Corporate Finance

Capital Structure

Presentation By:
CA Ashok Kumar Malhotra
7th Feb 2020
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 Capital Structure
• Revenue Generating Assets (analogy of Pizza)
• Operating Leverage versus financial leverage
• Objective: Optimum versus value
• Debt Characteristics versus equity
• Capital structure policy
• Ro, Rd, Re and WACC
• Arbitrage (example of full-cream milk business)

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 Factors influence Capital Structure
1. attitude of management,
2. situation of capital market,
3. guidelines issued by
regulatory authorities,
4. terms and conditions of
financing institutions,
5. cost of debt, rate of return on
investment,
6. tax shield on debt and
operating expenses,
7. existing capital structure,
8. pay out policy
9. growth opportunities,
10. size of the firm,
11. nature of business,
12. profitability,
13. liquidity,
14. prevailing rate of interest,
15. earning volatility,
16. cash flow,
17. possibility of take over etc.

These factors are highly psychological, conflicting, complex, and qualitative

in nature and sometimes beyond control also.

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 Capital Structure Theories -I
1. Net Income Approach

2. Net Operating Income (NOI) Approach

3. Modigliani Miller (MM) Approach

4. MM hypothesis under Corporate Taxes

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 Capital Structure Theories - II
These may be taken up later
5. Traditional Approach

6. Miller’s Model under Corporate Taxes and personal taxes

7. The Trade -Off Theory: Cost of Financial Distress and

agency

8. Pecking Order Theory

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• Net Income Approach:
EBIT - Interest - Income Tax = Net Income

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 Net Income Approach: Assumptions

1. There are no corporate taxes.

2. The cost of debt is less than the cost of equity i.e.
the capitalization rate of debt is less than the rate of
equity capitalization. This prompts the firm to
borrow.
3. The debt capitalization rate and the equity
capitalization rate remain constant.
4. The proportion of the debt does not affect the risk
perception of the investors. Investors are only
concerned with their desired return.
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 Net Income Approach: Assumptions

5. The cost of debt remains constant at any level of

debt.
6. Dividend pay out ratio is 100%.
7. No Bankruptcy

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 Criticism of NI Approach
1. Cost of debt at any level of debt is constant. In realty, the
funds providers insist for more rate of interest above
certain level of debt.
2. Constant risk perception of equity share holders is also
not correct. As the debt increases the financial risk also
increases and equity share holders will expect more
return on their investment and hence the rate equity
capitalization also increases with the increase in financial
leverage.
3. 100% dividend payout and absence of corporate tax are
not practically possible.

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Net Operation Income Approach (NOI) = EBIT

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 Net Operation Income Approach (NOI) -
Assumptions
1. There are no corporate taxes.
2. Cost of debt remains constant at all level of debt.
3. WACC does not change with the change in financial leverage
(Ko)
4. Value of the firm depends on expected net operating income
(EBIT) and overall capitalization rate or the opportunity cost
of capital (Ko)
5. Net operating income of the firm is not affected by the degree
of financial leverage. It is affected by the operating leverage
6.  The operating risk or business risk does not change with the
change in debt equity mix.

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 NOI - criticism
1. In real life absence of corporate tax is not correct.
2. The cost of debt increases with the increase in the quantum
of debt.
3. As the cost of debt increases with the increase in financial
leverage, the overall cost of capital also increases with
increase in financial leverage.
4. An investor values differently the firm having higher level of
debt in its capital structure than the firm having less debt or
no debt.

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 Assumptions of the M&M Model
• Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same rate
– Equal access to all relevant information
– No transaction costs
– No taxes
MM theory is just similar to NOI approach with a basic difference. The basic
difference is that the NOI approach explains the concept without investors’
behavioral justification, whereas M.M. Approach provides behavioral justification
in favour of the theory.
 MM Proposition I (No Taxes)
• We can create a levered or unlevered position
by adjusting the trading in our own account.
• This homemade leverage suggests that capital
structure is irrelevant in determining the value
of the firm:
VL = VU
 MM Proposition II (No Taxes)
• Proposition II
– Leverage increases the risk and return to stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
 MM Proposition II (No Taxes)
The derivation is straightforward:
B S
RW ACC   RB   RS Then set RW ACC  R0
BS BS
B S BS
 RB   RS  R0 multiply both sides by
BS BS S
BS B BS S BS
  RB    RS  R0
S BS S BS S
B BS
 RB  RS  R0
S S B
B B RS  R0  ( R0  RB )
 RB  RS  R0  R0 S
S S
 MM Proposition II (No Taxes)
Cost of capital: R

B
RS  R0   ( R0  RB )
(%)

SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity B
Ratio S
 MM Propositions I & II (With Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is
offset by the interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
 MM Proposition I (With Taxes)
The total cash flow to all stakeholde rs is
( EBIT  RB B )  (1  TC )  RB B
The present value of this stream of cash flows is VL
Clearly ( EBIT  RB B)  (1  TC )  RB B 
 EBIT  (1  TC )  RB B  (1  TC )  RB B
 EBIT  (1  TC )  RB B  RB BTC  RB B
The present value of the first term is VU
The present value of the second term is TCB
VL  VU  TC B
 MM Proposition II (With Taxes)
Start with M&M Proposition I with taxes: VL  VU  TC B
Since VL  S  B  S  B  VU  TC B
VU  S  B (1  TC )
The cash flows from each side of the balance sheet must equal:
SRS  BR B  VU R0  TC BR B
SRS  BR B  [ S  B(1  TC )]R0  TC RB B
B B B
Divide both sides by S RS  RB  [1  (1  TC )]R0  TC RB
S S S
B
Which quickly reduces to RS  R0   (1  TC )  ( R0  RB )
S
 The Effect of Financial Leverage

Cost of capital: R B
(%)
RS  R0   ( R0  RB )
SL

B
RS  R0   (1  TC )  ( R0  RB )
SL

R0

B SL
RW ACC   RB  (1  TC )   RS
BSL B  SL
RB

Debt-to-equity
ratio (B/S)
 Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.

B
RS  R0   ( R0  RB )
SL
 Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.
B
RS  R0   (1  TC )  ( R0  RB )
SL