Capital Structure 1

How do we want to finance our firm’s assets?

Distinguish between financial structure and capital structure.

Capital StructureCapital Structure

Analysis Analysis

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity







FinancialStructure







CapitalCapitalStructureStructure

Why is Capital Structure Why is Capital Structure Important?Important?

1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments.

2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital.

3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

Designing the capital structure – EBIT & EPS AnalysisA company is likely to face six possible consequences because of economic conditions. The EBIT likely to range from Rs500 to Rs400,000. the company has an option to decide on its financing mix by employing no debt, 25% debt, 50% debt or 75% debt. The company’s capital structure consists of 1 lakh ordinary shares of Rs10 each. Tax rate applicable is 35%. If the company uses debt the interest rate is likely to be 10%.

Calculate the impact of raising debt and varying EPS under different economic conditions like very poor (EBIT-Rs500), poor (Rs25000), Regular (Rs100000), Normal (Rs200000), Good(Rs300000), very good(Rs400000)

Conditions EBIT 0,Debt EPS

25% Debt EPS

50% Debt EPS

75% Debt EPS

Very Poor 500 0.00 -0.21 -0.64 -1.94

Poor 25000 0.16 0.00 -0.33 -1.30

Regular 100000 0.65 0.65 0.65 0.65

Normal 200000 1.30 1.52 1.95 3.25

Good 300000 1.95 2.38 3.25 5.85

Very Good 400000 2.60 3.25 4.55 8.45

EPS with all equity option 1EPS with all equity option 1

EPS = EPS = [[(1-T) EBIT(1-T) EBIT] / number of shares in plan 1 (N1)] / number of shares in plan 1 (N1)

Second option with debt and equitySecond option with debt and equityEPS = [(1-T)(EBIT -Interest]/ Number of shares in plan 2 (N2)EPS = [(1-T)(EBIT -Interest]/ Number of shares in plan 2 (N2)

Break even point in both the options to get the EBIT will be: Break even point in both the options to get the EBIT will be: [[(1-T) EBIT(1-T) EBIT] / number of shares in plan 1 (N1) = [(1-T)(EBIT -Interest]/ ] / number of shares in plan 1 (N1) = [(1-T)(EBIT -Interest]/ Number of shares in plan 2 (N2)Number of shares in plan 2 (N2)

Capital Structure Theory:Capital Structure Theory:

•Excess financial risk put the firm into Excess financial risk put the firm into bankruptcy cost and to use little bankruptcy cost and to use little financial leverage results in an financial leverage results in an undervaluation of the firm’s shares in undervaluation of the firm’s shares in the marketplace.the marketplace.

•Financial manager must know how to Financial manager must know how to find the optimal financial leverage usefind the optimal financial leverage use

What is the Optimal What is the Optimal Capital Structure?Capital Structure?

In a “perfect world” environment with no taxes, no transactions costs and perfectly efficient financial markets, capital structure does not matter.

This is known as the Independence Hypothesis of capital structure: firm value is independent of capital structure.

Analytical Setting:Analytical Setting:

•Investment policy and dividend policy are Investment policy and dividend policy are held constant throughout the discussionheld constant throughout the discussion

•Firm retains none of its current earningsFirm retains none of its current earnings

•Corporate income is not subject to any Corporate income is not subject to any taxation (removed later)taxation (removed later)

•Capital structure consists of only debt and Capital structure consists of only debt and equity. Degree of financial leverage is by equity. Degree of financial leverage is by retiring the debt or repurchase of equityretiring the debt or repurchase of equity

(More…)(More…)

•The expected values of EBIT of all investors are identical for each firm

•Securities are traded in perfect or efficient financial markets

Theories:Theories:1)1) Extreme Positions ViewExtreme Positions View• Independence Hypothesis (NOI Theory by D. Independence Hypothesis (NOI Theory by D.

Durand)Durand)• Dependence Hypothesis (NI Theory by D. Durand)Dependence Hypothesis (NI Theory by D. Durand)

2) Moderate View

This is not to say that the markets really This is not to say that the markets really behave in strict accordance with either behave in strict accordance with either position.position.

The point is to identify polar positions The point is to identify polar positions on how things might work.on how things might work.

