LECTURE 4 1

Capital Structure
The term Capital Structure is used to
represent the proportionate relationship
between Debt and Equity.
LECTURE 4 2
Optimum Capital Structure
Optimum capital structure is that capital
structure or combination of debt and equity
reduces the overall cost of capital and
maximize the market price per share or
total value of the firm.
Capital structure Theories
Capital
Structure
theories
Relevance
theories
Net
Income
Approach
Traditional
Approach
Irrelevanc
e Theories
Modigliani
and
Millers
Model
Net
Operating
Income
Approach
LECTURE 4 3
Assumptions of Capital
structure theories
There are only two sources of funds: perpetual riskless
debt and ordinary shares
There are no corporate taxes
The dividend pay out ratio is 100%
Total assets are not going to change
Total financing remains constant
Operating profit(EBIT) are also not expected to grow
Business risk is constant over time and is assumed to be
independent of its capital structure and financial risk
Perpetual life of the firm.

LECTURE 4 4
Net Income Approach
Proposed by Durand
According to this theory, capital structure
decision is relevant to the firm
Change in financial leverage will lead to a
corresponding change in overall cost of capital
and on the total value of the firm
If the degree of financial leverage increases , the
weighted average cost of capital will decline
while the value of firm as well as the market
price of ordinary shares will increase
LECTURE 4 5
Assumptions of NI approach
Cost of debt is less than cost of equity
Use of debt does not changes the risk
perception of investors
There are no taxes
LECTURE 4 6
Graph

ke
.10
cost of capital k0
.05
Kd



. 2 .4 .6 .8 1.0
Degree of leverage
LECTURE 4 7
Practical steps and formulae usage
according to this approach
Calculate market value of equity( S)
S= Net Income for equity shareholders
k

= NOI- Interest
k
Where k is cost of equity capital
LECTURE 4 8
Calculate market value of debt( D)
D= Interest
Cost of debt



LECTURE 4 9
Calculation of weighted average cost of capital
can be done:
WACC= NOI
Total Value of firm
There is one alternative method for calculation of
WACC
WACC= cost of equity* equity weight
+
cost of debt * debt weight

LECTURE 4 10
Calculate total value of firm(V)
V= S+D

LECTURE 4 11
Net Operating Income approach
This theory is also proposed by Durand
Essence of this approach is that the any
change in leverage will not lead to any
change in total value of the firm and the
market price as well as overall cost of
capital is independent of the degree of
leverage.
LECTURE 4 12
assumptions
WACC of the firm remains constant for all
degree of leverages
Cost of debt remains constant
Cost of equity capital increases with the degree
of leverage
Value of equity is a residual value which is
determined by deducting the total value of debt
from the total value of firm
There are no corporate taxes.
LECTURE 4 13
a. Effect of increase in
leverage on
LECTURE 4 14
Effect on Effect
a. Cost of equity capital Increase
b. WACC Remain constant
c.Total Value of the firm Remain constant
a. Effect of decrease in
leverage on
LECTURE 4 15
Effect on Effect
a. Cost of equity capital Decreases
b. WACC Remain constant
c.Total Value of the firm Remain constant
Graph

ke
.10
cost of capital k0
.05
Kd



. 2 .4 .6 .8 1.0
Degree of leverage
LECTURE 4 16
Practical steps and formulae usage
according to this approach
Calculate total value of firm
total value of firm= NOI
WACC
LECTURE 4 17
Calculate market value of debt( D)
D= Interest
Cost of debt
LECTURE 4 18
Calculate market value of equity as
follows:
Market value of equity= total value of firm
-
Market value of
debt
LECTURE 4 19
Calculate cost of equity capital or equity
capitalization rate as follows
= Net Income for equity shareholders
Market value of equity

