Capital Structure(7)

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Capital Structure DecisionsCapital Structure Decisions

UnitUnit -- 22



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Capital StructureCapital Structure Capital Structure refers to the combination or mix of debtCapital Structure refers to the combination or mix of debt

and equity which a company uses to finance its long termand equity which a company uses to finance its long termoperationsoperations

Raising of capital from different sources and their use inRaising of capital from different sources and their use indifferent assets by a company is made on the basis ofdifferent assets by a company is made on the basis ofcertain principles that provide a system of capital so thatcertain principles that provide a system of capital so thatthe maximum rate of return can be earned at a minimumthe maximum rate of return can be earned at a minimumcost. This sort of system of capital is known as capitalcost. This sort of system of capital is known as capitalstructure.structure.

Capital structure of a company refers to the compositionCapital structure of a company refers to the compositionor makeor make ² ² up of its capital. It includes all long term capitalup of its capital. It includes all long term capitalresources as well as short term capital resourcesresources as well as short term capital resources



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Forms/patterns of capital structureForms/patterns of capital structure Equity shares onlyEquity shares only

Equity and preference sharesEquity and preference shares

Equity shares and debenturesEquity shares and debentures

Equity shares, preference shares and debenturesEquity shares, preference shares and debentures



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ImportanceImportance Increases the value of a firmIncreases the value of a firm

Capital structure determine the risk Capital structure determine the risk assumed by the firmassumed by the firm

It determines the cost of capital of the firmIt determines the cost of capital of the firm

It affects the flexibility and liquidity of theIt affects the flexibility and liquidity of thefirmfirm

It affects the control of owners on the firmIt affects the control of owners on the firm

Works as a base for the financial decisionWorks as a base for the financial decision



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Factors Influencing CapitalFactors Influencing Capital

StructureStructure

Internal FactorsInternal Factors

External

Factors

External

Factors



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InternalF

actorsInternalF

actors Size of BusinessSize of Business

Nature of BusinessNature of Business

Regularity and Certainty of IncomeRegularity and Certainty of Income Assets Structure Assets Structure

Age of the Firm Age of the Firm

Desire to Retain ControlDesire to Retain Control

Future PlansF

uture Plans Operating RatioOperating Ratio

Trading on EquityTrading on Equity

Period and Purpose of FinancingPeriod and Purpose of Financing



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External

Factors

External

Factors

Capital Market ConditionsCapital Market Conditions

Nature of InvestorsNature of Investors

Statutory RequirementsStatutory Requirements

Taxation PolicyTaxation Policy

Policies of Financial InstitutionsPolicies of Financial Institutions

Cost ofF

inancingCost ofF

inancing Seasonal VariationsSeasonal Variations

Economic FluctuationsEconomic Fluctuations

Nature of CompetitionNature of Competition



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Optimal Capital StructureOptimal Capital Structure That capital structure or combination of debt &That capital structure or combination of debt &

equity that leads to the maximum value of firm.equity that leads to the maximum value of firm.

The optimal or the best capital structure impliesThe optimal or the best capital structure implies

the most economical and safe ratio betweenthe most economical and safe ratio between

various types of securities. various types of securities.

It is that mix of debt and equity which maximizesIt is that mix of debt and equity which maximizesthe value of the company and minimizes the costthe value of the company and minimizes the cost

of capital.of capital.



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Essentials of a Sound or OptimalEssentials of a Sound or Optimal

Capital StructureCapital Structure Minimum Cost of CapitalMinimum Cost of Capital

Minimum Risk Minimum Risk

Maximum ReturnMaximum Return Maximum ControlMaximum Control

SafetySafety

SimplicitySimplicity

FlexibilityF

lexibility Attractive Rules Attractive Rules

Commensurate to Legal RequirementsCommensurate to Legal Requirements

Sufficient liquiditySufficient liquidity

Avoidance of unnecessary restrictions Avoidance of unnecessary restrictions



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Theories of Capital StructureTheories of Capital Structure Net Income (NI) TheoryNet Income (NI) Theory

