CAPITAL STRUCTURE

MEANING :
Capital structure is the proportion of debt, preference and equity shares on a firm s balance sheet. TOTAL CAPITAL I. Equity capital Equity share capital Preference share cap Retained earnings Share premium II. Debt capital Term loans Debentures Deferred payment liabilities Other long term debt.

Optimum capital structure

Is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value the firm. The optimum capital structure minimizes the firms overall cost of capital and maximizes the value of the firm. Optimum capital structure is also referred as appropriate capital structure and sound capital structure

Factors determining capital structure

FACTORS

Internal
* Cost of capital * Risk factor * Control Factor * Objectives * Constitution of the company * Attitude of the management

External
* Economic Conditions * Interest rates * Policy Of lending * Tax Policies * Statutory restrictions

Theories of capital structure

Basic assumptions: 1. There are only two sources of funds used by a firm: perpetual risk less debt and ordinary shares. 2. There are no corporate taxes. This assumption is removed later. 3. The dividend-payout ratio is 100%. that is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings. 4. The total assets are given and do not change. The investment decisions are in other words assumed to be constant. 5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the cost of equity capital. 6. The operating profits (EBIT) are not expected to grow. 7. All investors are assumed to have same subjective probability distribution of the future expected EBIT for a given firm. 8. Business risk is constant over time and is assumed to be independent of its capital structure and financial risk. 9. Perpetual life of the firm.

Theories of capital structure

Net Income NI approach Net Operating Income NOI approach Modigliani Miller MM approach Traditional approach.

Net Income approach

This approach is given by Durand David Assumptions: this approach is based on three assumptions There are no taxes Cost of debt is less than the cost of equity Use of debt does not change the risk perception of the investor. According to this approach, the capital structure decision is relevant to the valuation of the firm.

 A change in the capital structure causes a overall change in the cost of capital and also in the total value of the firm. A higher debt content in the capital structure means a high financial leverage and this results in the decline in the overall weighted average cost of capital and therefore there is increase in the value of the firm. Thus with the cost of debt and the cost of equity being constant, the increased use of debt (increase in leverage), will magnify the share holders earnings and, thereby, the market value of the ordinary shares.

 Net Income= EBIT-I or earnings available to equity share holders. Value of the firm= market value of debt+ market value of equity. over all cost of capitalization (ko) = EBIT/V or (ko) = ki (B/V) + ke (S/V) Ki= cost of debt Ke= cost of equity B= total market value of debt S= total market value of equity

Net operating income approach

This is another theory suggested by Durand NOI approach is opposite to NI approach According to NOI approach value of the firm is independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm Any change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage

Assumptions
The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole The overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchanged The cost of debt (kd) is also constant There is no tax The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke)

Prepositions
NOI approach is based on the following prepositions: Overall cost of capital/ capitalization rate (ko) is constant: this approach argues that the overall capitalization rate of the firm remains constant for all degrees of leverage. The value of the firm given the level of EBIT is determined by V= EBIT/ko EBIT= earnings before interest and tax Ko= overall cost of capital or V=EBIT(1-t) / ke + Bt B= value of debt The split of the capitalization between debt and equity is therefore not significant

 Residual value of equity : The value of equity is the residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V) (S) = V-B S= value of equity V= value of firm B = value of debt

 Change in cost of equity capital The equity capitalization rate or cost of equity capital (Ke) increases with the degree of leverage. The increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the increased risk to the ordinary shareholders would expect a higher rate of return on their investment. The increase in the equity capitalization rate would match in the increase in debt equity ratio.

 Ke = Ko + (Ko-Ki) (B/S) or Ke= EBIT-I/V-B

Cost of debt The cost of debt (Ki) has two parts Explicit cost Implicit cost hidden cost Explicit cost is the rate of interest paid by debt. Implicit cost is the increase in the cost of equity due to increase in debt.

Optimal capital structure

The total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is the total value of the firm remain constant. The market price of shares will also not change with the change in debt equity ratio. There is nothing such as optimum capital structure any capital is optimum according to NOI approach.

Modigliani Miller Approach

The M.M thesis relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI approach. The NOI approach does not provide operational or behavioral justification for the irrelevance of the capital structure. The significance of M.M approach lies in the fact that it provides behavioral justification for constant overall cost of capital and therefore total value of firm.

Assumptions
a) Perfect capital market1. Securities are infinitely divisible 2. Investors are free to buy/ sell securities 3. Investors can borrow without restrictions on the same terms and conditions as the firm can 4. There are no transactions costs 5. Information is perfect, that is each investor has same information which is readily available to him without cost and 6. Investors are rational and behave accordingly.

b) Given the assumption of perfect information and rationality all investors have the same expectations of firm net operating income (EBIT) with which to evaluate the value of a firm c) Business risk is equal among all the firm within similar operating environment, that means all the firms can be divided into equivalent risk class . The term equivalent/homogeneous risk class means that the expected earnings have identical risk characteristics and firm within an industry are assumed to have same risk characteristics d) The dividend payout ratio 100% e) There are no taxes. This assumption is removed later

Basic prepositions
There are three basic preposition of M.M approach. Preposition 1 The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure, the ko and V are constant for all degrees of leverages. the total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. V=EBIT / ko V is determined by the assets in which the company has invested and not how those assets are financed

MM theory : Arbitrage
MM theory : Proposition 1: The basic premise of MM approach is that given the above assumptions the total value of a firm must be constant irrespective of degree of leverage (debt-equity ratio) similarly, the cost of capital as well as the market price of shares must be the same regardless of the financing-mix. The operational justification for the MM hypothesis is the Arbitrage process.