= NOI- Interest
Market value of equity

LECTURE 4 20
Traditional Approach(also called as
intermediate approach)
It has emerged as a compromise between NI
and NOI approach
It resembles the NI approach in arguing that cost
of capital and total value of firm are not
independent of the capital structure , but it does
not subscribes to the view that value of firm will
necessarily increase for all degrees of leverage.
It shares a feature with NOI approach that
beyond a certain degree of leverage the over all
cost increase leads to decrease in value of firm.
LECTURE 4 21
Crux of traditional approach
According to this approach a judicious mix of
debt and equity capital can increase the value of
firm by reducing the WACC.
1. Up to a reasonable limit of debt replacing
equity by a comparatively cheaper source which
is debt will decline the overall cost of capital .
Beyond the reasonable limit of leverage
increase in the cost of equity will more than
offset the advantage of lower cost debt which
will lead to increase in overall cost of capital.
LECTURE 4 22
Graph

LECTURE 4 23
MM Approach
It supports the NOI approach relating to
the independence of the cost of capital of
the degree of leverage at any level of debt
equity ratio.
It provides the behavioral justification for
overall constant cost of capital and
therefore total value of the firm.
LECTURE 4 24
Basic propositions
1. For firms in the same risk class, the total
market value is independent of its capital
structure or debt equity mix
Value of firm= Net operating income
Firms opportunity cost of capital
proposition number one simply states that two
firms with identical assets irrespective of how
these assets have been financed can not
command different market value. If these
happens arbitrage process will take place to
restore equilibrium in market.
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Given the assumptions of the perfect
information and rationality, all the investors
have the same expectation of the firms net
operating income(EBIT) with which to
evaluate the value of the firm
Business risk is equal among all firms
within similar operating environment. It
means firms can be divided into
homogeneous risk class.
LECTURE 4 26
The dividend pay out ratio is 100%
There are no taxes. This assumption is
removed later.
LECTURE 4 27
Key assumptions for proposition
I
Perfect capital market : Implications of perfect
capital market is:
a. Investors are free to buy or sell securities
b. They can borrow without restrictions on the
same terms and conditions as the firms do
c. There are no transaction cost
d. Information is perfect
e. investors are rational and behave accordingly.


LECTURE 4 28
Proposition II
Cost of equity of a levered firm is equal to
capitalization of a pure equity stream plus
a premium for financial risk .
LECTURE 4 29
Graph

LECTURE 4 30
Criticism of MM hypothesis
Shortcomings of this hypothesis lies in the assumption of
perfect capital market in which arbitrage is expected to
work. The arbitrage process will fail to bring the
equilibrium in the capital market for the following
reasons:
1. Lending and borrowing rate discrepancy
2. Non substitutability of personal and corporate leverage
3. Transaction costs
4. Institutional restrictions
5. Existence of corporate tax
LECTURE 4 31
MM hypothesis with corporate
tax
In their 1963article, MM have shown that value
of the firm will increase with debt due to the
deductibility of interest charges for tax
computation and the value of levered firm will be
higher than that of the unlevered firm.
Value of levered firm= Value of unlevered firm
+
PV of interest shield
LECTURE 4 32
Graph
Value
V1



Value of interest shield
Vu Vu


D/V

Leverage
LECTURE 4 33
Implications of MM hypothesis
with corporate taxes
Because of the tax deductibility of interest charges firm
can increase its value with leverage.
According to this optimum capital structure should be
one with 100% debt but in reality it does not happen
probably because of two reasons:
a. Personal income tax may offset the advantage of tax
shield
b. Excess borrowing may involve extra cost: that is cost of
financial distress
Firm should opt for a target debt ratio.
LECTURE 4 34
Financial leverage and
corporate and personal tax.
Companies everywhere pay corporate tax on their
earning . Further investors are also required to pay
personal taxes on the income earned by them.
A firm should thus aim at minimizing the total taxes to
investors and maximize the earnings available to the
investors while deciding about the borrowing
Here we try to analyze what happens to the value of the
firm with the personal taxes introduced. We shall
examine it under two cases:
a. Where the income from the debt and equity are taxed at
the same rates
b. When they are taxed at different rates.
LECTURE 4 35
Equal personal tax rates for equity
income and debt income
When there is no difference between the
personal tax rates of equity income and
interest income, then the levered firms
total income after tax is:
Unlevered firms income after all taxes
+
Net tax advantage of debt( Value of tax
shield after both
taxes)
LECTURE 4 36
Value of levered firm= Value of unlevered
firm
+
PV of interest shield

LECTURE 4 37
Unequal personal tax rates for
equity income and debt income
In practice the personal tax rates for dividend
and interest are different. Tax rates on dividend
is generally less than that on interest income.
As personal taxes increase the value of tax
shield comes down
How ever levered firms still remains more
valuable than un levered firm.
As long as personal taxes are not 100%, levered
firm will continue to enjoy tax advantage.