Net Operating Income (NOI) TheoryNet Operating Income (NOI) Theory Traditional TheoryTraditional Theory

ModiglianiModigliani--Miller (MMiller (M--M) TheoryM) Theory

TradeTrade--off Theoryoff Theory Signaling TheorySignaling Theory



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Net Income (NI) TheoryNet Income (NI) Theory This theory was propounded byThis theory was propounded by ´David Durandµ ´David Durandµ and isand is

also known as ´ Fixed ¶Ke· Theoryµ.also known as ´ Fixed ¶Ke· Theoryµ.

The capital structure decision is relevant for the valuationThe capital structure decision is relevant for the valuation

of the firm, a change in the financial leverage will lead toof the firm, a change in the financial leverage will lead toa change in the value of firma change in the value of firm

According to this theory a firm can increase the value of According to this theory a firm can increase the value ofthe firm and reduce the overall cost of capital bythe firm and reduce the overall cost of capital byincreasing the proportion of debt in its capital structureincreasing the proportion of debt in its capital structure

to the maximum possible extent.to the maximum possible extent.

It is due to the fact that debt is, generally a cheaper source of fundsIt is due to the fact that debt is, generally a cheaper source of funds

because:because: (i) Interest rates are lower than dividend rates due to element of risk,(i) Interest rates are lower than dividend rates due to element of risk,

(ii) The benefit of tax as the interest is deductible expense for income tax (ii) The benefit of tax as the interest is deductible expense for income tax

purpose.purpose.



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Net Income Approach : effect of leverage on cost

of capital

O X

Y

Degree of Leverage

CO

ST

O

F

C

A

P

IT

A

l

Kd

Ko

Ke

Here, Ke = cost of Equity, Kd = cost of Debt, Ko = overall cost



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Assumptions of NI Theory Assumptions of NI Theory The ¶Kd· ( cost of debt) is cheaper than theThe ¶Kd· ( cost of debt) is cheaper than the

¶Ke· ( cost of equity).¶Ke· ( cost of equity).

Income tax has been ignored.Income tax has been ignored.

There will be no corporate taxes.There will be no corporate taxes.

The ¶Kd· and ¶Ke· remain constant.The ¶Kd· and ¶Ke· remain constant.

The risk perception of investors is notThe risk perception of investors is not

changed by the use of debt.changed by the use of debt.



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Computation of the Total Value ofComputation of the Total Value of

theF

irmtheF

irm

Total Value of the Firm (V) = S + DTotal Value of the Firm (V) = S + D

Where,Where,

S = Market value of Shares =S = Market value of Shares = EBITEBIT--II == EE

Ke KeKe Ke

D = Market value of Debt = Face ValueD = Market value of Debt = Face Value

E = Earnings available for equity shareholdersE = Earnings available for equity shareholders

Ke = Cost of Equity capital or Equity capitalizationKe = Cost of Equity capital or Equity capitalization

rate.rate.



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Computation of the Overall Cost ofComputation of the Overall Cost of

Capital or Capitalization RateCapital or Capitalization Rate

K Ko =o = EBITEBIT

V V

Where,Where,

K Ko =o = Overall Cost of Capital or CapitalizationOverall Cost of Capital or CapitalizationRateRate

V = Value of the firm V = Value of the firm



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Net Operating Income Theory (NOI)Net Operating Income Theory (NOI) This theory was propounded byThis theory was propounded by ´David Durandµ ´David Durandµ

and is also known asand is also known as Írrelevant Theoryµ.Írrelevant Theoryµ.

This is just opposite to Net Income ApproachThis is just opposite to Net Income Approach According to this theory, the total market value of According to this theory, the total market value of

the firm (V) is not affected by the change in thethe firm (V) is not affected by the change in thecapital structure and the overall cost of capitalcapital structure and the overall cost of capital(Ko) remains fixed irrespective of the debt(Ko) remains fixed irrespective of the debt--equityequity

mix.mix. Any change in capital structure of the company Any change in capital structure of the company

does not affect the market value of the firm &does not affect the market value of the firm &overall cost remains constant.overall cost remains constant.



