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What should be the proportions of equity and debt in the capital structure of a firm? Put differently, how much financial leverage (use of debt capital) should a firm employ? What is the relationship between capital structure and firm value? What is the relationship between capital structure and cost of capital?

The primary objective of CS decisions is to maximize the market value of the firm through an appropriate mix of long-term sources of funds. This mix, called the optimal capital structure, will minimize the firms overall cost of capital. However, there are arguments as to whether a firm can, in reality, affect its valuation and its COC by varying the mixture of the funds used.

Assumptions & Definitions

There is no income tax, corporate or personal. Firm pursues a policy of paying all of its earnings as dividends. 100% dividend payout. Investors have identical subjective probability of PBIT for each company. Constant operating risk. The PBIT is not expected to grow or decline over time. Constant operating income. A firm can change its CS almost instantaneously w/o incurring transaction costs.

Given the assumptions, the analysis focuses on the following rates: Perpetual cost of debt (r D ) = I / D Where, I = annual interest charges and D = market value of debt outstanding. Firms required r.o.r. on equity (r ) = P / E E Where, P = earnings available to common stockholders, and E = market value of stock outstanding. Firms overall COC or capitalization rate (rA ) = EBIT / V Where, V = D + E and is the market value of the firm.

In each of the four approaches to determining CS, the concern is with what happens to r D , r E , and r A when the degree of leverage, as denoted by the debt/equity (D/E) ratio, increases. The approaches: Net Income (NI) approach Net Operating Income (NOI) approach Traditional Approach Modigliani-Miller (MM) approach

Net Income Approach

Suggests that both the overall COC, r and the A market value of the firm, V, are affected by the firms use of leverage. The critical assumption with this approach is that r D and r E remain unchanged as the D/E ratio increases. Assume that a firm has Rs.6000 in debt at 5% interest, that the expected level of EBIT is Rs.2000, and that the firms COC, r E , is equal to at 10%. The V of the firm is computed as:

P = EBIT I = Rs.2000 (Rs.6000 x 5%) = Rs.1700

V = E + D = (P/rE ) + D = (1700/0.10) + 6000 = Rs.23,000

The firms overall COC is: r A = EBIT/V = 2000/23,000 = 8.7%

The debt/equity ratio in this case is: D/E = 6000/17,000 = 35.29%

Now assume, as before, that the firm increases its debt from Rs.6000 to Rs.10,000 uses the proceeds to retire that amount of Stock, and that the interest rate on debt remains at 5%. Then the Value of the firm is: P = EBIT I = 2000 (10,000 x 5%) = Rs.1,500 V = E + D = (P/r E ) + D = (1500/0.10) + 10,000 = Rs.25,000 The overall COC is: r A = EBIT/V = 2000/25,000 = 8% The debt/equity ratio is now D/E = 10,000/15,000 = 66.67%

The NI approach shows that the firm is able to increase its value, V, and lower its COC, r A, as it increases the degree of leverage. Under this approach, the optimal CS is found farthest to the right. 15



------------------------------------------- r E

rA ------------------------------------------- r D

Leverage (D/E)

Net Operating Income Approach

Suggests that the firms overall COC, rA , and the value of firms market value of debt & stock outstanding, V, are both independent of the degree to which the company uses leverage. The key assumption with this approach is that r A is constant regardless of the degree of leverage.

Using the same example of the NI approach with r A constant at 10%, The market value (V) of the firm is computed as follows: V = EBIT/rA = 2000/0.10 = Rs.20,000 The cost of external equity (rE ) is computed as follows: P = EBIT I = Rs.2000 (Rs.6000 x 5%) = Rs.1700 E = V D = 20,000 6000 = Rs.14,000 Therefore, rE = P/E = 1700/14,000 = 12.14% The D/E ratio = 6000/14,000 = 42.86% Assume now that the firm increases its debt from Rs.6000 to Rs.10,000 and uses the proceeds to retire Rs.10,000 worth of stock And also that the interest rate on debt remains 5%. The value of the firm now is: V = EBIT/rA = 2000/0.10 = Rs.20,000 The cost of external equity is: P = EBIT I = Rs.2000 (Rs.10,000 x 5%) = Rs.1500 E = V D = 20,000 10,000 = Rs.10,000 Therefore, rE = P/E = 1500/10,000 = 15% The D/E ratio = 10,000/10,000 = 100%

Since the NOI approach assumes that rA remains constant regardless of changes in leverage, the COC cannot be altered through leverage. Hence this approach suggests that there is no one optimal CS as evidenced in the figure below: 15 r


10 ---------------------------------------------- r 5

---------------------------------------------- r D

Leverage (D/E)

Traditional Approach
Assumes that there is an optimal CS and that the firm can increase its value through leverage. This is a moderate view of the relationship between leverage and valuation that encompasses all the ground between the NI and the NOI approach. Using the same previous example, assume that rE is 12%. The value of the firm is:

P = EBIT I = Rs.2000 (Rs.6000 x 5%) = Rs.1700 V = E + D = (P/rE ) + D = (1700/0.12) + 6000 = Rs.20,167 The overall COC is: r A = EBIT/V = 2000/20,167 = 9.9% The D/E ratio is: 6000/14,167 = 42.35% Assume as before, firm increases its debt from Rs.6000 to Rs.10,000. Assume further that r D rises to 6% and r E at the degree of leverage is 14%. The value of firm, then, is: P = EBIT I = Rs.2000 (Rs.10,000 x 6%) = Rs.1400 V = E + D = (P/rE ) + D = (1400/0.14) + 10,000 = Rs.20,000 The overall COC is: r A = EBIT/V = 2000/20,000 = 10% The D/E ratio is: 10,000/10,000 = 100% Thus the firm value is lower and its COC slightly higher than when the debt is Rs.6000. This result is due to the increase in r E and, to a lesser extent, the increase in rD .