LECTURE 4 38
Millers theory
Merton miller in 1976 tried to answer the
question of optimum debt equity ratio in
situations which involves both corporate
and personal taxes. Key premises and
assumptions of the model are as follows
1. Miller introduced the concept of personal
taxes in MM hypothesis with corporate
taxes

LECTURE 4 39
2. Following points are relevant for a thorough
understanding of millers model
a. If personal taxes do not exist the present value of
interest tax shield is equal to the product of corporate tax
rate and amount of debt.
b. If the personal tax rate on interest income is greater than
personal tax rate of equity income , the present value of
interest tax shield will be less than what it is in point a.
c. If personal tax on equity is zero, the present value of the
interest tax shield depends on corporate tax rate and
personal tax rate on interest income.
LECTURE 4 40
3. Millers model is based on the assumption that personal
tax rate on equity income is zero, personal tax rate on
debt income varies across the investors and corporate
tax rate is constant across companies.
4. Investors would like to invest in equity but there would be
strong incentive from the firms point of view to borrow for
reduction of corporate taxes.
5. Company will tend to modify their capital structure in
such a manner that after tax debt income is same as
after tax equity income

LECTURE 4 41
6. Firms can issue debt to investors which do not have
taxable income so as to enhance their value
Value of levered firm= Value of unlevered firm
+
PV of interest shield

7.For inducing tax paying investors to lend or to switch
from equity to debt, they will have to be offered an higher
before tax rate of interest which is equal to
rate of Interest paid to tax exempt investors
1- personal tax rate on debt

LECTURE 4 42
where the value return which is offered on debt to tax
exempted investors is same as their expected return on
equity.
8. Firms will have to keep the interest rate rising to attract
investors in high tax bracket.
9. The tax advantage of debt vanishes in this case when
personal tax on interest income becomes equal to
corporate tax rate.

LECTURE 4 43
Important implications of Miller model:
There is optimum amount of debt in the
economy which is determined by
corporate and personal tax rates. There is
optimum debt equity ratio for all the firms
in the economy. There is no optimum debt
equity ratio for a single firm
LECTURE 4 44
Limitations
Miller model implies that tax exempt persons
and institutions will invest only debt securities
and high tax bracket investors in securities.
Where as in reality investors hold portfolio of
debt and equity
Personal Tax rate on equity income in number of
countries is not zero
Investors in high tax bracket can be induced to
invest in debt securities indirectly.

LECTURE 4 45
Trade off theory: cost of financial distress
and agency cost
When results of financial distress cost and agency costs
are included , MM results change significantly.
Financial Distress cost:
Firms inability to meet its obligations results in financial
distress that can lead to bankruptcy. Following things
can happen in this:
1. Conflicting interest of creditors and other stake holders
can delay the liquidation process
2. Assets sold under distress conditions fetch a lower price
3. Legal and administrative costs associated with
bankruptcy proceedings are quite high
LECTURE 4 46
4. Managers become Myopic
5. Employees , customers ,suppliers ,
distributors , investors and other stake
holders dilute their commitment to firm and
this has an adverse impact on sales,
operating costs and financing costs
First three are called as direct cost of
financial distress and last two are called
the indirect costs of financial distress.
LECTURE 4 47
Agency costs
In practice there may exist a conflict of
interest among shareholders, debt holders
and management. These conflicts give
rise to agency problems which involves
agency costs.
LECTURE 4 48
Effect of Financial Distress and
Agency cost
If MM model with corporate tax effect is valid:
Value of levered firm= Value of unlevered firm
+
Tax advantage of
debt
considering the tax effects and financial distress and
agency costs, the value of levered firm may be
expresses as:


