Capital Structure 7

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Unit - 2

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Capital StructureyCapital Structure refers to the combination

or mix of debt and equity which a company

uses to finance its long term operationsyRaising of capital from different sources and

their use in different assets bya company ismade on the basis of certain principles that

provide a system of capital so that themaximum rate of return can be earned at aminimum cost. This sort of system of capitalis known as capital structure.

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Factors Infl ncing a ital Str ct r

yInternal Factors

yExternal Factors

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Int rnal Factors

y Size of Business

y Nature of Business

y Regularityand Certainty ofIncome

yAssets Structure

yAge of the Firm

y Desire to Retain Control

y

Future Plansy Operating Ratio

y Trading on Equity

y Period and Purpose of Financing

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Ext rnalFact

ors

y Capital Market Conditions

y Nature ofInvestors

y Statutory Requirementsy Taxation Policy

y Policies of FinancialInstitutions

y Cost of Financing

y Seasonal Variations

y Economic Fluctuations

y Nature ofCompetition

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Optimal apital Str ct r

y That capital structure or combination of debt &equity that leads to the maximum value of firm.

y The optimal or the best capital structure impliesthe most economicaland safe ratio betweenvarious types of securities.

y It is that mix of debt and equity which maximizesthe value of the companyand minimizes the costof capital.

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Essentials of a Sound or Optimal

Capital Structure

y Minimum Cost ofCapitaly Minimum Risky

Maximum Returny Maximum Controly Safetyy Simplicityy

FlexibilityyAttractive Rulesy Legal Requirementsy Sufficient liquidity

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Net Income (NI) Theoryy This theory was propounded byDavid Durandand is also known as Fixed Ke Theory.

yAccording to this theorya firm can increase thevalue of the firm and reduce the overall cost of

capital by increasing the proportion of debt inits capital structure to the maximum possibleextent.It is due to the fact that debt is, generallya

cheaper source of funds

because:y (i)Interest rates are lower than dividend rates

due to element of risk,y (ii) The benefit of tax as the interest is

deductible expense for income tax purpose. 10


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Ass mptions ofNI Theoryy The Kd ( cost of debt) is cheaper than the Ke ( cost

of equity).

yIncome tax has been ignored.

y There will be no corporate taxes.

y The Kd and Ke remain constant.

y The risk perception of investors is not changed by the

use of debt.

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Computation oftheOverall Cost ofCapital

or Capitalization Ratey Ko = EBIT

V

Where,

Ko = OverallCost ofCapital or Capitalization Rate

V = Value of the firm

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Net Operating IncomeTheory (NOI)y This theory was propounded byDavid Durandand is also known as Irrelevant Theory.

y This is just opposite to Net Income ApproachyAccording to this theory, the total market value of

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

mix.yAny change in capital structure of the company

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

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Assumptions ofNOI Theory

y The split of total capitalization between debt andequity is not essential or relevant.

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

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

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

y The corporate income tax does not exist.

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Computation oftheTotal ValueoftheFirm

V = EBIT

Ko

Where,

V = V alue of the firm

Ko = Overall cost of capital

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Market ValueofEquity CapitalS = V D

Where,S = Market Value ofEquityCapital

V = Value of the Firm

D = Market value of the Debt

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Cost ofEquity Capitaly Ke = EBIT I X 100

S

Where,Ke = Equity capitalization Rate or Cost ofEquity

I = Interest on Debt

S = Market Value ofEquityCapital ( V D)

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Traditional Theoryy This theory was propounded byEzra Solomon, also

known as Intermediateapproach. This is acompromise between the two extremes of NI & NOIapproach

yAccording to this theory, a firm can reduce the

overall cost of capital or increase the total value ofthe firm by increasing the debt proportion in itscapital structure to a certain limit. Because debt is acheap source of raising funds as compared to equity

capital.y The manner in which the overall cost of capitaland

value of the firm reacts to changes in the degree offinancialleverage is divided into three stages.

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Effects ofChanges in Capital Structureon

Koand V

As per Ezra Solomon:

First Stage: The use of debt in capital structure

increases the Vand decreases the Ko.y Because Keremains constant or rises slightlywith debt, but it does not rise fast enough tooffset the advantages oflow cost debt.

y Kdremains constant or rises very negligibly.

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Koand Vy Second Stage: During this Stage, there is a range in

which the Vwill be maximum and the Kowill beminimum.

y Once the firm has reached a certain degree offinancialleverage, increase in leverage does notaffect the Ko & V of the firm.

y

Because the increase in the Ke,due to addedfinancial risk completely offset the advantage of

using low cost of debt capital.

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Koand Vy Third Stage: The V will decrease and the Ko will

increase.

y Because further increase of debt in the capitalstructure, beyond the acceptable limit increasesthe financial risk.

y Kd would also rise because the lender willalso

raise the rate of interest as they may requirecompensation for the higher risk.

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Computation ofMarket ValueofShares &

ValueoftheFirmS = EBIT I

Ke

V = S + D

Ko= EBIT

V

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Modigliani-Miller Theory

y This theory was propounded by Franco Modiglianiand Merton Miller.

y

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

y

They have given two approachesy In the Absence ofCorporate Taxesy When Corporate Taxes Exist

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Assumptions ofM-MApproach

y PerfectCapital Markety No Transaction Costy Homogeneous Risk Class: Expected EBIT ofall the

firms have identical risk characteristics.y Investors act rationallyy Risk in terms of expected EBIT should also be

identical for determination of market value of theshares

y Cent-Percent Distribution of earnings to theshareholders

y No Corporate Taxes: But later on in 1963 theyremoved this assumption.

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In theAbsenceofCorporateTaxes

yAccording to this approach the Vand its Koareindependent of its capital structure.

y The debt-equity mix of the firm is irrelevant indetermining the total value of the firm.

y Because with increased use of debt as a source offinance, Keincreases and the advantage oflowcost debt is offset equally by the increased Ke.

y In the opinion of them, two identical firms in allrespect, except their capital structure, cannot havedifferent market value or cost of capital due toArbitrage Process.

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MMModels: In the Absence of Corporate Taxes

y Proposition IVL = VUyValue of firm is INDEPENDENT of its leverage

yVL = value oflevered firm, VU = Value of

Unlevered firmy If two companies differ only in way theyare

financed and their market values, then investorswould sell shares of the higher-valued firm, and

buy those of the lower-valued firm.y This would continue until they had exactly the

same market value.

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y MM APPROACH Corporate Taxes Exist

y MM agree the V will increase and ko will declinewith leverage, if corporate taxes are introducedTax deductibility of interest payments

y MM states that Vl = V u + Dt Implication V ismaximized when CS contains only D HoweverExcessive use of debt has certain disadvantagesOptimalCS is not one that has max debt but one

which has the desired amt of debt, determined atapoint where ko is minimum.

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Capital Structure 7