Capital Structure Policy

Capital Structure, Cost of Capital,

and the Value of the Firm
 Key issues:
 What is the relationship between capital structure
and firm value?
 What is the optimal capital structure?

satya acharya 2
1. Basics of Financial Leverage
 Ignoringtaxes, and assuming a firm needs 500,000 shares if it
uses no debt financing:
A. With no debt:
EPS = EBIT/500,000
B. With Rs2,500,000 in debt at 10% -- view debt as an annuity,
principal needn’t be paid back at maturity:

EPS = (EBIT - Rs______)/250,000

satya acharya 3
 Relationship between EBIT and ESP under different
capital structure

EBIT Rs200K Rs500K Rs1000

K
EPS (No 0.4 1.0 2.0
Debt)
EPS (D/E = -0.2 1.0 3.0
1)
satya acharya 4
Financial Leverage, EPS and EBIT
EPS
(Rs)
3 D/E =
1
2.5

2
D/E =
1.5 0
1

0.5 Note: Gains and losses to

shareholders are
0
magnified through
– 0.5 leverage
–1
EBIT (Rs millions, no
taxes)
0 0.2 0.4 0.6 0.8 1

satya acharya 5
What is the cross point?
Set EPS in A and B equal, we have
EBIT = Rs500,000

So EPS = Rs_ __ /share

What is meant by this point?

satya acharya 6
Break-Even EBIT
 Find EBIT where EPS is the same under both
the current and proposed capital structures
 If we expect EBIT to be greater than the
break-even point, then leverage is beneficial
to our stockholders
 If we expect EBIT to be less than the break-
even point, then leverage is detrimental to our
stockholders
satya acharya 7
Choosing a Capital Structure
 What is the primary goal of financial
managers?
 Maximize stockholder wealth
 We want to choose the capital structure that
will maximize stockholder wealth
 We can maximize stockholder wealth by
maximizing firm value or minimizing WACC

satya acharya 8
The Effect of Leverage
 How does leverage affect the EPS and ROE of a
firm?
 When we increase the amount of debt financing, we
increase the fixed interest expense
 If we have a really good year, then we pay our fixed cost
and we have more left over for our stockholders
 If we have a really bad year, we still have to pay our fixed
costs and we have less left over for our stockholders
 Leverage amplifies the variation in both EPS and
ROE
satya acharya 9
 What is “Capital Structure”?
 Definition
The Capital Structure of a firm is the mix of different securities
issued by the firm to finance its operations.
 Bonds, Bank loans
 Equity, Preferences shares
 Warrants

 What is the optimal capital structure?

 Debt/equity mix
 Maturity structure of debt
 Option features
 Currency-mix

satya acharya 10
Assumptions
 Only two source of funding, perpetual debt and
equity capital
 No corporate Tax
 The dividend Pay out ratio is 100%
 Total assets are given and no change on them
 Business Risk is const and irrespective of the
financial risk of the firm
 All investor have the same subjective probability
distribution of future expected earning of the firm

satya acharya 11
 Value of Equity = Net Income/Cost of Equity
 Value of Debt = Interest/Cost of Debt
 Value of Firm = Value of Debt + Value of
Equity
 Firm’s cost of Capital = Net Operating
Income/Value of Firm
 WACC = Kd x prop of Debt + Ke x Prop of
Equity
satya acharya 12
Debt-equity Mix and the Value
of the Firm
 Capital structure theories:
 Net operating income (NOI) approach.(Durand)
 Net income (NI) approach.(Durand)
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal
taxes.
 Trade-off theory: costs and benefits of leverage.

satya acharya 13
 Net Income (NI) Approach
According to NI approach both
the cost of debt and the cost of
equity are independent of the C ost

capital structure; they remain

constant regardless of how much
debt the firm uses. As a result,
ke, ko ke
the overall cost of capital
declines and the firm value ko
increases with debt. This kd kd

approach has no basis in reality;

the optimum capital structure
would be 100 per cent debt D ebt

financing under NI approach.

