Unit: 8

Theories of Capital Structure

 Capital Structure Theories

Whether or not capital structure matters?

Can the firm affect its total valuation & its required return
by changing its financing mix?
What happens to the total valuation of the firm and to its
cost of capital when the ratio of debt to equity, or degree
of leverage is varied.
Capital Structure
Theories
ASSUMPTIONS
Firms use only two sources of funds equity &
debt.
Perpetual debt are used
No change in investment decisions of the firm, i.e.
no change in total assets.
100 % dividend payout ratio, i.e. no retained
earnings.
Business risk of firm is not affected by the
financing mix.
No corporate or personal taxation.
Investors expect future profitability of the firm.
Basic definitions

Three capitalization rates:

1. Debt capitalization rate (ki):
Annual interest charges (F)
ki = -----------------------------------------
Market value of debt (B)
2. Equity capitalization rate (ke):
Earnings to com.stockholders (E)
ke= -------------------------------------------------
Market value of stock (S)
3. Overall capitalization rate (ko):
Net operating earnings (O)
ko= -------------------------------------------------
Total market value of firm (V)
where, V= B+S
B S
OR ko= ki -------- + ke ---------
B+S B+S
Theories of Capital structure

Approaches to capital structure:

1. Net income (NI) approach
2. Net operating income (NOI) approach
3. Traditional approach
4. Modigliani & Miller approach without tax and with tax
5. Other theories
Capital Structure Theories
A) Net Income Approach (NI)
Net Income approach proposes that there is a
definite relationship between capital structure and
value of the firm.
The capital structure of a firm influences its cost of
capital (WACC), and thus directly affects the value
of the firm.
NI approach assumptions
o NI approach assumes that a continuous increase in
debt does not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e.
Kd < K e ]
o Corporate income taxes do not exist.
Capital Structure Theories
A) Net Income Approach (NI)
As per NI approach, higher use of debt capital
will result in reduction of WACC. As a
consequence, value of firm will be increased.
Value of firm = Earnings
WACC
Earnings (EBIT) being constant and WACC is
reduced, the value of a firm will always increase.
Thus, as per NI approach, a firm will have
maximum value at a point where WACC is
minimum, i.e. when the firm is almost debt-
financed.
Capital Structure Theories
A) Net Income Approach (NI)
As the
Cost
proportion of
debt (Kd) in
ke, ko ke capital
ko structure
kd kd
increases, the
Debt
WACC (Ko)
reduces.
Capital Structure Theories
A) Net Income Approach (NI)
Example

B=$1000, O=$1000, Interest=15%, ke=20%, V=?, ko=?

If B increases from $1000 to $3000, V=? Ko=?

Items Before After debt incr.

to $3,000
O Net operating earnings $1,000 $1,000
F Interest 150 450
E Earn.avail.to com.stockholders $850 $550
ke Equity capitalization rate 0.2 0.2
S Market value of stock $4,250 $2,750
B Market value of debt 1,000 3,000
V Total value of firm 5,250 5,750
O $1,000
Ko = ------------ = ------------ 19.05 17.39
V 5,250 percent percent
 Capital Structure Theories
B) Net Operating Income
(NOI)
Net Operating Income (NOI) approach is the
exact opposite of the Net Income (NI) approach.
As per NOI approach, value of a firm is not
dependent upon its capital structure.
Assumptions
o WACC is always constant, and it depends on the
business risk.
o Value of the firm is calculated using the overall
cost of capital i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
Capital Structure Theories
B) Net Operating Income (NOI)
NOI propositions (i.e. school of thought)
The use of higher debt component (borrowing) in the
capital structure increases the risk of shareholders.
Increase in shareholders risk causes the equity
capitalization rate to increase, i.e. higher cost of
equity (Ke) i.e.More debt issue leads stockholders to demand
more dividend, as a result of which K e would increase.
A higher cost of equity (Ke) offsets the advantages
gained due to cheaper cost of debt (K d )
In other words, the finance mix is irrelevant and
does not affect the value of the firm.
Capital Structure Theories
B) Net Operating Income
(NOI) Cost of capital