1) Independence Hypothesis1) Independence Hypothesis

Firm value does not depend on capital structure.

Firm’s composite cost of capital and Firm’s composite cost of capital and common stock price are both common stock price are both independent of the degree of financial independent of the degree of financial leverage.leverage.

•Independence hypothesis- if the capital Independence hypothesis- if the capital structure has no impact on the total structure has no impact on the total market value of the firm, then the value of market value of the firm, then the value of the firm is arrived by capitalizing the firm is arrived by capitalizing (discounting) the firm’s operating income (discounting) the firm’s operating income (EBIT) . Therefore this hypothesis is called (EBIT) . Therefore this hypothesis is called Net Operating Income.Net Operating Income.

•Value of equity is the residual valueValue of equity is the residual value

Independence HypothesisIndependence Hypothesis

Cost ofCost ofCapitalCapital

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0% debt financial leverage 100%debt0% debt financial leverage 100%debt

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kc = cost of equitykc = cost of equitykd = cost of debtkd = cost of debtko = cost of capitalko = cost of capital

kc = cost of equitykc = cost of equitykd = cost of debtkd = cost of debtko = cost of capitalko = cost of capital



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financial leveragefinancial leverage

If we have an all-equity If we have an all-equity financed firm, what is financed firm, what is

the cost of capital?the cost of capital?

If we have an all-equity If we have an all-equity financed firm, what is financed firm, what is

the cost of capital?the cost of capital?

.



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If we have an all-equity If we have an all-equity financed firm, the cost of financed firm, the cost of capital is just the cost of capital is just the cost of

equity.equity..



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kd


Suppose we begin adding debtSuppose we begin adding debtfinancing at a cost of kd. financing at a cost of kd.



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Suppose we begin adding debtSuppose we begin adding debtfinancing at a cost of kd. financing at a cost of kd.

kd is lower than kc, so whatkd is lower than kc, so whatshould happen to the costshould happen to the cost

of capital?of capital?



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It should go down. It should go down. But how should increasingBut how should increasingleverage affect kc?leverage affect kc?



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According to the According to the Independence Hypothesis,Independence Hypothesis,the increase in debt will cause the increase in debt will cause kc to rise.kc to rise.



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Increasing leverage causes theIncreasing leverage causes thecost of equity tocost of equity torise.rise.



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financial leverage

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Increasing leverage causes theIncreasing leverage causes thecost of equity to rise.cost of equity to rise.

What will What will be the net effectbe the net effect

on the overall cost on the overall cost of capital? of capital?



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The cost of capital doesThe cost of capital doesnot change. Leverage hasnot change. Leverage hasno effect on the costno effect on the costof capital andof capital andtherefore,therefore,



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The cost of capital doesThe cost of capital doesnot change. Leverage hasnot change. Leverage hasno effect on the costno effect on the costof capital andof capital andtherefore,therefore, it has it has no effectno effect on on

the value of the firm.the value of the firm.


In a “perfect markets” environment, capital structure is irrelevant. In other words, changes in capital structure do not affect firm value.

The EBIT of the firm is expected to be Rs1 lakh and the company has debt of Rs3 lakhs in its capital structure. The cost of debt is 10% and the over all cost of capital is 12.5%.If the company change the debt equity ratio and now increased the debt capital to Rs5 lakhs. Find the value of firm under IH/NOI approach

Mv of debt 300000cost of capital 12.50%cost of debt 10.00%EBIT 100000interest 30000EACS 70000mv of firm 800000mv of debt 300000mv of equity 500000cost of equity 0.14

Mv of debt 500000cost of capital 12.50%cost of debt 10.00%EBIT 100000interest 50000EACS 50000mv of firm 800000mv of debt 500000mv of equity 300000cost of equity 0.166667

•Firm’s cost of equity will rise at precisely the Firm’s cost of equity will rise at precisely the same rate as the earnings and dividends do.same rate as the earnings and dividends do.

•Use of financial leverage brings a change in the Use of financial leverage brings a change in the cost of common equity large enough to offset the cost of common equity large enough to offset the benefits of higher dividends to investors. This benefits of higher dividends to investors. This will keep the composite cost of funds constant.will keep the composite cost of funds constant.