LECTURE 4 49
Value of levered firm= Value of unlevered firm
+
PV of interest shield
-
present value of expected costs of financial distress
-
Present value of agency cost
LECTURE 4 50
Graph

LECTURE 4 51
Summary of trade off Theory
Every firm has an optimal debt equity ratio that
maximizes its value
Optimal debt equity ratio of a profitable firm that has
stable tangible assets would be higher as compared to
that of an unprofitable firm with risky intangible asset.
This theory explains well regarding industry difference in
capital structure. For example power companies uses
more debts and software companies borrow less.
The trade off theory however cannot explain why some
profitable companies depend so less on debt.
LECTURE 4 52
Pecking order and Signaling
theory
In a study published in 1961, Donaldson
conducted a study , finding of which are as
follows:
1. Firms prefer to relay on internal accruals
that is on retained earning and
depreciation cash flow
2. Firms sets out the target pay out ratio at
such a level that capital expenditures are
normally covered by internal accruals
LECTURE 4 53
3. Dividends are raised only when the firm is
confident that the higher dividend can be
maintained. Dividend are not lowered
unless things are very bad
4. If a firms internal accruals exceeds its
capital expenditure requirements , it will
invest in marketable securities , retire
debt, raise dividend, resort to acquisitions
or buyback its shares.
LECTURE 4 54
5. If a firms internal accruals are less than its non
postponable capital expenditures, it will first draw down
its marketable securities portfolio and then seek external
finance.
when it resorts to external finance, it will issue debt, then
convertible debt and then finally equity.
This is called as pecking order theory. This explains why
highly profitable firms generally use little debt and why
less profitable companies borrow more.
Thus there is an inconsistency between Tradeoff theory
and observed pecking order
LECTURE 4 55
In order to explain the observed pecking
order of financing, Myers proposed a new
theory called as signaling or asymmetric
information theory of capital structure.
LECTURE 4 56
Signaling theory
Mayer tried to explain the Donaldsons
finding logically by arguing that There is
asymmetric information. That means that
managers have more information about
the firm as compared to investors.
Empirical evidences suggest that more is
the asymmetry of information the greater
is the likely share price reaction to a
financing announcement.
LECTURE 4 57
Designing Capital Structure
Designing an optimum capital structure is very
difficult. Operationally each company aims to
design an appropriate capital structure . Three
aspects needs to be explored when we are
trying to understand capital structure planning.
1. Features of an appropriate capital structure.
2. Various analysis done prior to choosing
appropriate capital structure
3. Factors affecting capital structure

LECTURE 4 58
Features of an appropriate
capital structure.
A sound or an appropriate capital structure should
have the following features:
1. Profitability
2. Solvency
3. Flexibility
4. Conservatism
5. Control
Relative importance of each of these features may
differ from company to company.
LECTURE 4 59
Analysis prior to choosing
appropriate capital structure
EBIT-EPS analysis
ROI-ROE analysis
Leverage analysis
Ratio analysis
Cash Flow Analysis
Comparative Analysis

LECTURE 4 60
Factors affecting choice of
capital structure
Profitability Aspect
1. EBIT-EPS analysis
2. Coverage ratio
Liquidity aspect
1. Cash Flow Analysis
Control
Leverage ratio for other firms in the industry
Nature of Industry
LECTURE 4 61
Consultation with investment bankers and
lenders
Maintaining Maneuverability for commercial
strategy
Timing of issue
Characteristics of the company
Tax planning
Purpose of financing
Period of financing.