Cost
(Ko) is constant.
As the
ke

proportion of
debt increases,
ko

kd
(Ke) increases.
Debt
No effect on
total cost of
capital (WACC)
Capital Structure Theories
B) Net Operating Income
(NOI)
Capital Structure Theories
C) Traditional Approach
The NI approach and NOI approach hold extreme
views on the relationship between capital
structure, cost of capital and the value of a firm.
Traditional approach (intermediate approach) is
a compromise between these two extreme
approaches.
Traditional approach confirms the existence of an
optimal capital structure; where WACC is
minimum and value is the firm is maximum.
As per this approach, a best possible mix of debt
and equity will maximize the value of the firm.
Capital Structure Theories
C) Traditional Approach
The approach works in 3 stages
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings
will not affect WACC and the value of firm will also
stagnate.
3) Increase in debt beyond this point increases shareholders
risk (financial risk) and hence Ke increases. Kd also rises
due to higher debt, WACC increases & value of firm
decreases.
Capital Structure Theories
C) Traditional Approach
Cost of capital
Cost
(Ko) is reduces
ke
initially.
At a point, it ko

settles
But after this kd

point, (Ko)
increases, due to Debt

increase in the
cost of equity. (Ke)
Capital Structure Theories
C) Traditional Approach
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
Assumptions
o Capital markets are perfect and investors are free to buy,
sell, & switch between securities. Securities are infinitely
divisible.
o Investors can borrow without restrictions at par with the
firms.
o Investors are rational & informed of risk-return of all
securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM Model proposition
Proposition I
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate
(i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
V(L)=V(u)=
L) Expected EBIT
Expected WACC
Proposition II
This proposition defines cost of equity. Cost of equity to a
levered firm is equal to the cost of unlevered firm in the
same risk class plus risk premium.
Ke(L) = Ke(u) + Risk Premium
= Ke(u) + [ke(u) Kd]B/S
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM Model proposition
o Asper MM, identical firms (except capital
structure) will have the same level of earnings.
o Asper MM approach, if market values of
identical firms are different, arbitrage
process will take place.
o Inthis process, investors will switch their
securities between identical firms (from levered
firms to un-levered firms) and receive the same
returns from both firms.
Capital Structure Theories
D) Modigliani Miller Model
(MM)Firm
Levered
Value of levered firm = Rs. 110,000
Equity Rs. 60,000 + Debt Rs. 50,000
Kd = 6 % , EBIT = Rs. 10,000,
Investor holds 10 % share capital

Un-Levered Firm
Value of un-levered firm = Rs. 100,000 (all
equity)
EBIT = Rs. 10,000
Capital Structure Theories
C) Modigliani Miller Model
(MM)
Return from Levered Firm:

Investment 10% 110, 000 50 , 000 10% 60, 000 6 , 000
Return 10% 10, 000 6% 50, 000 1, 000 300 700
Alternate Strategy:
1. Sell shares in L: 10% 60,000 6,000
2. Borrow (personal leverage): 10% 50,000 5,000
3. Buy shares in U : 10% 100,000 10,000
Return from Alternate Strategy:
Investment 10,000
Return 10% 10,000 1,000
Less: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Cash available 11,000 10,000 1,000
 Homemade leverage: Arbitrage argument
Acc to MM, whether the firm employs debt or not, it does
not matter really.
Investors are able to substitute personal or homemade
leverage for corporate leverage.
Acc. to MM, capital structure changes are not a thing of value
in the perfect capital market world.
If the two firms are identical in each and every respects except
for their capital structures, then the total values of the two firms
must be the same.
If not, arbitrage will occur, and it will drive values of the two
firms together.
Consider the two firms, A & B, identical in every
respects except their capital structures. B has
$30,000 of 12 percent bonds.Total value =?
Co. A Co. B
O NOI $10,000 $10,000
I Interest (12%,$30,000) 0 3,600
E Earnings avail. to
common stockholders 10,000 6,400
keEquity cap. rate 0.15 0.16
S Market value of stock 66,667 40,000
B Market value of debt 0 30,000
V Total value of firm 66,667 70,000
Ko Implied overall cap rate 15% 14.3%
B/S Debt-equity ratio 0 75%
MM maintain that this situation cannot last long.
Arbitrage will occur very soon, which will drive the values
of two firms together.
 Company B cannot command a higher total value simply
because it has a financing mix different from company As.
Investors in Company B would move to Company A because
they get the same return with less capital outlay.
The arbitrage process will be ceased when the values of the
two firms would be identical.
Arbitrage steps:
If you are a rational investor who owns 1 percent of the stock
of Company B, the levered firm, worth $400, you should:
[ Class Exercise]
Students are requested to show arbitrage proof.
1. Sell the stock in Company B for $400.
2. Borrow $300 at 12 percent interest. This personal debt is equal
to 1 percent of the debt of Company B - proportional
ownership.
3. Buy 1 percent of the shares of Company A for $666.67.
Return?
Return in Company B: 16% of $400 = $64.
Return in Company A: 15% of $666.67 = $100
Less interest:12% of $300 = 36
Net return 64
Cash outlay?
Outlay in Company B:1% of $40,000 $400
Outlay in Company A:1% of $66,667.67 $666.67
Less Personal debt 300.00
Net outlay 366.67
Here you have saving of $33.33
 M&M with Corporate Taxes