•Independence Hypothesis says, one capital Independence Hypothesis says, one capital structure is as good as any other, the financial structure is as good as any other, the financial officers should not waste time searching for an officers should not waste time searching for an optimal capital structure.optimal capital structure.

Dependence Hypothesis Dependence Hypothesis (NI Theory)(NI Theory)

Since debt is less expensive than equity, more debt financing would provide a lower cost of capital.

A lower cost of capital would increase firm value.

Debt financing have a favorable effect on the company’s stock price

It is the net income (earnings available It is the net income (earnings available to common shareholders) that is to common shareholders) that is capitalized to arrive at the market capitalized to arrive at the market value of common equity. Because of value of common equity. Because of this, the dependence hypothesis is also this, the dependence hypothesis is also called called Net Income approachNet Income approach to to valuation. valuation.

The explicit and implicit costs of debt The explicit and implicit costs of debt are one and the same. The use of more are one and the same. The use of more debt does not change the cost of equity.debt does not change the cost of equity.

Dependence HypothesisDependence Hypothesis


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Cost of debt is lower Cost of debt is lower than cost of equitythan cost of equityas leverage increases and both as leverage increases and both are not affected by leverage.are not affected by leverage.


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becausebecauseof the tax benefitof the tax benefit associated with associated with debt financing.debt financing.



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So, what will happen to theSo, what will happen to thecost of capital as leveragecost of capital as leverageincreases?increases?

So, what will happen to theSo, what will happen to thecost of capital as leveragecost of capital as leverageincreases?increases?



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The low cost of debt The low cost of debt reduces the cost of reduces the cost of capital.capital.

koko


The EBIT of the firm is expected to be Rs1 lakh and the company has debt of Rs3 lakh in its capital structure. The cost of debt is 10% and cost of equity is 13%.If the company wants to change the debt equity ratio by increasing debt capital to Rs5 lakhs, what will happen to the value of the firm

If initially there are 2500 number of shares. When company increased debt to 5 lakhs means repay the shareholders Rs200000 at market price

Mv of debt 300000cost of equity 13.00%cost of debt 10.00%EBIT 100000interest 30000EACS 70000mv of equity 538461.5mv of firm 838461.5cost of capital 0.119266Alternative approach to Cost of capitalWd 0.357798We 0.642202WACC 0.119266no of shares 2500market price per share 215.3846

mv of debt 500000cost of equity 13.00%cost of debt 10.00%EBIT 100000interest 50000EACS 50000mv of equity 384615.4mv of firm 884615.4cost of capital 0.113043Alternative approach to Cost of capitalWd 0.565217We 0.434783WACC 0.113043share price per share calculation:share capital paid back 200000at market price 215no of shares reduced 930.2326shares remaning 1569.767take it as 1570market price per share 244.978

The more debt financing used, the greater the tax benefit, and the greater the value of the firm.

So, this would mean that all firms should be financed with 100% debt, right?

Why are firms not financed with 100% debt?


Bankruptcy costs: costs of financial distress.

Financing becomes difficult to get.

Customers leave due to uncertainty.

Possible restructuring or liquidation costs if bankruptcy occurs.

Why is 100% debt not Why is 100% debt not optimal?optimal?

Agency costs: costs associated with protecting bondholders.

Bondholders (principals) lend money to the firm and expect it to be invested wisely.

Stockholders own the firm and elect the board and hire managers (agents).

Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases.

Why is 100% debt not optimal?Why is 100% debt not optimal?

The previous hypothesis examines capital structure in a “perfect market.”

The moderate position examines capital structure under more realistic conditions.

For example, what happens if we include corporate taxes?

3) Moderate Position3) Moderate Position

Tax effects of financing with debtTax effects of financing with debt

with stock with debtEBIT 400,000 400,000- interest expense 0 (50,000)EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 264,000 231,000- dividends (50,000) 0Retained earnings 214,000 231,000

Tax effects of financing with debtTax effects of financing with debt

with stock with debtEBIT 400,000 400,000- interest expense 0 (50,000)EBT 400,000 350,000- taxes (34%) (136,000) (119,000)EAT 264,000 231,000- dividends (50,000) 0Retained earnings 214,000 231,000

Moderate Position with Moderate Position with Bankruptcy and Agency CostsBankruptcy and Agency Costs



The cost of debt increases as theThe cost of debt increases as theproportion of debt increases. proportion of debt increases.

