CAPITAL STRUCTURE

Learning Outcomes
Understand the theoretical controversy about capital structure and the value of the firm. Highlight the differences between the ModiglianiMiller view and the traditional view on the relationship between capital structure and the cost of capital and the value of the firm. Focus on the interest tax shield advantage of debt as well as its disadvantage in terms of costs of financial distress.

Introduction
Financial manager tries to achieve optimum capital structure because: It affects the value of the firm or Share price, either by increasing expected earnings or reducing the cost of capital.

Capital Structure Theories

The total capital structure theories can be categorised into two relevant and irrelevant theories. The following are the main theories/Approaches of capital structure: 1. Net income (theory) Approach (Relevant) 2. Net operating income Approach (Irrelevant) 3. Modigliani and Miller Approach (Irrelevant) 4. Traditional Approach (Neutral)

Assumption of Capital Structure Theories

1. Firm uses only two sources of funds: perceptual riskless debt and equity; 2. There are no corporate or income: or personal tax; 3. The dividend payout ratio is 100% [There are no retained earnings]; 4. The firms total assets are given and do not change [Investment decision is assumed to be constant]. 5. The firms total financing remains constant. [Total capital is same, but proportion of debt and equity may be changed]; 6. The firms operating profits (EBIT) are not expected to grow; 7. The business risk is remained constant and is independent of capital structure and financial risk; 8. All investors have the same subject probability distribution of the expected EBIT for a given firm; and 9. The firm has perpetual life;

Definitions used in Capital Structure

E = Total market value of equity D = Total market value of debt V = Total market value of the firm I = Annual interest payment NI = Net income or equity earnings NOI = Net operating income Ki = pre-tax cost of debt Cost of debt (Ki) = I 100 D Cost of equity (Ke) = N I or Ko+ [KoKi] D E E Cost of Capital (Ko) = WdKi + WeKe or [EBIT V] 100 Value of the Firm (V) = EBIT Ko

Net Income Approach

NI Approach: A change in the proportion in capital structure will lead to a corresponding change in Ko and V. Assumptions (i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the risk perception of investors. (iv) Cost of debt and cost of equity remains constant;

N I Approach (Contd..)
E = NI Ke

Degree Of Leverage

D E

Numerical I
ABC Ltd expects operating profit (EBIT) of Rs. 1,00,000. The company has raised 12% debentures of Rs. 3,00,000. The companys equity capital cost is 13%. Determine value of firm and C.O.C.

Solution:
Particulars EBIT Less: Debenture Interest (3,00,000*12/100) Rs. 1,00,000 36,000

Net Income
Value of Firm Market Value of Equity (NI/Ke) (64,000/0.13) Add: Market Value of Debt Cost of Capital Ko Ko

64,000
E+D 4,92,307.69 3,00,000.00 792,307.69 (EBIT/V)100 (1,00,000/7,92,307.69) 12.62%

Net Operating Income Approach (NOI)

NOI Approach: Says that there is no relation between capital structure and Ko and V. Assumptions (i) Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. (ii) The market capitalizes the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity; (iii) The market value of equity is residue [i.e., Total value of the firm minus market value of debt) (iv) The use of debt funds increases the received risk of equity investors, there by ke increases (v) The debt advantage is set off exactly by increase in cost of equity. (vi) Cost of debt (Ki) remains constant (vii) There are no corporate taxes.

NOI (Contd.)
V = EBIT Ko E = V-D

Degree Of Leverage

D E

Numerical 2
ABC Ltd expects operating income of Rs. 1,00,000. The company has 12% debt of Rs. 3,00,000. The companys overall cost of capital is 13%. Calculate the total value of firm and equity capitalization rate (Ke).

Solution
Value of the Firm = EBIT / Ko = Rs. 1,00,000 / 0.13 = Rs. 7,69,230.77 Market Value of equity = V-D = Rs. 7,69,230.77- Rs. 3,00,000 = Rs. 4,69,230.77 EBIT-I V-D Rs. 1,00,000-Rs. 36,000 4,69,230.77 Or Ke =Ko + (Ko-Ki) D E = 0.13+ (0.13-0.12) 3,00,000 4,69,230.77

Cost of Equity/Equity Capitalization Rate (ke)

Modigliani-Miller Approach
MM Approach: Total value of firm is independent of its capital structure Assumptions a. Information is available at free of cost b. The same information is available for all investors c. Securities are infinitely divisible d. Investors are free to buy or sell securities e. There is no transaction cost f. There are no bankruptcy costs g. Investors can borrow without restrictions as the same terms on which a firm can borrow h. Dividend payout ratio is 100 percent i. EBIT is not affected by the use of debt

MM Approach (Contd.)
Proposition: I. Ko and V are independent of capital structure II. Ke = capitalisation rate of the pure equity plus a premium for financial risk. Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt) III. The cut of rate for investment purposes is completely independent of the way in which an investment is financed.

MM Approach [Proposition: I]
Arbitrage Process: Refers to an act of buying an asset or security in one market at lower price and selling it is an other market at higher price. Steps in working out Arbitrage Process Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return). Step 2: Calculation of Savings in Investment by moving from levered firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm. Step 3: Calculation of Increased Income, by investing total funds available.

Limitations of MM Approach
Investors cannot borrow on the same terms and conditions of a firm Personal leverage is not substitute for corporate leverage Existence of transaction cost Institutional restriction on personal leverage Asymmetric information Existence of corporate tax

MM Approach: with Corporate Taxes

MM Approach with tax says affects value of the firm VL = VU + Dt Where VL = Value of levered firm VU = Value of unlevered firm, D = Amount of Debt t = Tax rate In other words value of levered firm (VL) is equal to the market to the market value of unlevered firm VU plus the discounted present value of the tax saving resulting from tax deductibility a interest payments. VL = VU + pv of tax shield

Traditional Approach
Traditional Approach is midway between NI and NOI theories
Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital

Traditional Approach (Contd.)

Main propositions The following three are the main propositions of traditional approach 1. The pretax cost of debt (Ki) remains more or less constant up to a certain degree of leverage and /but rises thereafter of an increasing rate 2. The cost of equity capital (Ke) remains more or less constant rises slightly up to a certain degree of leverage and rises sharper there after, due to increased perceived risk. 3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It (a) Decreases up to a certain point level of degree of leverage [stage I increasing firm value]; (b) Remains more or less unchanged for moderate increase in leverage thereafter [stage II optimum value of firm], and (c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].

Traditional approach (contd.)

D E

Practical Considerations in Determining Capital Structure

Control Widely-held Companies Closely-held Companies Flexibility Loan Covenants Early Repay ability Reserve Capacity Marketability Market Conditions Flotation Costs Capacity of Raising Funds Agency Costs

THANK YOU

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