CAIPCC/Paper3/FinMgt/FinDecisions/CapitalStructure

Capital Structure Decisions

CA Navin Khandelwal
 Learning Objectives:

u A “Capital structure”
u An optimal capital structure
u Value of firm
u EBIT-EPS
u Break Even or Indifference Analysis
u Constructing and interpreting an EBIT-EPS chart
u Test learning by illustrative examples
Optimum Capital Structure
 Optimum capital structure

u Is the capital structure at which the weighted

average cost of capital is minimum and thereby
maximum value the firm.
u The optimum capital structure minimizes the firms
overall cost of capital and maximizes the value of the
firm.
u Optimum capital structure is also referred as
“ appropriate capital structure”
Factors determining Capital Structure
 Theories of capital structure
Basic assumptions:

• There are only two sources of funds used by a firm: perpetual

risk less debt and ordinary shares.
• There are no corporate taxes. This assumption is removed
later.
• 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.
• The total assets are given and do not change. The investment
decisions are in other words assumed to be constant.
• The operating profits (EBIT) are not expected to grow.
 Factors determining capital structure

Factors

Internal External
•Cost of capital •Economic conditions
•Risk factor •Interest rates
•Control factor •Policy of lending
•Objectives •Tax policies
•Constitution of the company
•Statutory restrictions
•Attitude of the management
Theories of capital structure
 Theories of capital structure…. Contd.

• 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.
• All investors are assumed to have same subjective probability
distribution of the future expected EBIT for a given firm.
• Business risk is constant over time and is assumed to be
independent of its capital structure and financial risk.
• Perpetual life of the firm.
Approaches to Capital Structure
Approaches to Capital Structure

u Net Income NI approach

u Net Operating Income NOI approach
u Modigliani Miller MM approach
u Traditional approach
Net Income Approach
 Net Income Approach
u This approach is given by ‘Durand David’
u Assumptions: this approach is based on three assumptions
u There are no taxes
u Cost of debt is less than the cost of equity
u Use of debt does not change the risk perception of the investor.

u According to this approach, the capital structure decision is

relevant to the valuation of the firm.
u A change in the capital structure causes a overall change in
the cost of capital and also in the total value of the firm.
 Net Income Approach
u 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.
u 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.
u NI Net Income= EBIT-I or earnings available to equity share holders.
u Value of the firm:
market value of debt
+ market value of equity.
Net Income Approach
Overall 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 Income Approach
u Net income approach view of capital structure:

Cost of equity

Average cost of capital

Cost of
capital Cost of debt

Degree of leverage
Net Operating Income NOI approach
 Net Operating Income Approach
u This is another theory suggested by Durand
u NOI approach is opposite to NI approach
u 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
u 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
Net Operating Income Approach: Assumptions
u 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
u The overall cost of capital (ko) of the firm is constant
and depends upon the business risk which also is
assumed to be unchanged
u The cost of debt (kd) is also constant
u There is no tax
u 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)
 NOI Approach: Propositions
NOI approach is based on the following prepositions:
Overall cost of capital/ capitalization rate (ko) is constant:
NOI 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) + Bt
ke
B= value of debt
 NOI Approach: Prepositions
NOI approach is based on the following prepositions:
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
 NOI Approach: Prepositions
Change in cost of equity capital
u The cost of equity capital (Ke) increases with the degree of
leverage.
u 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.
u To compensate for the increased risk to the ordinary
shareholders would expect a higher rate of return on their
investment.
u The increase in the equity capitalization rate would match in
the increase in debt equity ratio.
Optimal Capital Structure
 Optimal Capital Structure

u The total value of the firm is unaffected by its capital

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

bhushan
 Optimal Capital Structure

ke

Cost of
capital
ko

ki

Degree of leverage
Modigliani Miller Approach
 Modigliani Miller (MM) Approach

u The M.M thesis relating to the relationship between the

capital structure, cost of capital and valuation is akin to
the NOI approach.

u The NOI approach does not provide operational or

behavioral justification for the irrelevance of the capital
structure.

u 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.
MM Approach: Assumptions
“Perfect capital market”
u Securities are infinitely divisible
u Investors are free to buy/ sell securities
u Investors can borrow without restrictions on the same
terms and conditions as the firm can
u There are no transactions costs
u Information is perfect, that is each investor has same
information which is readily available to him without
cost; &
u Investors are rational and behave accordingly.
 MM Approach: Assumptions.. Contd...
u 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
u Business risk is equal among all the firm within similar
operating environment, that means all the firms can be
divided into “equivalent risk class”.
u 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
u The dividend payout ratio 100%
u There are no taxes. (This assumption is removed later)
 MM Approach: Propositions
There are three basic proposition of M.M approach.
Preposition One
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 Approach: Proposition 1

