CAPITAL STRUCTURE

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.

Net Income (NI) Approach

This approach is developed by Durand.
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. This approach has no basis in reality.

The optimum capital structure would be 100 per cent debt financing under NI approach.

Assumptions
There are no taxes.
Cost of debt is less than cost of equity. Use of debt in capital structure does not change the risk perception of investors. Cost of debt & cost of equity remains constant.

Increase of debt (cheapest source) in capital structure reduces cost of capital k0, there is no change in cost of equity leading to an increase in the total value of the firm.
Cost

Kd = Cost of debt Ke Cost of equity Ko = Cost of Capital

ke, ko ke

kd

ko kd

Debt

Net Operating Approach

Income

(NOI)

This approach is developed by Durand. It is opposite to NI approach. The capital structure of the firm is irrelevant. Any change in debt proportion in capital structure will not lead to any change in the cost of capital (ko). 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.

Assumption
Overall cost of capital remains unchanged for all degrees of leverage. The market value of form is residue (total value of firm market value of debt. The use of debt funds increases the received risk of equity investors, there by cost of equity (ke) increases. The debt advantage is set off exactly by inrease in cost of equity. The cost of debt remains the same (kd). The are no corporate taxes.

Cost ke

ko kd

Debt

Traditional Approach
It is the mid-way between NI & NOI approaches. An optimum mix of debt & equity can increase the value of firm by reducing the wieghted average cost of capital. 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

MODIGLIANI-MILLER APPROACH
ASSUMPTION Information is available at free of cost.

The same information is available for all investors.

Securities are indefinitely divisible. Investors are free to buy or sell securities. There is no transaction cost. Investors can borrow without restrictions as the same terms on which a firm can borrow.

EBIT is not affected by the use of debt.

Proposition I
It states that two pharmaceutical firms which have identical assets, have equal market share, same business condition & risk, investors have expect same rate of return & cost of capital will be the same. 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

ko

Debt MM's Proposition I

MMs Proposition II
In the absence of corporate tax, the firms capital structure does not affect its net operating income. The opportunity cost of capital depends on the firms operating risk. Firms capital structure does not affect its operating risk, there is no need for opportunity cost of capital to change with firms capital structure.

Cost ke

ko

kd

Debt MM's Proposition II

MM Hypothesis With Corporate Tax

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. The value of firm will increase & cost of capital will decline, if corporate taxes are allowed.

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.

TRADE-OFF THEORY
According to this theory, every firm has optimal debt-equity ratio that maximises its value. The optimal debt-equity ratio of a profitable firm with stable & tangible assets would be higher. The optimal debt-equity ratio of a unprofitable firm with risky & intangible assets would be higher. Eg. Software industry.

 Financial distress arises when a firm is not able to meet its obligations to debt-holders. For a given level of debt, financial distress occurs because of the business (operating) risk. With higher business risk, the probability of financial distress becomes greater. Determinants of business risk are:
Cyclical variations Intensity of competition Price fluctuations Firm size and diversification Stages in the industry life cycle

Cost of Financial Distress

Demoralised employee. Customer fear about quality of product/service. Suppliers discontinue credit. Investors become concerned. Shareholder start selling share if firm is at financial distress but solvent. Manager starts pocketing firm resources. Agency cost conflict of interest among shareholders, management & debt-holder.

SIGNALING THEORY
Firm prefer to rely on internal accruals like retained earnings, depreciation cash flow. Expected future investment opportunities and expected future cash flow influence dividend payout. The dividend payout is fixed in such a way so that capital expenditure are covered by internal accruals. Dividend are raised higher only when firm believes that it can be maintained. Dividend are not lowered unless things are very bad.

 If internal accruals of firm exceeds capital expenditure, it will invest in marketable securities, reduce debt, raise dividend or buyback its shares. If internal accruals of firm are less than nonpostponable capital expenditure, it will adopt pecking order of financing. Pecking order of financing
Internal financing (retained earning). Debt finance Equity finance

Features of an Appropriate Capital Structure

Return Risk Flexibility Capacity Control

Practical Considerations in Determining Capital Structure

Control Nature of business. Size of business Flexibility Loan repayment ability. Early Repay ability Marketability Market Conditions Flotation Costs Capacity of Raising Funds