LECTURE 4 62
LECTURE 4 63
Principles of Capital structure
management
While deciding on optimum capital structure,
there are certain Principles which ought to
be followed:
1.Cost Principle
2.Risk Principle
3.Control Principle
4.Flexibility Principle
5.Timing Principle.
LECTURE 4 64
Factors to be considered in
planning Capital Structure

Nature of industry
Maintaining a maneuverability
Tax planning
Control
Government policies
Purpose of financing


LECTURE 4 65
Leverage
Employment of an asset or source of funds
for which the firm has to pay a fixed cost
or fixed return may be termed as
Leverage.
There are two types of leverage:
1. Operating Leverage
2. Financial Leverage
LECTURE 4 66
Operating Leverage
Operating leverage results from the
existence of fixed operating expenses in
the firms income stream.
Operating leverage may be defined as the
firms ability to use fixed operating cost to
magnify the effect of changes in sales on
its earnings before interest and taxes.
LECTURE 4 67
Operating leverage represents the relationship
between the firms earnings before interest and
taxes (EBIT) and sales.
When a firm has fixed operating costs, an increase
in sales volume results in a more than
proportionate increase in EBIT. Similarly a
decrease in the level of sales has an exactly
opposite effect. This is operating leverage, the
former being favorable while the later being
unfavorable. Leverage thus works in both the
directions.
LECTURE 4 68
Operating Leverage can be more precisely expressed
and measured in terms of degree of operating
leverage (DOL).
DOL = Percentage change in EBIT
> 1
Percentage change in sales
When proportionate change in EBIT as a result of a
given change in sales is more than the proportionate
change in sales, operating leverage exists. Greater
the DOL, the higher is the operating leverage.
LECTURE 4 69
Financial Leverage
The use of the fixed charges source of funds, such
as debt and preference capital along with the
owners equity in the capital structure is
described as financial leverage or gearing or
trading on equity.
The financial leverage employed by a company is
intended to earn more return on the fixed charge
funds than theirs costs.
Financial leverage represents the relationship
between the firms earnings before interest and
taxes (EBIT) and the earnings available for
ordinary shareholders.
LECTURE 4 70
Financial Leverage is defined as the ability
of firm to use fixed financial charges to
magnify the effects of changes in EBIT on
the earnings per share..
Financial Leverage is also called as
trading on equity.
LECTURE 4 71
Financial leverage can be more precisely
expressed in terms of the degree of
financial leverage.
DFL = Percentage change in EPS
>1
Percentage change in EBIT
LECTURE 4 72
Combined Leverage: Total Risk
If both the leverage is combined , the result is total
leverage and the risk associated with combined
leverage is known as total risk.
DCL = DOL* DFL
DCL = % change in EPS
% change in sales
Combined leverage is the measure of the total risk
of the firm. To keep the risk within the
managerial limits, a firm which has high degree
of operating leverage should have low financial
leverage and vice versa.
LECTURE 4 73
EBIT-EPS Analysis
EBIT EPS analysis as a method to study the
effect of leverages, involves comparison of
alternative methods of financing under
various assumptions of EBIT. The choice
of combination of the various sources
would be one which given the level of
EBIT would ensure the largest EPS.
LECTURE 4 74
Financial Break Even Point
It is that level of EBIT at which firm can
cover all fixed financial charges.

Financial Break Even Point= I + D(p)
1-t
where I= Annual Interest charges
D(p)=Preference Dividend
t= Tax rate
LECTURE 4 75
Indifference point
The EBIT level at which the EPS is the same for two
alternative financial plans is referred to as the
indifference point
In operational terms, if the expected level is to exceed the
indifference level of EBIT, the use of fixed charges
source of funds would be advantageous and would lead
to an increase in the EPS available to the shareholders.
The capital structure should include debt.
If however the expected level of the EBIT is less than the
indifference point , the advantage of EPS would be
available from the use of Equity capital.
LECTURE 4 76
Indifference point can also be computed
using market value as the basis. Since
operational objective of financial
management is the maximization of share
prices, indifference point can be defined
as that level of EBIT at which market price
of shares of a firm is identical for two
different financial plans.
LECTURE 4 77
Indifference point
In operational terms, if the expected level is to
exceed the indifference level of EBIT, the use of
fixed charges source of funds would be
advantageous and would lead to an increase in
the Market price of shares.. The capital structure
should include debt.
If however the expected level of the EBIT is less
than the indifference point , the market price per
share would decrease by the use of debt.
Advantage would be available from the use of
equity capital.