Capital Structure Theories

Capital Structure Decisions

 Decision Dilemma: Big Question

How much debt should be employed in the

business?

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 Keep in Mind
• Objective of a firm  Maximization of the firm’s value

• Capital structure decision  Examine from the point of its impact on

the value of the firm

• Value of a firm = function (Cost of capital)  Study the impact of

leverage on cost of capital

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 Capital Structure Theories
Impact of different debt levels (gearing levels) on WACC

• WACC = function of (Component cost)

• Component cost = Cost of equity, preference share, debt  Function of
investors’ expectations

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 Effect of Varied Capital Structures on WACC
• While considering the effect of different capital structures on WACC,
focus on the action of two competing forces:
1. Debt finance is a cheaper than equity finance  As a company gears
up (the proportion of debt in the capital structure increases), all
other things being equal WACC will decrease.
2. As a company gears up, shareholders’ risk increases  For this extra
risk, the shareholders require extra returns, all other things being
equal WACC will increase.

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 Effect of Varied Capital Structures
on WACC
• Overall effect on the WACC depends upon the relative size
and strength of these two opposing forces

• Two school of thoughts:

– Capital structure is relevant – Optimum capital structure exists
– Capital structure is irrelevant – No optimum capital structure exists
(Based on the assumption that value is a function of investment)

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 Theories of Capital Structure
• Net Income theory
• Traditional theory
• Modigliani-Miller (MM) theory – Without and with taxes
• Trade off theory
• Signaling theory
• Pecking order theory

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Relevance of Capital Structure
Net Income Theory and
Traditional Theory

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Net Income (NI) Approach

Effect of leverage on the cost of capital under NI approach

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 Net Income (NI) Approach
• Kd and Ke  Remain constant regardless of how much debt the firm
uses i.e. Kd and Ke are independent of the capital structure

• Impact on Ko  Declines  Firm value increases with debt

• Optimum capital structure  100% debt financing

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Traditional Approach

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 Traditional Approach
• Kd  Remain constant regardless of how much debt the firm uses
• Ke  Increases with employing more debt, 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
• Ko  Declines initially but starts and the firm value increases with debt

• Moderate degree of debt can lower the firm’s overall cost of capital and
thereby, increase the firm value
• Relationship between capital structure and the firm value  First stage:
Increasing value, Second stage: Optimum value, Third stage: Declining value
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Irrelevance of Capital Structure
MM Theory without Taxes

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 MM Approach Without Tax: Proposition I
• For firms in the same risk class,
the total market value is
independent of the debt-equity
mix.
• Value of firm  Expected net
operating income/ Discount rate
• Discount rate/ Capitalisation rate
 Opportunity cost of capital
appropriate to that risk class

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Cost of capital and Value of the firm
under MM proposition I

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 MM’s Proposition II
• Financial leverage causes two opposing effects  Increases the
shareholders’ return but it also increases their financial risk 
Shareholders will increase the required rate of return (i.e., the cost of
equity) on their investment to compensate for the financial risk 
Higher the financial risk, the higher the shareholders’ required rate of
return or the cost of equity

• Ke for a levered firm > Ko

• Ke = Ko + Financial risk premium

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Relevance of Capital Structure
MM Theory under Corporate Taxes

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 MM Hypothesis: With Taxes
• MM show that the value of the firm will increase with debt due to the
tax deductibility of interest for tax computation  Value of the levered
firm will be higher than of the unlevered firm

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MM Hypothesis: With Taxes

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Value of the levered firm

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MM Hypothesis

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 Implications of the MM Hypothesis
with Corporate Taxes
• MM’s ‘tax-corrected’ view  Due to tax deductibility of interest charges,
a firm can increase its value with leverage  Optimum capital structure
is almost 100 per cent debt

• In practice  Firms do not employ large amounts of debt, nor are

lenders ready to lend beyond certain limits, which they decide

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 Trade-off Theory:
Costs of Financial Distress and Agency Costs

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 Financial Distress
• Financial distress  Arises when a firm is not able to meet its
obligations to debt-holders because of the business (operating) risk
• Higher the business risk  Higher is the probability of financial distress
• Determinants of business risk are:
– Operating leverage (fixed and variable costs)
– Cyclical variations
– Intensity of competition
– Price fluctuations
– Firm size and diversification
– Stages in the industry life cycle
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 Costs of Financial Distress

• Financial distress  Ultimately force a company to insolvency

• Direct costs of financial distress  Costs of insolvency
• Indirect costs of financial distress  Costs related to the actions of
employees, managers, customers, suppliers and shareholders

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Cont…

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Value of Levered Firm under Corporate Taxes & Financial Distress

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 Tradeoff Theory and Optimal Capital Structure
• Two factors can have a material impact on the role of capital structure in
determining firm value:
– Interest expense is tax deductible (benefit of debt)
– Debt makes it more likely that firms will experience financial distress costs
(drawback of debt)
• Firms must trade off the benefit and drawback of debt while making
financing decisions
Trade Off Theory

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 Signaling Theory
• Asymmetric information – Managers have better information than
outside investors and it affects capital structure
• Two situations
 When manager know that prospects are favorable  Expect managers to
avoid selling new stock and raise capital through debt even if debt ratio
goes up
 When manager know that prospects are unfavorable  Expect managers
to sell new stock and bring new investors to share the losses

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 Signaling Theory
• Conclusion
 Firms with extremely bright prospects prefer not to finance through new
stock offerings
 Firms with poor prospects prefer new stock issue

• Signal for the investors

 If a company announces new issue offering…
 Positive signal or negative signal?

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 Takeaway from Signaling Theory
for Capital Structure Decisions
• Issuing stock emits a negative signal so depresses the stock price,
however, even if the company’s prospects are bright, a firm should, in
normal times, maintain a reserve borrowing capacity that can be used in
the event that some especially good investment opportunity comes
along.

• This means that a firm in normal times, use more equity and less debt
than is suggested by the tax benefit model.

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 Pecking Order Theory
• Order of importance

• Managers have a preferred pecking order for raining capital and this
affects the capital structure decisions
1. Retained earnings
2. Debt
3. New share capital

• Reasons for pecking order – Flotation cost, spontaneous capital

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 Checklist for Capital Structure Decisions
• Sales stability
• Asset structure
• Operating leverage
• Loan covenants
• Flexibility
• Profitability
• Taxes
• Control
• Management attitude
• Lender and rating agency attitude
• Market conditions
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