Ko %

Degree of leverage
(B/V)
 MM Approach: Propositions
Proposition 2
The second proposition of M.M approach is that the ke is
equal to the capitalization rate of a pure equity stream plus
a premium for financial risk equal to the difference
between the pure equity capitalization rate (ke) and (ki)
times the ratio of debt to equity.
In other words “ke increases in the manner to offset exactly
the use of a less expensive source of funds represented by
debt” or
The rate of return required by the shareholders increases
linearly as the debt/equity ratio is Increased.
Ke(L) = Ke(u)+[(ke(u)-ki)*D/E]
 MM Approach: Propositions

Proposition Three
The cut-off rate for the investment purpose is completely
independent of the way in which an investment is financed.
The cut off rate for investment will be in all cases the WACC .
Criticism of MM approach

uRisk perception
uConvenience
uCost
uInstitutional restrictions
uDouble leverage
uTransaction cost
uTaxes
Traditional Approach
 Traditional approach : WHY?
u The net income approach (NI) as well as net operating income
approach(NOI) represent two extremes as regards the
theoretical relationship b/w:
“Capital Structure”
“Weighted Average Cost of Capital”
“Value of the firm”
u NI Approach: Use of debt in the capital structure will always
affect the overall cost of capital and the total valuation
NOI approach: argues- “capital structure is totally irrelevant”
u The MM Approach supports the NOI approach. But the
assumptions of MM approach are of doubtful validity.
 Traditional approach : WHY?

u The traditional approach is the midway between the NI and

NOI approaches.
u It partakes of some features of both these approaches.
“Thus also known as Intermediate approach”
u It resembles or agrees with the NI approach in arguing that
cost of capital and total value of the firm are not independent
of the capital structure. But it dose not agree with the view
that the value of firm will necessarily increase at all degrees of
leverage .
 Traditional approach : WHY?
u It shares a feature with NOI approach also that beyond a
certain degree of leverage, the overall cost increases leading to
decrease in the total value of the firm. And it differs with NOI
approach in that it dose not argue that the weighted average
cost of capital is constant for all degrees of leverage.
u The crux of traditional view relating to leverage and valuation
is that through judicious use of debt-equity proportions, a firm
can increase its total value and there by reduce its over all cost
of capital.
u The rationale behind this view is that debt is relatively cheaper
source of funds as compared to ordinary shares.
 Traditional approach : WHY?

u With a change in the leverage, that is , using more

debt in place of equity, a relatively cheaper source of
fund replaces a source of fund which has relatively
higher cost. This obviously causes a decline in the
over all cost of capital.
u If the debt-equity ratio is raised further, the firm
would become financially more risky to the investors
who will penalize the firm by demanding a higher
equity capitalization rate (ke). But the increase in ke
may not be so high to neutralize the benefit of using
cheaper debt.
 Traditional approach : WHY?

If, however, the debt is increased further two things are

likely to happen:
owing to increased financial risk ke will record a
substantial rise
(ii) the firm would become very risky to creditors who also
would be compensated by a higher return such that ki
will rise
 Traditional approach : WHY?

u The use of debt beyond a certain point will,

therefore, have the effect of raising the weighted
average cost of capital and conversely reducing the
total value of the firm.
u Thus up to a point the use of debt will favorably
affect the value of the firm; beyond that point use of
debt will adversely affect the value of the firm. At
that level of debt-equity ratio, the capital structure is
an optimal capital structure.
Over all cost of capital and optimum leverage
Cost of equity
Ke

Cost of WACC
capital

Cost of debt
Ki

Optimum level of
capital

Degree of leverage
Overall Cost of Capital & Value of Firm

Market
value

Value of firm

Value of equity
Value of debt

Optimum level of capital

Degree of leverage
 EBIT-EPS analysis

u EBIT-EPS analysis should be considered logically as the first

step in the direction of designing a firm’s capital structure.
u EBIT-EPS analysis shows the impact of various financing
alternatives on EPS at various levels of EBIT.
This analysis is useful for two reasons
u The EPS is the measure of firms performance given the P/E
ratio, the larger the EPS the larger would be the value of the
firm
u The EBIT-EPS analysis information can be extremely useful to
finance manager in arriving at an appropriate financing
decision.
 EBIT -EPS Analysis

u In general, the relationship between EBIT and EPS is as

follows
EPS= (EBIT-I) (1-t)
N
Where
EPS= earning per share
EBIT= earnings before interest and tax
I= interest
t= tax
N= number of equity shares
 Break even EBIT level or Indifference point

u The breakeven EBIT for two alternative financing plans

is the level of EBIT for which the EPS is the same under
both the financing plans.
(EBIT-I) (1-t) = (EBIT-I) (1-t)
N N
 Financial breakeven

u 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.