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The cost of debt increases as theThe cost of debt increases as theproportion of debt increases. Atproportion of debt increases. Atsome point, the capital markets some point, the capital markets will consider any new debt will consider any new debt excessive, and therefore muchexcessive, and therefore muchriskier.riskier.

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Increasing debt also increasesIncreasing debt also increasesthe cost of equity since thethe cost of equity since theequity becomes equity becomes riskier.riskier.

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financial leverage

Increasing debt also increasesIncreasing debt also increasesthe cost of equity since thethe cost of equity since theequity becomes equity becomes riskier.riskier.

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At first, the cost of capital falls.At first, the cost of capital falls.Why?Why?

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financial leverage

Because the cost of equity is notBecause the cost of equity is notrising enough to offset therising enough to offset thelow after-tax cost oflow after-tax cost ofdebt.debt.

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At higher debt levels, the higher At higher debt levels, the higher costs of debt and equity cause costs of debt and equity cause the cost of capital to the cost of capital to increase.increase.

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financial leverage

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At some point, there will be aAt some point, there will be aminimum cost of minimum cost of capital!capital!

Modigliani-Miller Approach:

This approach is a kin to NOI approach and it is based on research work by Modigliani &Miller (the cost of capital, corporation finance and the theory of investment), American Economic review XL VIII, June 1958

Assumptions:

1. Perfect capital market- securities are infinitely divisible, 1. Perfect capital market- securities are infinitely divisible, investors are free to buy/sell securities, investors can borrow investors are free to buy/sell securities, investors can borrow without restrictions on the same terms and conditions as firms, without restrictions on the same terms and conditions as firms, there are no transaction cost, each investor has the same there are no transaction cost, each investor has the same information and it is readily available without any cost, information and it is readily available without any cost, investors are rational and they behave rationallyinvestors are rational and they behave rationally2. All investors have the same expectation of the firm’s 2. All investors have the same expectation of the firm’s operating income (EBIT)operating income (EBIT)3. Business risk is equal among all the firms within the similar 3. Business risk is equal among all the firms within the similar operating environment operating environment 4. Dividend payout ratio is 100%4. Dividend payout ratio is 100%5. There is no taxes (removed later)5. There is no taxes (removed later)6.MM propositions prove that if all the assumption are met the 6.MM propositions prove that if all the assumption are met the market value of the firms is equal irrespective of leveragemarket value of the firms is equal irrespective of leverage

MM Approach without tax:MM Approach without tax:

Proposition I: the value of the firm is established by capitalizing its expected net operating income (EBIT) at a constant over all cost of capital

V(L) = V(U) = EBIT/WACC = EBIT/K0

Here L is the levered and U is unlevered firm

Here analyzed the impact of leverage under the assumption that there is no corporate or personal tax on the basis of two propositions:

Here as per the proposition I, both L and U firms have the same business risk and the standard deviation is the same Proposition II:The cost of equity to a levered firm is equal to the cost of equity to an unlevered firm in the same risk class plus a risk premium whose size depends on both the differentials between an unlevered firm’s cost of debt and equity and the amount of debt used.K0(L) = K0(U) +Risk premium = Ke(U) +(Ke(U) –Kd)(D/S)Here D is the market value of debt and S is the market value of equity and Kd is the cost of debt

Taken together the two MM propositions imply that the inclusion of more debt in the capital structure will not increase the value of the firm, because the benefit of cheap debt will be exactly offset by an increase in the riskiness, hence the cost of equity will move up. So MM argues that in the world of no tax, both firms value and its WACC would be unaffected by its leverage decision

MM’s Arbitrage proof:

MM used an arbitrage proof to support their propositions. They proved that if the two firms’ value is different and they way of financing is different, the investors can sell the shares of over valued firm and buy the shares of under valued firm continuously than the value of both the firms will be the same

Example on Arbitrage:There are two firms A and B, where A is a levered firm and employs debt equity ratio of 60:40. firm B is a equity financed firm. Capital requirement of both the companies is Rs10 lakh. EBIT of both the companies is assumed to be Rs2 lakh. The debt is 10% and the cost of equity for A is 18% and for B is 12%.

