Capital Structure Theory

Amit Deshmukh Kuldeep Kumbhar

Capital Structure Theory

Capital Structure Theory

Understand the theoretical controversy about capital structure and the value of the firm. Capital structure represents the mix or proportion of a firms permanent long-term financing represented by Debt, Preferred stock, and common stock equity. In theory, capital structure can affect the value of the firm by affecting either its expected earnings or cost of capital, or both.

Debt-equity Mix and the Value of the Firm

Capital structure theories:

Net operating income (NOI) approach. Traditional approach and Net income (NI) approach. MM hypothesis with and without corporate tax. Millers hypothesis with corporate and personal taxes. Trade-off theory: costs and benefits of leverage.

Assumptions
1. 2. There are only two sources of funds used by a firm; perpetual riskless debt and ordinary shares. There are no corporate taxes. This assumption is removed later. Dividend payout ratio is 100%. Total assets of the firm are given & do not change (i.e. investment decisions are assumed to be constant). Total financing remaining constant firm can change its degree of leverage (capital structure) either by selling shares & use the proceeds to retire debt or raising more debt to reduce capital. Operating Profit (EBIT) not expected to grow.

3. 4.
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6.

Net Income (NI) Approach

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
Cost

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ke

kd

ko kd

Debt

Net Operating Income (NOI) Approach

According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.
Cost ke

ko kd

Debt

Traditional Approach
The traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.
Cost ke

ko

kd

Debt

MM Approach Without Tax: Proposition I

MMs Proposition I states that the firms value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

Cost

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Debt MM's Proposition I