. He creates debt by borrowing Rs 5000.( Home Made Leverage) Spends his own equity = Rs 3000 Return = 12.5% of RS 8000 = Rs 1000 less Rs 500 = RS 500 What is the Advantage? Financial Management Lectures by JPS

MM Approach
He has still Rs 125 left which he cam invest @ 12.5% in B Return is 12.5% of 125 = 15.625 ARBITRAGE Profit = Rs 15.625 This process will keep on till this arbitrage profit goes on decreasing till it becomes zero. At that stage the valuationof the firms are equal and thus no aribtrage profit can be made further

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