satya acharya 14
Net Income (NI) Approach
V = E + D = NOI - Int / Ke + Int / Kd
= NOI – Kd D / Ke + Kd D/ Kd
= NOI / Ke + D – KdD/ Ke
= NOI / Ke + D ( 1 – Kd / Ke )
The firm will substitute debt for equity and so long as Ke and Kd
are constant, the value of the firm V increases buy debt multiplied
by a constant rate (Ke -Kd) / Ke

satya acharya 15
Net Income (NI) Approach
Leverage( 0.00 18.18 33.34 46.15 66.67 94.74 100
D/V)

NOI 100 100 100 100 100 100 100

Int - 10 20 30 50 90 100
NI 100 90 80 70 50 10 -
Kd 5 5 5 5 5 5 5
Ke 10 10 10 10 10 10 10
E 1000 900 800 700 500 100 0
D 0 200 400 600 1000 1800 2000
V 1000 1100 1200 1300 1500 1900 2000
satya acharya 16
 Net Operating Income (NOI) Approach

According to NOI approach the

value of the firm and the C ost
weighted average cost of capital ke
are independent of the firm’s
capital structure. In the absence
of taxes, an individual holding all ko
the debt and equity securities
will receive the same cash flows kd

regardless of the capital

structure and therefore, value of D ebt
the company is the same.

satya acharya 17
Net Operating Income (NOI) Approach

 The overall capitalization rate of the firm remain

constant
V = EBIT/ Ko
 Residual value of Equity : S = V-B
 The equity capitalization rate increases with degree
of leverage
 Ke = Ko + (Ko – Ki) B/S
 Cost of debt has two component , Explicit Cost and
Implicit Cost
satya acharya 18
Net Operating Income (NOI) Approach
 Operating Income Rs EBIT 50 50 50
50,000 ,cost of debt
Ko .125 .125 .125
10% ,outstanding debt
Rs 200,000 . Its overall V 400 400 400
cost of capital is 12.5%
.Value of the firm and B 200 300 100
equity capitalization
S 200 100 300
rate .
Ke. .15 .20 .133
satya acharya 19
Traditional Approach

The traditional approach argues that moderate degree

of debt can lower the firm’s 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.

satya acharya 20
Capital Structure Does not Matter!
The Modigliani-Miller Propositions
 Under the assumption that:
 There are no taxes. and Full Pay out
 Perfect Capital Markets
 Homogeneous Risk Classes
 The investment and operating policies of the firm are given.
☛ the value of a firm is independent of its capital structure

(MM Proposition I).

 However,
 Assumptions are not realistic.
 Focus on cases where one of the assumptions are violated.
satya acharya 21
Capital Structure Theory Under Three
Special Cases
 Case I – Assumptions
 No corporate or personal taxes
 No bankruptcy costs
 Case II – Assumptions
 Corporate taxes, but no personal taxes
 No bankruptcy costs
 Case III – Assumptions
 Corporate taxes, but no personal taxes
 Bankruptcy costs
satya acharya 22
No Taxes or Bankruptcy Costs
 Proposition I
 The value of the firm is NOT affected by changes
in the capital structure
 The cash flows of the firm do not change,
therefore value doesn’t change
 Proposition II
 The WACC of the firm is NOT affected by
capital structure

satya acharya 23
Arbitrage
U L
Net Op In 10000 10000
Int (6%) 0 3000
Net Income 10000 7000
Ke .100 .177
M V of Equity 100000 60000
MV OF Debt 0 50000
Value of Firm 100000 110000
WACC 0.10 satya acharya
.091 24
Arbitrage
Return fromLevered Firm:
Investment =
%10 ( − , 50=000
110,000 =) 60,000, ( 6 000
10% )
Return  − ×6% ( 50,000
=10% 10,000
 = − 1
=,000) 300 700
Alternate Strategy:
L 60,000× 6,000
1. Sell shares in : 10% =
2. Borrow(personal leverage): 10% ×
50,000= 5,000
3. Buy shares in : 10% × 10,000
U 100,000 =
Return fromAlternate Strategy:
Investment =10,000
Return =10%× 10,000
= 1,000
= ×
Less : Interest on personal borrowing 6% 5,000 3 = 00
= −
Net return 1,000 300 =700
=
Ca sh available 11,000 −
10,000=1,000
satya acharya 25
 Investment Return
Inv In L’s Share α ( Vl-Dl) α ( X –Kd Dl)