Find first the value of the two firms

Firm A Firm BTotal capital employed 1000000 1000000Ratio of debt in capital structure 0.6 0Debt 600000 0Equity 400000 1000000Cost of debt 0.1 0.1Cost of equity 0.13 0.12EBIT 200000 200000Interest on debt 60000 0EBT 140000 200000Value of shareholders 1076923.08 1666666.67Value of debt 600000 0Value of firm 1676923.08 1666666.67Cost of capital 0.1192661 0.12

From the above it is clear that the value of firm A (levered firm) is more that firm B(unlevered). To make the value equal we should follow arbitrage process suggested by MM

Arbitrage process-Let us say an investor holds 20% shares of the levered firm:Let us say an investor holds 20% shares of the levered firm:Means holding Rs215384.6 worth of equity in the company A. Means holding Rs215384.6 worth of equity in the company A. this means his share in EBT/PAT will also be 20% which works this means his share in EBT/PAT will also be 20% which works out to be Rs28000.out to be Rs28000.If he sells his holding in firm A and invests in firm B which is If he sells his holding in firm A and invests in firm B which is unlevered, the financial risk of the investor will be less because unlevered, the financial risk of the investor will be less because firm B is debt free. Under recession even profit will be therefirm B is debt free. Under recession even profit will be there

Now if he wants to hold 20% in firm B Now if he wants to hold 20% in firm B he requires Rs333,333 (20% of equity value of B) he requires Rs333,333 (20% of equity value of B) He already has Rs215384.6 and rest Rs117,949 he will borrowHe already has Rs215384.6 and rest Rs117,949 he will borrowAs the lending rate for the corporate and the individual is same As the lending rate for the corporate and the individual is same so he can borrow at 10%.so he can borrow at 10%.As now he is holding 20% in firm B, his share of EBT/PAT will As now he is holding 20% in firm B, his share of EBT/PAT will be 20% which is Rs40,000 be 20% which is Rs40,000

Out of this Rs40,000 if he pays a interest on his loan of Rs11,794.9(10% of 117949), he is left with Rs28205.1(40000 – 11794.9)

Which means that by shifting his investment from A to firm B he can able to earn an extra profit of Rs205.1 (Rs28205.1 – Rs28000) and also reduce his risk level

Reverse Arbitrage Process:

In the above example if the cost of equity of the levered firm is 18%, we will suddenly find that the total value of the levered firm is less than the unlevered firm.In this type of situation, the investor will sell the shares of unlevered firm and buy shares of levered firm until the two firms value are equal

MM Approach with Corporate Tax:

MM’s original work, published in 1958, assumed zero taxes. In 1963, they published a second article that incorporates corporate taxes.With corporate taxes, they conclude that leverage would increase a firm’s value. This is because interest is tax-deductable expenses, hence more of a leveraged firm’s operating incomes flows through to investors

Proposition I:

The value of a levered firm is equal to the value of an unlevered firm in the same risk class plus the gain from leverage. The gain from the leverage is the value of the tax savings, found as the product of the corporate tax rate (T) times the amount of debt the firm used (D):V(L) = V(U) + TD

When the corporate taxes are introduced, the value of the levered firm exceeds that of the unlevered firm by the amount TD. Since the gain from leverage increases as debt increases, the firm’s value is maximum at 100 percent debt financing.As all cash flows are assumed to be perpetuity , the value of the unlevered firm can be found byV(U) = EBIT(1-T)/Ke(U)…….With zero debt the value of the firm is its equity value

Proposition II:The cost of equity to a levered firm is equal to1.The cost of equity to an unlevered firm in the same risk class plus2.A risk premium whose size depends on the differential between the cost of equity and debt to an unlevered firm, the amount of financial leverage used, and the corporate tax rate

Ke(L) = Ke(U) +(Ke(U) –Kd)(1-T)(D/S)

As in the above equation the (1-T) is less than 1, so the corporate taxes cause the cost of equity to rise less rapidly with leverage than it would in the absence of taxes.Proposition II, together with the fact that taxes reduce the effective cost of debt, is what produces the proposition I result the firm’s value increases as its leverage increases.