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Degree of Leverage

Kd

Ko

KeCO

S

T

OF

C

A

P

I

T

Al

Here, Ke = cost of Equity, Kd = cost of Debt, Ko = overall cost

The NOI Approach : effect of leverageThe NOI Approach : effect of leverage

on cost of capitalon cost of capital



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Assumptions of NOI Theory Assumptions of NOI Theory The split of total capitalization between debt andThe split of total capitalization between debt and

equity is not essential or relevant.equity is not essential or relevant.

The equity shareholders and other investors i.e.The equity shareholders and other investors i.e.the market capitalizes the value of the firm as athe market capitalizes the value of the firm as a

whole. whole.

The business risk at each level of debtThe business risk at each level of debt--equity mix equity mix

remains constant. Therefore, overall cost ofremains constant. Therefore, overall cost of

capital also remains constant.capital also remains constant.

The corporate income tax does not exist.The corporate income tax does not exist.



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Computation of the Total Value ofComputation of the Total Value of

theF

irmtheF

irm

V = V = EBITEBIT

KoKo

Where,Where,

V V == Value of the firm Value of the firmKo = Overall cost of capitalKo = Overall cost of capital



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Market Value ofE

quity CapitalMarket Value ofE

quity CapitalS = V S = V ² ² DD

Where,Where,

S = Market Value of Equity CapitalS = Market Value of Equity Capital

V = Value of the Firm V = Value of the FirmD = Market value of the DebtD = Market value of the Debt



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Cost ofE

quity CapitalCost ofE

quity Capital Ke =Ke = EBITEBIT ² ² II X 100X 100

SS

Where,Where,

Ke = Equity capitalization Rate or Cost ofKe = Equity capitalization Rate or Cost of

EquityEquity

I = Interest on DebtI = Interest on Debt

S = Market Value of Equity Capital ( V S = Market Value of Equity Capital ( V ² ²D)D)



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Traditional TheoryTraditional Theory This theory was propounded by Ezra Solomon, also knownThis theory was propounded by Ezra Solomon, also known

as Íntermediate approachµ as Íntermediate approachµ

This is a compromise between the two extremes of NI &This is a compromise between the two extremes of NI &NOI approachNOI approach

According to this theory, a firm can reduce the overall According to this theory, a firm can reduce the overallcost of capital or increase the total value of the firm bycost of capital or increase the total value of the firm byincreasing the debt proportion in its capital structure to aincreasing the debt proportion in its capital structure to a

certain limit. Because debt is a cheap source ofcertain limit. Because debt is a cheap source of raisingraisingfunds as compared to equity capital.funds as compared to equity capital.

The manner in which the overall cost of capital and valueThe manner in which the overall cost of capital and valueof the firm reacts to changes in the degree of financialof the firm reacts to changes in the degree of financialleverage is divided into three stages.leverage is divided into three stages.



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Effects of Changes in CapitalEffects of Changes in Capital

Structure onStructure on ¶Ko·¶Ko· andand ¶V·¶V·

As per Ezra Solomon: As per Ezra Solomon:

First Stage: The use of debt in capitalFirst Stage: The use of debt in capital

structure increases the ¶structure increases the ¶V· V· and decreasesand decreases

thethe ¶Ko·.¶Ko·.

BecauseBecause ¶Ke·¶Ke· remains constant or rises slightlyremains constant or rises slightly

with debt, but it does not rise fast enough to with debt, but it does not rise fast enough tooffset the advantages of low cost debt.offset the advantages of low cost debt.

¶¶Kd·Kd· remains constant or rises very negligibly.remains constant or rises very negligibly.