Vl > Vu

Buy U Share α Vu αX
Borrow debt - α Dl - α Kd Dl
α ( Vl-Dl) α ( X –Kd Dl)
satya acharya 26
 MM’s Proposition II
The cost of equity for a levered firm
equals the constant overall cost of C ost
capital plus a risk premium that ke
equals the spread between the overall
cost of capital and the cost of debt
multiplied by the firm’s debt-equity
ratio. For financial leverage to be
irrelevant, the overall cost of capital ko
must remain constant, regardless of
the amount of debt employed. This kd
implies that the cost of equity must
rise as financial risk increases.

D ebt
M M 's P r o p o s iti o n II

satya acharya 27
MM Propositions I and II
MM Proposition I :
X
V=
ko
X
ko =
V
MM Proposition II :
X − kd D
ke =
S
ke = ko + (ko − kd )D/S

satya acharya 28
 An all equity financed company has 10000
shares outstanding. The market value of these
Rs120,000.The expected operating income is
Rs 18,000.EPS,1.8.
 Ke = 18000/120000 = .15
 It is borrowing Rs 60000 at 6%
 EPS = 18000-3000/5000= 2.88
 Ke = .15 + (.15 -.06)1= 24%
satya acharya 29
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. 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
all-equity 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.

satya acharya 30
LEVERAGEBENEFITUNDERCORPOATEANDPERSONALTAXES

Unlev Lev Unlev Lev

Corptax 0% 0% 35% 35%
Corptaxondiv 0% 0% 10% 10%
Perstaxondiv 0% 0% 0% 0%
Perstaxonint 0% 0% 0% 0%

PBIT 2500 2500 2500 2500

Int 0 700 0 700
PBT 2500 1800 2500 1800
Corptax 0 0 875 630
PAT 2500 1800 1625 1170
Div 2500 1800 1477 1064
Divtax 0 0 148 106
Tol corptax 0 0 1023 736

Divincom e 2500 1800 1477 1064

Perstaxondiv 0 0 0 0
ATdivincom e 2500 1800 1477 1064
Int incom e 0 700 0 700
Perstaxonint 0 0 0 0
ATint incom e 0 700 0 700
ATtotal incom e 2500 2500 1477 1764
N et leveragebenifit 0 287

satya acharya 31
MM Hypothesis with Corporate Tax
After-tax earnings of Unlevered Firm:
T
X =X −
(1T )
Value of Unlevered Firm:
X (1 −
T)
Vu =
ku
After-tax earnings of Levered Firm:
T
X =X
( −k Dd− + ) k Dd
)(1 T
= X− +) Tk Dd
(1 T
Value of Levered Firm:
X (1 −
T) Tk dD
Vl = +
ku kd
satya acharya
=V+
u TD 32
 LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES

Unlev Lev Unlev Lev Unlev Lev Unlev Lev Unlev Lev
Corp tax 0% 0% 35% 35% 35% 35% 35% 35% 35% 35%
Corp tax on div 0% 0% 10% 10% 10% 10% 10% 10% 10% 10%
Pers tax on div 0% 0% 0% 0% 20% 20% 20% 20% 20% 20%
Pers tax on int 0% 0% 0% 0% 0% 0% 20% 20% 30% 30%

PBIT 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500
Int 0 700 0 700 0 700 0 700 0 700
PBT 2500 1800 2500 1800 2500 1800 2500 1800 2500 1800
Corp tax 0 0 875 630 875 630 875 630 875 630
PAT 2500 1800 1625 1170 1625 1170 1625 1170 1625 1170
Div 2500 1800 1477 1064 1477 1064 1477 1064 1407 1064
Div tax 0 0 148 106 148 106 148 106 148 106
Tol corp tax 0 0 1023 736 1023 736 1023 736 1023 736