These two observations indicate that the optimal capital structure occurs before the debt/equity ratio equals 100% as shown in the Figure below:

rE Percent 10 rA rD 5




Leverage (D/E)

Miller-Modigliani (MM) Position

MM advocates that the relationship between leverage and valuation is explained by the NOI approach. Assumptions: Perfect Capital Market freely available information, transactions are costless, etc. Rational Investors & Managers Investors choose combination of risk & return that is best and managers act in interest of shareholders. Homogeneous Expectations Investors hold identical expectations about future operating earnings. Equivalent Risk Classes Firms can be grouped this way on the basis of their business risk. Absence of Taxes There is no tax.

More specifically, MMs propositions are summarized below:

Value of firm is equal to its operating income. Market value of firm and its COC are independent of its capital structure. That is, V = D + E = expected operating income divided by discount rate applicable to the risk class to which the firm belongs. Cost of equity or required r.o.r. on equity increases so as to exactly offset the use of cheaper debt money. Cutoff rate for capital budgeting decisions is completely independent of the way in which an investment is financed.

Risk-Return Tradeoff
MMs proposition I says that financial leverage has no effect on wealth of shareholders. MMs proposition II says that r.o.r. expected by shareholders increases with financial leverage. Why are shareholders indifferent to increased leverage when it enhances expected return? Because an increase in expected return is accompanied by an increase in risk which in turn raises the shareholders required r.o.r.

Just as the expected return on the firms assets is a weighted average of the expected return on its securities, the beta of a firms assets is the weighted average of the beta of its securities. In symbols: A = (D/D+E)D + (E/D+E)E
That is, Beta of assets = Proportion of Debt x Beta of Debt + Proportion of Equity x Beta of Equity

Now, the beta of firms equity can be expressed: E = A + D/E(A D) The reason why investors require higher return as leverage increases is now obvious. The required return rises to match the increased risk (beta).

Factors Affecting Capital Structure

Growth rate of future sales Stability of future sales Competitive structures in the industry Asset makeup of the individual firm Attitude of owners and management toward risk Control position of owners and management Lenders attitude toward the industry and a particular firm

Tradeoff Theory
When a firm is unable to meet its obligations it results in financial distress that can lead to bankruptcy. When a firm experiences financial distress several things can happen: Delay in the liquidation of assets due to conflict between shareholders and creditors. Assets sold under distress conditions may fetch a price that is significantly less than their economic value. High legal and administrative costs.

Managers become myopic. In a bid to survive in the short-run, they may sacrifice actions meant to build value in the long-run. Employees, customers, suppliers, distributors, investors, and other stakeholders dilute their commitment to the firm leading to adverse impact on sales and operating costs. So, greater the level of debt, higher the probability of financial distress. There are direct costs and indirect costs associated with financial distress.

There is an agency relationship between shareholders and creditors of firms that have substantial amounts of debt. In such firms, managers acting in the interest of shareholders may hurt the interest of creditors. Aware of this, creditors will impose restrictions on the operational freedom of management and monitor the firm. The loss of efficiency on account of restrictions represent agency costs associated with debt.

Considering the tax effect and financial distress and agency costs, the value of a levered firm may be expressed as follows:
Value of levered firm = Value of unlevered firm + Tax advantage of debt PV of expected costs of financial distress PV of agency costs.

As per the Tradeoff Theory, the optimal d/e ratio of a firm depends on the tradeoff between the tax advantage of debt on one hand and the financial distress & agency costs on the other hand. As per this theory, the optimal d/e ratio for a profitable firm that has stable, tangible assets would be higher than the optimal d/e ratio for an unprofitable firm with risky, intangible assets. This theory, however, cannot explain why some profitable companies depend so little on debt.

Pecking Order & Signaling Theory

Gordon Donaldson (1961) examined how companies actually established their CS. That firms prefer to rely on retained earnings and depreciation cash flow. That firms set the target payout ratios at such a level that capital expenditures are covered by internal accruals. That a firm will invest in marketable securities, retire debt, raise dividends, or buyback its shares if its internal accruals exceed capital expenditure requirements.

That if a firms internal accruals are less than its capital expenditures it resorts to external finance. It will first issue debt, then convertible debt, and finally equity stock. Thus there is a pecking order of financing. This explains why highly profitable firms generally use little debt. On the other hand, less profitable firms borrow more because their financing needs exceed retained earnings and debt finance comes before external equity in the pecking order.

Noting the inconsistency between the trade-off theory and the pecking order, Myers proposed a new theory, called signaling, or asymmetric information theory of CS. Because of the problem of asymmetric information, firms would do well to maintain reserve borrowing capacity which will enable them to exploit profitable investment opportunities without issuing equity shares at a low price. The need to maintain reserve borrowing power implies that the actual debt-equity ratio will be lower compared to what is suggested by the trade-off theory.