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Structure onStructure on ¶Ko·¶Ko· andand ¶V·¶V· Second Stage: During this Stage, there is aSecond Stage: During this Stage, there is a

range in which therange in which the ¶V·¶V· will be maximum and will be maximum and

thethe ¶Ko·¶Ko· will be minimum. will be minimum. Once the firm has reached a certain degree ofOnce the firm has reached a certain degree of

financial leverage, increase in leverage doesfinancial leverage, increase in leverage doesnot affect the Ko & V of the firm.not affect the Ko & V of the firm.

Because the increase in theBecause the increase in the ¶Ke·,¶Ke·, due to addeddue to addedfinancial risk completely offset the advantagefinancial risk completely offset the advantageof using low cost of debt capital.of using low cost of debt capital.



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Structure onStructure on ¶Ko·¶Ko· andand ¶V·¶V·

Third Stage: The ¶V· will decrease and theThird Stage: The ¶V· will decrease and the

¶Ko· will increase.¶Ko· will increase.

Because further increase of debt in the capitalBecause further increase of debt in the capital

structure, beyond the acceptable limitstructure, beyond the acceptable limit

increases the financial risk.increases the financial risk.

Kd would also rise because the lender will alsoKd would also rise because the lender will alsoraise the rate of interest as they may requireraise the rate of interest as they may require

compensation for the higher risk.compensation for the higher risk.



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Traditional approachTraditional approach

O X

Y

AB

Range of optimal

Capital structure

Kd

Ko

Ke



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Computation of Market Value ofComputation of Market Value of

Shares & Value of theF

irmShares & Value of theF

irm

S =S = EBITEBIT ² ² II

KeKe

V = S + D V = S + D

KoKo == EBITEBIT

V V



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ModiglianiModigliani--Miller TheoryMiller Theory

This theory was propounded by Franco ModiglianiThis theory was propounded by Franco Modiglianiand Merton Miller.and Merton Miller.

M & M hypothesis is identical with the NOIM & M hypothesis is identical with the NOIapproaches if taxes are ignored. When corporateapproaches if taxes are ignored. When corporatetaxes are assumed to exist, their hypothesis istaxes are assumed to exist, their hypothesis issimilar to NI Approach.similar to NI Approach.

They have given two approachesThey have given two approaches In the Absence of Corporate TaxesIn the Absence of Corporate Taxes

When Corporate Taxes ExistWhen Corporate Taxes Exist



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In the Absence of Corporate TaxesIn the Absence of Corporate Taxes According to this approach the According to this approach the ¶V·¶V· and itsand its ¶Ko·¶Ko· areare

independent of its capital structure.independent of its capital structure.

The debtThe debt--equity mix of the firm is irrelevant inequity mix of the firm is irrelevant indetermining the total value of the firm.determining the total value of the firm.

Because with increased use of debt as a sourceBecause with increased use of debt as a sourceof finance, ¶of finance, ¶Ke·Ke· increases and the advantage ofincreases and the advantage oflow cost debt is offset equally by the increasedlow cost debt is offset equally by the increased

¶¶Ke·.Ke·. In the opinion of them, two identical firms in allIn the opinion of them, two identical firms in all

respect, except their capital structure, cannotrespect, except their capital structure, cannothave different market value or cost of capital duehave different market value or cost of capital dueto Arbitrage Process.to Arbitrage Process.



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Assumptions of M Assumptions of M--M ApproachM Approach

Perfect Capital MarketPerfect Capital Market

No Transaction CostNo Transaction Cost

Homogeneous Risk Class: Expected EBIT of all theHomogeneous Risk Class: Expected EBIT of all thefirms have identical risk characteristics.firms have identical risk characteristics.

Investors act rationallyInvestors act rationally

Risk in terms of expected EBIT should also beRisk in terms of expected EBIT should also be

identical for determination of market value of theidentical for determination of market value of thesharesshares

CentCent--Percent Distribution of earnings to thePercent Distribution of earnings to theshareholdersshareholders

No Corporate Taxes: But later on in 1969 theyNo Corporate Taxes: But later on in 1969 they

removed this assumption.removed this assumption.