Div income 2500 1800 1477 1064 1477 1064 1477 1064 1407 1064
Pers tax on div 0 0 0 0 295 213 295 213 281 213
AT div income 2500 1800 1477 1064 1182 851.2 1182 851.2 1126 851.2
Int income 0 700 0 700 0 700 0 700 0 700
Pers tax on int 0 0 0 0 0 0 0 140 0 210
AT int income 0 700 0 700 0 700 0 560 0 490
AT total income 2500 2500 1477 1764 1182 1551 1182 1411 1126 1341
Net leverage benifit 0 287 370 230 216

satya acharya 33
 When corporate tax rate and equity income
personal tax rate decreases ,the advantage of
borrowing decreases.
 The benefit also when personal tax rate on
interest income increases.
 When the firm will stop borrowing?

satya acharya 34
Miller’s Approach with Corporate
and Personal Taxes
After-tax earnings of Unlevered Firm:
T
X =X (1
− T )(1
− T )e
Value of Unlevered Firm:
X (1 −T )(1− T )e
Vu =
ku
After-tax earnings of Levered Firm:
T
X = (X − k Dd )(1
− T− + )e k −
)(1 T Dd (1 T d)
= X (1
− T )(1
− T+ )e k − d −T ) d k
D (1 − Dd(1−T )(1d T ) e

Va lue of Levered Firm:

X (1 −T )(1− T )e kdD [ (1 −
Td )− (1−T )(1
− Te ) ]
Vl = +
ku (1 −T e) kd−(1 T b)
 (1 − T)(1− T)e
= Vu+ D −1 
 (1 −
satya acharya T)
b 35
 Value of levered firm = Vu + PV of Interest tax
shield
 If personal taxes do not exist then value
=Vu+TD
 If personal tax rate on int > equity the present
value of tax shield will be less than TD

satya acharya 36
 Miller assume that personal tax rate on equity income =
0.The investor will prefer to invest in equity.
 Firm will borrow to reduce the corporate tax
 Tax paying investor will be attracted if the firm offer
them a higher pre tax return..10 (1-.2) = 12.5.Income tax
is progressive.
 The firm will stop borrowing when personal tax rate
equals to corporate tax rate,
the interest rate = kd/(1-T)
satya acharya 37
%
Demand rate of
interest
id = io/(1 – Tb)

is= io/(1 – Tc)

Supply rate
of interest

Borrowing

satya acharya 38
 U L
NoI 100 100
Int 0 50
IBT 100 50
Corp tax rate (35%) 35 17.5
IAT 65 32.5
Income to share holder 65 32.5
Div tax(12.5%) 7.22 3.61
Div 57.78 28.89
Personal tax on Div 0 0
Div after tax 57.78 28.89
Int to debt holder 0 50
Per tax on Int(30%) 0 15
Int after tax 0 35
Total income to Investor 57.78 63.89
Int tax shield satya acharya 6.11 39
Financial Distress
 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:
 Operating leverage (fixed and variable costs)
 Cyclical variations
 Intensity of competition
 Price fluctuations
 Firm size and diversification
 Stages in the industry life cycle

satya acharya 40
Consequences of Financial Distress
 Bankruptcy costs
Specific bankruptcy costs include legal and administrative
costs along with the sale of assets at “distress” prices to
meet creditor claims. Lenders build into their required
interest rate the expected costs of bankruptcy which reduces
the market value of equity by a corresponding amount.
 Indirect costs
 Investingin risky projects.
 Reluctance to undertake profitable projects.

 Premature liquidation.