u If EBIT is less than financial break even point, then

EPS will be negative
u 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.
Choices for CAPITAL STRUCTURE

DEBT EQUITY PREFERENCE

DEBT DEBT
EQUITY
PREFERENCE EQUITY
PREFERENCE

DEBT+EQUITY+PREFERENCE
Illustrative Examples
Total Capital Required Rs. 10,00,000
EBIT Rs. 500,000
Assume Corporate Tax 50%
Case – 1 Only Debt
Case – 2 Only Equity
Case – 3 Only Preference
Case – 4 Debt + Equity
Case – 5 Equity + Preference
Case - 6 Debt+Preference
Case – 7 Debt+Equity+Preference
Illustrative Examples- Case 1- Only Debt

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 100,000

PBT(Profit Before Tax) Rs. 400,000
(-) Tax @ 50% Rs. 200,000
PAT(Profit After Tax) Rs. 200,000
Illustrative Examples- Case 2- Only Equity

EBIT Rs. 500,000

(-) Interest @ 10% Nil

PBT(Profit Before Tax) Rs. 500,000
(-) Tax @ 50% Rs. 250,000
PAT(Profit After Tax) Rs. 250,000
No. of Eq. Shareholders 100,000
EPS (Earning/Share) Rs. 2.50/Share
Illustrative Examples- Case 3- Only Preference

EBIT Rs. 500,000

(-) Interest @ 10% Nil

PBT(Profit Before Tax) Rs. 500,000
(-) Tax @ 50% Rs. 250,000
PAT(Profit After Tax) Rs. 250,000
(-) Pref. Dividend @ 10% Rs. 100,000
NPAT (Net PAT) Rs. 150,000
Illustrative Examples- Case 4- Debt + Equity

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 50,000

PBT(Profit Before Tax) Rs. 450,000
(-) Tax @ 50% Rs. 225,000
PAT(Profit After Tax) Rs. 225,000
No. of Eq. Shareholders 50,000
EPS (Earning/Share) Rs. 4.50/Share
Illustrative Ex.- Case 5- Equity + Preference

EBIT Rs. 500,000

(-) Interest @ 10% NIL

EBT(Earning Before Tax) Rs. 500,000
(-) Tax @ 50% Rs. 250,000
EAT(Earning After Tax) Rs. 250,000
(-)Preference dividend Rs. 50,000
NPAT Rs. 200,000
/No. of Equity share 50,000
EPS Rs. 4
Illustrative Ex.- Case 6- Debt + Preference

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 50,000

EBT(Earning Before Tax) Rs. 450,000
(-) Tax @ 50% Rs. 225,000
EAT(Earning After Tax) Rs. 225,000
(-)Preference dividend Rs. 50,000
NPAT Rs. 175,000
Illus. Ex.- Case 7- Debt + Equity +Preference

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 20,000

EBT(Earning Before Tax) Rs. 480,000
(-) Tax @ 50% Rs. 240,000
EAT(Earning After Tax) Rs. 240,000
(-)Preference dividend Rs. 30,000
NPAT Rs. 210,000
No. of Equity Share 50,000
EPS Rs. 4.20/Share
 Comparison of Results
CASE PAT EPS

Only Debt Rs. 400,000 N.A.

Only Equity Rs. 250,000 Rs. 2.50/Share
Only Preference Rs. 250,000 N.A.
Debt + Equity Rs. 225,000 Rs. 4.50/Share
Equity + Preference Rs. 250,000 Rs. 4.00/Share

Debt+Preference Rs. 225,000 N.A.

Debt+Equity+ Rs. 240,000 Rs. 4.20/Share
Preference
Questions asked in Exams 2 (May 2003)
Calculate the level of EBIT at which EPS indifference point b/w following
financing alternatives will occur.
1. Equity Share capital of Rs. 600,000; 12% debentures of Rs. 400,000.
2. Equity Share capital of Rs. 400,000; 14% preference shares of Rs.
200,000 and 12% debentures of Rs. 400,000.
Assume the company is in 35% tax bracket and par value of equity share is
Rs. 10 in each case.