When corporate taxes are introduced, then

debt financing causes a positive benefit to the
value of the firm.
The reason for this is that debt interest
payments reduce taxable income and thus
reduce taxes.
Thus with debt, there is more after-tax cash flow
available to security holders (equity and debt) than
there is without debt.
Thus the value of the equity and debt securities
combined is greater.
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a companys annual tax shields = Debt Interest TC

=B Kd TC

If the savings are in perpetuity

Kd B TC
PV TC B
Kd
This represents the increase in the value in the levered firm over the
unlevered firm.

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M&M Proposition I (with Corporate Taxes)

Proposition I (with Corporate Taxes)

Firm value increases with leverage

VL = V U + T C B

TC B is the present value of the taxes saved because of

the interest payment.
These interest tax shields increase the total value of the
firm.

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 The Value of a Levered Firm Under
MM Proposition I with Corporate Taxes

Value of
the firm
(VL )

VL = VU + TC B

Present value of tax

shield on debt

VU VU

Total Debt (B)

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 M&M Proposition II (with Corp. Taxes)
Proposition II (with Corporate Taxes)
This proposition is similar to Prop. II in the no tax
case, however, now the risk and return of equity
does not rise as quickly as the debt/equity ratio is
increased because low-risk tax cash flows are
saved.
Some of the increase in equity risk and return is
offset by interest tax shield
Ke(L) = Ke(U) + (B/S)(1-TC)(Ke(u) - Kd)

Kd is the interest rate (cost of debt)

Ke(L) is the cost of equity for the levered firm

Ke(u) is the cost of capital for the all-equity firm

B is the value of debt

S is the value of levered equity 33
The Effect of Financial Leverage on the Cost
of Debt and Equity Capital
Cost of capital: r
(%)

B
ke ( L) Ke(u ) (1 TC ) [ K e (u ) K d ]
S

r0
B S
K 0(WACC ) K d (1 TC ) Ke
BS BS
rB

Debt-to-equity
ratio (B/S)
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Corporate taxes
The advantage of debt in a world of corporate
taxes is that interest payments are tax deductible.
Consequently, total amount of payments available
for both debt holders and stockholders is greater
if debt is employed.
Suppose the EBIT are $2000 for companies X &
Y, and they are alike in every respect except in
leverage.
Co. Y has $5,000 in debt at 12 percent interest.
Assume corporate tax rate is 40 percent.
 Co.X Co.Y
EBIT $2,000 2,000
Less interest (12%, $5000) 0 600
Profit before taxes 2,000 1,400
Taxes @40% 800 560
Income avail. to stockholders 1,200 840

Income to all investors 1200 1440

Thus total income is greater for a levered firm.
Govt pays a subsidy to the levered company.
Total income to all investors increases by the
interest payment times the tax rate, $600*0.4=
$240.
 If the debt employed is permanent, the PV of the
tax shield = TcB =0.4($5000) =$2000.
Or $240/0.12 =$2,000.
Thus the value of a levered firm would be more by
$2000.
Value of a levered firm = Value if unlevered + Value
of tax shield
= $7,500* + $2,000 = $9,500.
* If required return for unlevered firm is 16 percent,
its value would be $1200/0.16 = $7,500. (Because
Ke=E/S or S = E/Ke).
 Millers Theory: Corporate and Personal
Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct
interest expenses.
Personal taxes favor equity financing, since no gain is reported until
stock is sold, and long-term gains are taxed at a lower rate.