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Assumptions Contd«««. Assumptions Contd«««.

All cash flows are perpetuities All cash flows are perpetuities Perpetual debt is issued, firms have zero growth, andPerpetual debt is issued, firms have zero growth, and

expected EBIT is constant over timeexpected EBIT is constant over time No agency or financial distress costs (e.g.,No agency or financial distress costs (e.g.,

bankruptcy)bankruptcy)

No transaction costsNo transaction costs

The cutThe cut ² ² off point of investment in a firm isoff point of investment in a firm iscapitalization ratecapitalization rate

All debt is risk less, and both individuals and All debt is risk less, and both individuals andcorporations can borrow unlimited amounts ofcorporations can borrow unlimited amounts ofmoney at the risk money at the risk--free ratefree rate



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MM Models: MM with Zero TaxesMM Models: MM with Zero Taxes

Proposition IProposition I

V V LL = V = V UU

Value of firm is INDEPENDENT of its leverage Value of firm is INDEPENDENT of its leverage VL = value of levered firm, VU = Value of Unlevered firm VL = value of levered firm, VU = Value of Unlevered firm

Proof (in general)Proof (in general)

² ² If two companies differ only in way they are financed and theirIf two companies differ only in way they are financed and their

market values, then investors would sell shares of the highermarket values, then investors would sell shares of the higher--

valued firm, and buy those of the lower valued firm, and buy those of the lower--valued firm. valued firm.

² ² This would continue until they had exactly the same marketThis would continue until they had exactly the same market

value. value.

² ² Arbitrage cannot exist in equilibrium. Arbitrage cannot exist in equilibrium.

² ² So, V So, V LL

= V = V UU



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Proposition IIProposition II

rrsLsL = r= rsUsU + Risk premium+ Risk premium

As firm·s use of debt increases, its cost of As firm·s use of debt increases, its cost ofequity also increasesequity also increases

I and II togetherI and II together

More debt does NOT increase firm valueMore debt does NOT increase firm valuebecause benefits of cheaper debt are offset bybecause benefits of cheaper debt are offset by

increase in riskiness and cost of equityincrease in riskiness and cost of equity

Without taxes, capital structure isWithout taxes, capital structure is IRRELEVANTIRRELEVANT



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Value of Firm,

V ($)

VLVU

Debt ($)



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Cost of Capital (%)

Ko

Kd

Debt/ValueRatio (%)

Ke



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MM Models: Summary of MM withMM Models: Summary of MM with

Zero TaxesZero Taxes

MM prove, under a very restrictive set ofMM prove, under a very restrictive set of

assumptions, that a firm·s value isassumptions, that a firm·s value is

unaffectedunaffected by its financing mix by its financing mix Capital structure isCapital structure is IRRELE VANTIRRELE VANT!!

Any increase in ROE resulting from financial Any increase in ROE resulting from financial

leverage isleverage is exactly offsetexactly offset by the increase inby the increase in

risk risk

In other words, with zero taxes, the increase inIn other words, with zero taxes, the increase in

the return to shareholders from the use of debtthe return to shareholders from the use of debt

is exactly offset by the increase in risk is exactly offset by the increase in risk



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MM Models: MM with CorporateMM Models: MM with Corporate

TaxesTaxes

Corporate tax laws favor debt financingCorporate tax laws favor debt financing

Which ResultWhich Result

² ² MoreE

BIT goes to investors and less to taxes when leverage isMoreE

BIT goes to investors and less to taxes when leverage isusedused

Proposition IProposition I V V LL = V = V UU + TD+ TD

TD = discounted present value of the tax savingsTD = discounted present value of the tax savingsresulting from the tax deductibility of the interestresulting from the tax deductibility of the interestcharges.charges.



