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Chapter

CAPITAL STRUCTURE THEORY

CAPITAL STRUCTURE

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Capital Structure Defined

CAPITAL STRUCTURE THEORY

 The term capital structure is used to represent the proportionate relationship between debt and equity.  The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure.

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 How should the investment project be financed?

CAPITAL STRUCTURE THEORY

Questions while Making the Financing Decision

 How does financing affect the shareholders risk, return and value?  Does there exist an optimum financing mix in terms of the maximum value to the firms shareholders?  What factors in practice should a company consider in designing its financing policy?

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CAPITAL STRUCTURE THEORY

Features of An Appropriate Capital Structure

 capital structure is that capital structure at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum. Appropriate capital structure should have the following features  Profitability  Solvency  Flexibility  Control

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Determinants of Capital Structure
 Seasonal Variations  Tax benefit of Debt  Flexibility  Control  Industry Leverage Ratios  Agency Costs  Industry Life Cycle  Degree of Competition  Company Characteristics  Requirements of Investors  Timing of Public Issue  Legal Requirements

CAPITAL STRUCTURE THEORY

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E = Total Market Value of Equity. D = Total Market Value of Debt. V = Total Market Value of the Firm. I = Annual Interest payment. NI = Net Income. NOI = Net Operating Income. Ee = Earning Available to Equity Shareholder.

CAPITAL STRUCTURE THEORY

Definitions used in Capital Structure

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Patterns / Forms of Capital Structure
Following are the forms of capital structure:     Complete equity share capital;

CAPITAL STRUCTURE THEORY

Different proportions of equity and preference share capital; Different proportions of equity and debenture (debt) capital and Different proportions of equity, preference and debenture (debt) capital.

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Assumption of Capital Structure Theories
There are only two sources of funds i.e.: debt and equity.

CAPITAL STRUCTURE THEORY

 The total assets of the company are given and do not change. [Investment decision is assumed to be constant].  The total financing remains constant. [Total capital is same, but proportion of debt and equity may be changed].  Operating profits (EBIT) are not expected to grow.  All the investors are assumed to have the same expectation about the future profits.  Business risk is constant over time and assumed to be independent of its capital structure and financial risk.  Corporate tax does not exit.  The company has infinite life.  Dividend payout ratio = 100%.
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CAPITAL STRUCTURE THEORY

A Conceptual Look --Relevant Rates of Return

kd = the yield on the companys debt

kd

I D

Annual interest on debt Market value of debt

Assumptions:
Interest paid each and every year Bond life is infinite Results in the valuation of a perpetual bond No taxes (Note: allows us to focus on just capital structure issues.)

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CAPITAL STRUCTURE THEORY

A Conceptual Look --Relevant Rates of Return ke = the expected return on the companys equity Earnings available to E E common shareholders ke = S = Market value of common S stock outstanding
Assumptions:
Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm
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A Conceptual Look --Relevant 2 ND Rates of Return

CAPITAL STRUCTURE THEORY

Ko = an overall capitalization rate for the firm O Earnings to all capital supplier Ko = Total Market value of the firm V Assumptions:
V = B + S = total market value of the firm Earnings to all capital supplier or EBIT=Interest plus earnings available to common shareholders

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Debt-equity Mix and the Value of the Firm
 Capital structure theories:  Traditional approach and Net income (NI) approach.  Net operating income (NOI) approach  MM hypothesis with and without corporate tax.  Millers hypothesis with corporate and personal taxes.  Trade-off theory: costs and benefits of leverage.

CAPITAL STRUCTURE THEORY

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CAPITAL STRUCTURE THEORY

Net Income Approach

A change in the proportion in capital structure will lead to a corresponding change in Ko and V. Assumptions: (i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the risk perception of investors. (iv) Cost of debt and cost of equity remains constant;

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Net Income (NI) Approach
 According to NI approach both the
Cost

CAPITAL STRUCTURE THEORY

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.
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ke, ko

ke

kd

ko kd

Debt

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CAPITAL STRUCTURE THEORY

Formula used for NI Approach

Net Income [NI] = EBIT Debenture Interest. Market Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D] Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke] Market value of Debt [D] = Interest [I] / Cost of Debt [Kd] Cost of Capital [Ko or R] = EBIT / V * 100 or EBIT/ (E+D) * 100

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CAPITAL STRUCTURE THEORY

Net Operating Income Approach

There is no relation between capital structure and Ko and V. Assumptions:  Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage.  The market capitalizes the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity;  The market value of equity is residue [i.e., Total value of the firm minus market value of debt)  The use of debt funds increases the received risk of equity investors, there by ke increases  The debt advantage is set off exactly by increase in cost of equity.  Cost of debt (Ki) remains constant  There are no corporate taxes.

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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 flows all the debt of and the equity securities will receive the same cash regardless capital structure and therefore, value of the company is the same.
ost

CAPITAL STRUCTURE THEORY

o d

ebt

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CAPITAL STRUCTURE THEORY

Formula used for NOI Approach

Value of the Firm [V] = EBIT / Ko Market Value of Equity [E] = V D Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT I / V-D

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MM Approach Without Tax: Proposition I

CAPITAL STRUCTURE THEORY

 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.

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MMs Proposition II

CAPITAL STRUCTURE THEORY

 The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firms debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.

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MM Hypothesis With Corporate Tax


CAPITAL STRUCTURE THEORY

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the allequity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

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        Profitability Solvency Return Risk Flexibility Capacity Control Conservatism

CAPITAL STRUCTURE THEORY

Features of an Appropriate Capital Structure

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