Arbitrage
The term arbitrage refers to an act of buying an asset/security in one market (at lower price) and selling it in another market (at higher price) to derive benefits from the price differentials The increase in demand will force up the price of lower priced goods and increase in supply will force down the price of the high priced goods. MM argues that the process of arbitrage will prevent the different market values for equivalent firms, simply because of capital structure difference.

Arbitrage process
The investor of the firm whose value is higher(overvalued) will sell their shares and instead buy the shares of the firm whose value is lower (undervalued) The behavior of investors will have the effect of (i) increasing the share prices (value) of the firm whose shares are being purchased; (ii) lowering the share prices (value) of the firm whose shares are being sold . This will continue till the market prices of both the firms become identical . The use of debt by the investor for arbitrage is called as Home Made or Personal leverage

Limitations or Criticism of MM approach

Risk perception Convenience Cost Institutional restrictions Double leverage Transaction cost Taxes

Risk perception
In the first place, the risk perceptions of personal and corporate leverage are different. The risk exposure to investor is greater with personal leverage than with corporate leverage. The liability of an investor is limited in corporate enterprise. The risk to which he is exposed is limited to his relative holdings in the company The liability of an individual borrower is, on the other hand, unlimited as even his personal property is liable to be used for payment to the creditors. The risk to the investor with personal borrowings is higher.

Convenience
Apart from higher risk exposure the investor would find the personal leverage inconvenient. This is so because with corporate leverage the formalities and procedures involved in borrowing are to be observed by the firms. In case of personal leverage these will be the responsibility of the investor borrower.

Cost
Another constraint on the perfect substitutability of personal and corporate leverage and, hence, the effectiveness of the arbitrage process is the relatively high cost of borrowing with personal leverage. As a general rule, large borrowers with high credit standing can borrow at a lower rate of interest compared to borrowers who are small and do not enjoy high credit standing. For this reason it is reasonable to assume that a firm can obtain a loan at a cost lower than what a individual investor would have to pay As a result of higher interest charges, the advantage of personal leverage would disappear and the MM assumption of corporate and personal leverage being perfect substitutes would be a doubtful validity

Institutional restrictions
Yet another problem with the MM hypothesis is that institutional restrictions stand in the way of smooth operation of the arbitrage process. Several institutional investors such as insurance companies, mutual funds, commercial bank and so on are not allowed to engage in personal leverage. Thus switching the option from the unlevered to levered firm may not apply to all investors and, to that extent, personal leverage is an imperfect substitute for corporate leverage.

Double leverage
A related dimension is that in certain situations, the arbitrage process may not actually work. For instance, when an investor has already borrowed funds while investing in shares of an unlevered firm. If the value of that is more than that of a levered firm, the arbitrage process will require selling securities of the overvalued firm (unlevered) and purchasing the securities of undervalued firm(levered). Thus, an investor would have double leverage both in personal portfolio as well as in the firms portfolio. The MM assumption will not hold true in such a situation.

Transaction cost
Transaction cost would effect arbitrage process. The effect of transaction/flotation cost is that the investor would receive net proceeds from the sale of securities which will be lower than the investment holding in the levered/unlevered firm, to the extent of brokerage fees and other costs. He would therefore have to invest a large amount in the shares of the unlevered/levered firm, than his present investment, to earn the same returns. This implies that the arbitrage process will be hampered and will not be effective.

Taxes
Finally if the corporate taxes are taken into account, the MM Approach will fail to explain the relationship between financing decision(capital structure) and the value of the firm MM themselves are aware of it and in fact, recognized it.

Traditional approach
In the earlier discussions we have seen that the net income approach (NI) as well as net operating income approach(NOI) represent two extremes as regards the theoretical relationship between the capital structure, the weighted average cost of capital and value of the firm. While the NI Approach takes the position that the use of debt in the capital structure will always affect the overall cost of capital and the total valuation, the NOI approach argues that capital structure is totally irrelevant. The MM Approach supports the NOI approach. But the assumptions of MM approach are of doubtful vaidity.

EBIT-EPS analysis
Keeping in mind the primary objective of financial management of maximizing the market value of the firm, the EBIT-EPS analysis should be considered logically as the first step in the direction of designing a firm s capital structure. EBIT-EPS analysis shows the impact of various financing alternatives on EPS at various levels of EBIT.

Financial breakeven
It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. interest and preference dividends. It denotes the level of EBIT for which the firms EPS just equals to zero. If EBIT is less than financial break even point, then EPS will be negative But if the expected level of EBIT exceeds than that of break even point more fixed costs financing instruments can be inducted in the capital structure otherwise the use of equity will be preferred.