Example:To illustrate the MM model, assume the following data of XYZ company an old established firm that supplies electricity to residential customers in several cities of India1.XYZ currently has no debt, it is an all-equity company2.Expected EBIT =240000. EBIT is not expected to increase over time, so XYZ is in a no growth situation3.XYZ pays out all of its income as dividends as it does not require funds4.If XYZ begin to use debt, it can borrow at 8%. This borrowing rate is constant, does not increase regardless of debt used. Any amount raised by selling debt would be used to repurchase shares, so the assets would remain constant5.The business risk is inherent in XYZ assets and thus in its EBIT required rate of return Ke(U) is 12%, if no debt is used

Under no tax-Find out if value of the firm, cost of equity and over all cost of capital if the company started using the debt as;Debt- 0 5 10 15 20Equity- 20 15 10 5 0

With no tax:Assume that tax is 0, at any level of debt, proposition I can be used to find the value of the firm

V(L) =V(U) = EBIT/Ke(U) = 2.4/0.12 = 20 lakhs

If the firm uses 10 lakhs of debt, stock value will be also 10 lakhsWe can find the cost of equity Ke(L) and its WACC at a debt level of 10lakhs.First use the proposition II to find the leveraged cost of equity= 12 + (12% - 8%)(10/10) = 16%Now to calculate the WACC= (D/V)Kd(1-T) + (S/V)Ke= (10/20)(8%)(1)+(10/20)(16) = 12%

Now For different levels of debt and value, cost of equity and WACC

Debt Equity Value Kd Ke WACC

0 20 20 8 12 12

5 15 20 8 13.33 12

10 10 20 8 16 12

15 5 20 8 24 12

20 0 20 8 - 12

With corporate tax;Suppose the tax rate is 40% and the all other things are constant only the EBIT is changed from 2.4 to 4 lakhs When the firm has 0 debt but it pays tax, so its value will be: V(U) = EBIT(1-T)/Ke(U)

= 4(.6)/.12= Rs20 lakhs

Now if the firm uses 10 lakhs of debt in the world of tax we see by proportion I that the total market value rises to 24V(L)=V(U)+TD= 20+(10*.4)= Rs24 lakhs So the value of equity = 24-10=14

We can also find the cost of equity of the firm and the WACC at a debt level of 10 lakhs.

First we should find the cost of equity under proposition II

Ke(L) = Ke(U) +(Ke(U) –Kd)(1-T)(D/S)

= 12+(12%-8%)(1-.4)(10/14) = 13.71%

The WACC = (D/V)(Kd)(1-T) +(S/V)Ke

= (10/24)(8%)(1-.4) + (14/24)13.71% = 10%

Now calculate the value of the firm, cost of equity, WACC with tax under different levels of debt used by the firm. Start with all equity value 20, and increase debt further to 5,10,15,20,25,30,33.33

Debt Equity Value D/V Kd Ke WACC

0 20 20 0 8 12 12

5 17 22 22.73 8 12.71 10.91

10 14 24 41.67 8 13.71 10

15 11 26 57.69 8 15.27 9.23

20 8 28 71.43 8 18 8.57

25 5 30 83.33 8 24 8

30 2 32 93.75 8 48 7.5

33.33 0 33.33 100 12 - 12

Limitations of MM approach:

1.Personal leverage impractical2.No transaction cost not in reality3.Personal and corporate borrowing rate is different in the practical market place

The Hamada Equation:Increase in debt will also increase the risk of the shareholders and has an impact on the cost of equity.This equation developed by Robert Hamada (portfolio analysis, market equilibrium and corporation finance, Journal of finance, March 1969)

He says that the beta increases with the financial leverageβ= β (U) [1+(1-T)(D/E)] This shows how increase in debt/equity ratio increase the beta. Here β (U) is the beta of unlevered firmβ(U) = β / [1+(1-T)(D/E)]

This beta is to be used in CAPM to get the cost of equity and that the over all cost of capital is to be calculated taking the weight and component costs

Documents

Capital Structure 1