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TaxesTaxes

Proposition IIProposition II

rrsLsL = r= rsUsU + (r+ (rsUsU -- rrdd)(1)(1--T)(D/S)T)(D/S)

NotesNotes

V V LL doesdoes notnot equal V equal V UU

rrsLsL increases with leverage at aincreases with leverage at a slowerslower raterate

when corporate taxes are considered when corporate taxes are considered



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TaxesTaxes

Value of Firm, V ($)

Debt($)

VL

VU

TD



40


TaxesTaxes

Cost of C

apital (%)

Debt/ValueRatio (%)

Ke

Ko

Kd(1 - T)



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Criticisms of MM & Miller ModelsCriticisms of MM & Miller Models

Main objectionsMain objections

Assumptions too strict and not realistic Assumptions too strict and not realistic

Ignores costs of financial distress and agencyIgnores costs of financial distress and agency

costscosts

Note though that firms did increase theirNote though that firms did increase their

use of debt after MMuse of debt after MM



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TradeTrade--Off ModelOff Model

Recognize that costs of financial distressRecognize that costs of financial distress

and agency costs are realand agency costs are real

Financial distress costs (includes bankruptcy)Financial distress costs (includes bankruptcy)

² ² Direct costsDirect costs

² ² Lawyer·s fees, court costs, administrative expenses,Lawyer·s fees, court costs, administrative expenses,

assets disappear or become obsoleteassets disappear or become obsolete

² ² Indirect costsIndirect costs ² ² Managers make short run decisions, customers andManagers make short run decisions, customers and

suppliers may impose costssuppliers may impose costs

More debt, more likely to experience distressMore debt, more likely to experience distress



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Agency costs Agency costs

² ² Stockholders (thus management) want risk whileStockholders (thus management) want risk while

bondholders do notbondholders do not ² ² Use covenants to align interestsUse covenants to align interests

»» Costs: monitoring to ensure they are followed, also mayCosts: monitoring to ensure they are followed, also may

hamper businesshamper business

² ² In essence, lost efficiency and monitoring costs reduceIn essence, lost efficiency and monitoring costs reduce

advantage of debtadvantage of debt

Given agency costs and financial distressGiven agency costs and financial distress

V V LL = V = V UU + TD+ TD -- (PV of expected costs of financial(PV of expected costs of financial

distress)distress) -- (PV of agency costs)(PV of agency costs)

No precise statement about optimal structureNo precise statement about optimal structure



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V ($)

Debt ($)

VUA

B

C

EF

A: Value of firm with noleverage

B: MM value of firm

(VL=VU+TD)

C: Actual firm value

D: Optimal debt level

E: PV of tax shelter (TD)

F: Financial distress and

agency costs

D



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ImplicationsImplications

Greater business risk, greater expected distress costsGreater business risk, greater expected distress costs

² ² Optimal debt level?Optimal debt level?

Tangible, marketable assets versus intangible assetsTangible, marketable assets versus intangible assets


Firms in highest tax bracketFirms in highest tax bracket


Intuitive but empirical support is MIX EDIntuitive but empirical support is MIX ED



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So, what can we say aboutSo, what can we say about

optimal capital structures?optimal capital structures?

Debt has tax benefits, so firms should useDebt has tax benefits, so firms should use

some debtsome debt

Financial distress and agency costs limit debtFinancial distress and agency costs limit debtusageusage

Distress costs higher for firms with intangibleDistress costs higher for firms with intangible

assetsassets

Because of asymmetric information, firms willBecause of asymmetric information, firms will

follow pecking orderfollow pecking order

Because of asymmetric information, firmsBecause of asymmetric information, firms

should maintain reserve for borrowingshould maintain reserve for borrowing



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Target Capital StructureTarget Capital Structure

Choose structure which maximizes theChoose structure which maximizes the

value of the stock value of the stock

Again, must use judgement Again, must use judgement

Some toolsSome tools

Financial forecasting models can help showFinancial forecasting models can help show

how capital structure changes are likely tohow capital structure changes are likely toaffect stock prices, coverage ratios, and so onaffect stock prices, coverage ratios, and so on

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Capital Structure(7)

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