38
Millers Model with Corporate and
Personal Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1 B
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.

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Tc = 40%, Td = 30%,
and Ts = 12%.

(1 - 0.40)(1 - 0.12)
VL = VU + 1 B
(1 - 0.30)
= VU + (1 - 0.75)B
= VU + 0.25B.

Value rises with debt; each $1 increase in debt

raises Ls value by $0.25.
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 Corporate plus personal taxes
If both corporate & personal taxes are present,
total income to all securityholders would be
greater for the firm employing the debt.
Assume 30% personal tax rate on debt & stock
income. Co.X Co.Y
Debt income $ 0 600
Less Personal taxes @30% 0 -180
Debt income after personal taxes 0 420
Income avail. to stock holders 1,200 840
Less personal taxes @30% -360 -252
Stockholders income after taxes 840 588
Income to all investors after taxes 840 1008
Thus total income is still greater for a levered firm,
though it is less than before.
 When personal taxes are present, PV of debt tax shield would be:

(1-tc)(1-tps)
PV of tax shield= 1- -------------------- B
1-tpd
If tps & tpd are taxed at the same rate, then PV of tax shield would be
TcB.
Suppose the marginal corporate tax rate is 35 percent, the marginal
personal tax rate on debt income is 30 percent, and the market
value of debt is $1 million.
If the marginal personal tax rate on stock income is 28 percent, PV
of tax shield would be $331,429.
 If the personal tax rate on stock income is 0.20
instead of 0.28, then:
(1-.35)(1- .2)
PV of tax shield= 1- ------------------ $1million
1 - 0.3
= $257,143.
If tps=0.32, then PV of tax shield would be
$369,000.
 Conclusions with Personal Taxes

Use of debt financing remains advantageous, but benefits are less than
under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in equilibrium, the tax rates of
marginal investors would adjust until there was no advantage to debt.

44
 Effect of Bankruptcy Cost

MM theory ignores bankruptcy (financial distress)

costs, which increase as more leverage is used.
At low leverage levels, tax benefits outweigh
bankruptcy costs.
At high levels, bankruptcy costs outweigh tax
benefits.
An optimal capital structure exists that balances these
costs and benefits.

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 Incentive issues and Incentive cost

VL= VU +TCBPVexpected financial distress costs

The value of the levered firm is reduced by the
present value of the expected financial distress
costs.
Financial Distress

Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
 Financial signaling & Asymmetric information

MM assumed that investors and managers have the

same information.
But, managers often have better information. Thus,
they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Managers may use capital structure changes to
convey information about the profitability & risk of
the firm.

48
 Investors understand this, so view new stock sales as a
negative signal.

Debt issues are regarded as good news and stock issues

as bad news.
Greater the asymmetry in information between insiders
(management) and outsiders (security holders), the
greater is the likely stock price reaction to a financing
announcement.
 Pecking Order Theory

Gordon Donaldson (Corporate debt capacity Journal of

Finance, July 1984), followed by Stewart Myers (Capital
Structure Puzzles Journal of Finance, July 1984) suggest
that management follows a preference ordering when it
comes to financing:
1. Internal financing: No floatation costs. If no retained
earnings, external financing is preferred.
2. Straight debt: Float. costs are less. Good news.
3. Preferred stock
4. Hybrid securities (Convertibles)
5. Straight equity: Float. costs are high. Bad news.
Pecking order story is mainly a behavioral explanation of
why certain firms finance the way they do.

50
 Firms use internally generated funds first, because there are no flotation
costs or negative signals.
If more funds are needed, firms then issue debt because it has lower
flotation costs than equity and not negative signals.
If more funds are needed, firms then issue equity.