 Short-term orientation.

satya acharya 41
Debt Policy and Shareholders Conflicts
 Shareholder—manager conflicts
 Managers have a tendency to consume some of the firm’s
resources in the form of various perquisites.
 Managers have a tendency to become unduly risk averse and
shirk their responsibilities as they have no equity interest or
when their equity interest falls. They may be passing up
profitable opportunities.
 Shareholder—bondholder conflicts
 Shareholder value is created either by increasing the value of
the firm or by reducing the the value of its bonds. Increasing the
risk of the firm or issuing substantial new debt are ways to
redistribute wealth from bondholders to shareholders.
Shareholders do not like excessive debt.

satya acharya 42
 Monitoring
 Outside investors will discount the prices they are willing
to pay for the firm’s securities realising that managers may
not operate in their best interests.
 Firms agree for monitoring and restrictive covenants to

assure the suppliers of capital that they will not operate

contrary to their interests.
 Agency Costs
 Agency costs are the costs of the monitoring and control
mechanisms.
 Agency costs of debt include the recognition of the
possibility of wealth expropriation by shareholders.
 Agency costs of equity include the incentive that
management has to expand the firm beyond the point at
which shareholder wealth is maximised.
satya acharya 43
Financial Distress
Maximum value of firm
Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
satya acharya 44
Optimum Capital Structure:
Trade-off Theory
 The optimum capital structure is a function of:
 Agency costs associated with debt
 The costs of financial distress
 Interest tax shield

 The value of a levered firm is:

Value of unlevered firm
+ PV of tax shield
– PV of financial distress

satya acharya 45
Pecking Order Theory
The announcement of a share issue reduces the share price because
investors believe managers are more likely to issue when shares are
overpriced.

Firms prefer internal finance since funds can be raised without

sending adverse signals.

If external finance is required, firms issue debt first and equity as a

last resort.

The most profitable firms borrow less not because they have lower
target debt ratios but because they don't need external finance.

satya acharya 46
Pecking Order Theory
Implications:
 Internal equity may be better than external
equity.
 Financial slack is valuable.
 If external capital is required, debt is better.

satya acharya 47
Features of an Appropriate Capital
Structure
 Return
 Risk

 Flexibility

 Capacity

 Control

satya acharya 48
Approaches to Establish Appropriate
Capital Structure
 EBIT—EPS approach for analyzing the
impact of debt on EPS.
 Valuation approach for determining the
impact of debt on the shareholders’ value.
 Cash flow approach for analyzing the
firm’s ability to service debt.

satya acharya 49
Cash Flow Approach to Target
Capital Structure
 Cash adequacy and solvency
 In determining a firm’s target capital structure, a key issue is the
firm’s ability to service its debt. The focus of this analysis is also
on the risk of cash insolvency—the probability of running out of
the cash—given a particular amount of debt in the capital
structure. This analysis is based on a thorough cash flow analysis
and not on rules of thumb based on various coverage ratios.
 Components of cash flow analysis
 Operating cash flows
 Non-operating cash flows
 Financial cash flows

satya acharya 50
 Reserve financial capacity
 Reduction in operating and financial flexibility is costly to
firms competing in charging product and factor markets.
Thus firms need to maintain reserve financial resources in
the form of unused debt capacity, large quantities of liquid
assets, excess lines of credit, access to a broad range of fund
sources.
 Focus of cash flow analysis
 Focus on liquidity and solvency
 Identifies discretionary cash flows

 Lists reserve financial flows

 Goes beyond financial statement analysis

 Relates debt policy to the firm value

satya acharya 51
 Cash Flow Analysis Versus EBIT–
EPS Analysis
 The cash flow analysis has the following advantages
over EBIT–EPS analysis:
 It focuses on the liquidity and solvency of the firm over a long-
period of time, even encompassing adverse circumstances. Thus, it
evaluates the firm’s ability to meet fixed obligations.
 It goes beyond the analysis of profit and loss statement and also
considers changes in the balance sheet items.
 It identifies discretionary cash flows. The firm can thus prepare an
action plan to face adverse situations.
 It provides a list of potential financial flows which can be utilized
under emergency.
 It is a long-term dynamic analysis and does not remain confined to a
single period analysis.
satya acharya 52
Practical Considerations in Determining
Capital Structure
 Control
 Widely-held Companies
 Closely-held Companies
 Flexibility
 Loan Covenants
 Early Repay ability
 Reserve Capacity
 Marketability
 Market Conditions
 Flotation Costs
 Capacity of Raising Funds
 Agency Costs
satya acharya 53