Capital Structure

Determination

4-1

Overview of the Last

Lecture
Market Value Ratios

EPS

DPS

DPO

P/E

Common Size Analysis

Index Analysis

Capital Structure
Determination

A Conceptual Look
The Total-Value Principle
Presence of Market Imperfections and Incentive Issues
The Effect of Taxes
Taxes and Market Imperfections Combined
Financial Signaling

Capital Structure
Capital Structure -- The mix (or proportion)
of a firms permanent long-term financing
represented by debt, preferred stock, and
common stock equity.

Concerned with the effect of capital Market decisions on security prices.

Assume: (1) investment and asset management decisions are held constant and (2)
consider only debt-versus-equity financing.

A Conceptual Look --Relevant

Rates of Return
ri = the yield on the companys debt

ri =

I
B

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.)

A Conceptual Look --Relevant

Rates of Return
re = the expected return on the companys equity
Earnings available to
E
E
common shareholders
re = 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

A Conceptual Look --Relevant

Rates of Return
ro = an overall capitalization rate for the firm

ro

O
O
=
V
V

Net operating income

Total market value of the
firm

Assumptions:
V = B + S = total market value of the
firm
O = I + E = net operating income =
interest paid plus earnings available to
common shareholders

Capitalization Rate

Capitalization Rate, ro -- The discount rate

used to determine the present value of a
stream of expected cash flows.

ro = ri

B
B+S

+ re

S
B+S

Net Operating Income

Approach
Net Operating Income Approach -- A theory of
capital structure in which the weighted
average cost of capital and the total value of
the firm remain constant as financial leverage
is changed.
Assume:

Net operating income equals Rs.1,350

Market value of debt is Rs.1,800 at 10% interest

Overall capitalization rate is 15%

Net Operating Income

Approach
Lets assum that a firms Net operating income equals Rs.1,350 with Market value of debt is
Rs.1,800 at 10% interest and Overall capitalization rate is 15%
We can find out Required return on equity

What happens to ki, ke, and ko

when leverage, B/S, increases?

Required Rate of Return

on Equity
Calculating the required rate of return on
equity

Total firm value

= O / ro

Market value = V - B

= Rs.1,350 / .15

= Rs.9,000

= Rs.9,000 -Rs.1,800

of equity

= Rs.7,200

Required return

=E/S

on equity*
equity

= (Rs.1,350 - Rs.180)
Rs.180 / Rs.7,200

= 16.25%

Interest payments
= Rs.1,800 x 10%

* B / S = Rs.1,800 / Rs.7,200 = .25

Required Rate of Return

on Equity
What is the rate of return on equity if
B=Rs.3,000?

Total firm value

= O / ro

Market value = V - B

= Rs.1,350 / .15

= Rs.9,000

= Rs.9,000 - Rs.3,000

of equity

= Rs.6,000

Required return

=E/S

on equity*
equity

= (Rs.1,350 - Rs.300)
Rs.300 / Rs.6,000

17.50%
Interest=payments
= Rs.3,000 x 10%

* B / S = Rs.3,000 / Rs.6,000 = .50

Required Rate of Return

on Equity
Examine a variety of different debt-toequity ratios and the resulting required
rate of return on equity.
B/S
0.00
0.25
0.50
1.00
2.00

ri
--10%
10%
10%
10%

re
ro
15.00%
15%
16.25%
15%
17.50%
15%
20.00%
15%
25.00%
15%

Required Rate of Return

on Equity
Capital costs and the NOI approach in a
graphical representation.
Capital Costs (%)

.25

re = 16.25% and
.20 17.5% respectively
.15

re (Required return on equity)

ro (Capitalization rate)

.10

ri (Yield on debt)

.05
0

.25

.50

.75
1.0
1.25
1.50
Financial Leverage (B / S)

1.75

2.0

Summary of NOI Approach

Critical assumption is ro remains constant.

An increase in cheaper debt funds is exactly

offset by an increase in the required rate of
return on equity.
As long as ri is constant, re is a linear function
of the debt-to-equity ratio.
Thus, there is no one optimal capital
structure.
structure

Traditional Approach

Traditional Approach -- A theory of capital

structure in which there exists an optimal
capital structure and where management can
increase the total value of the firm through the
judicious use of financial leverage.
Optimal Capital Structure -- The capital structure that minimizes the firms cost of capital
and thereby maximizes the value of the firm.

Summary of the Traditional

Approach

Financial leverage can be defined as the degree

to which a company uses fixed-income
securities, such as debt and preferred equity.
With a high degree of financial leverage come
high interest payments.
As a result, the bottom-line earnings per share is
negatively affected by interest payments. As
interest payments increase as a result of
increased financial leverage, EPS is driven lower.

Optimal Capital Structure:

Traditional Approach
Traditional Approach
re

Capital Costs (%)

.25

ro

.20
.15

ri

.10
.05

Optimal Capital Structure

Financial Leverage (B / S)

Summary of the Traditional

Approach

The cost of capital is dependent on the capital

structure of the firm.

Initially, low-cost debt is not rising and replaces more

expensive equity financing and ro declines.
Then, increasing financial leverage and the associated
increase in re and ri more than offsets the benefits of
lower cost debt financing.

Thus, there is one optimal capital structure

where ro is at its lowest point.
This is also the point where the firms total value
will be the largest (discounting at ro).

Summary

Capital Structure

Required rate of return on debt and equity

Total Capitalization rate

NOI Approach

Traditional Approach