Capital Structure Theories FINAL

8/3/2019 Capital Structure Theories FINAL

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Prof. Meghana Patil


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Concept of value of the firmy The value of the firm depends on the earning of the

firm & earning depends upon the investment decision

y The earning of the firm is capitalized at the rate equalto cost of capital in order to find out the value of thefirm.


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y EBIT has three claimants

y The debt holders-interest

y Govt. taxy The shareholders-dividend

y The investment decision decides the size of the EBITpool while capital structure mix will decides the way it

is to be sliced


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y The total value of the firm is the sum of its value to thedebt holder & to its shareholder & is determined by

the amount ofEBIT going to them respectivelyy The investment decision can increase the value of the

firm by increasing the size ofEBIT whereas the capitalstructure mix can affect the value of the firm only by

reducing the share ofEBIT going to the Govt.


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Meaning of Capital Structure

y Capital Structure: Include only long-term debt and total

stockholder investment

Capital Structure = Long-term Debt + Preferred Stock + Net worth (or)

Capital Structure = Total Assets Current Liabilities


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Optimum Capital structure

Optimum Capital Structure: The level of debt equity

proportion where market value of share is maximum, and cost

of capital is minimumFeatures:

Profitability

Solvency

Flexibility Conservatism

Control


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Determinants of Capital structure

y Tax benefit of debt

y Flexibility

y Control

y Industry leverage ratios

ySeasonal variations

y Degree of competition

y Industry life cycle

y Agency cost

y Company characteristics

y Timing of public issue

y Requirements of investors

y Period of finance

y Purpose of finance

y Legal requirements


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Approaches in Determining OptimumCapital Structure

1. EBI T EPS Approach: This approach is helpful to

analyse the impact of debt on earnings per share.

2. Valuation Approach: It determines the impact of use of

debt on the shareholders value and

3. Cash Flow Approach: It analyses the firms debt

service capacity.


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Indifferent point

y Point ofIndifference: The level of EBIT at which EPS is

same for two alternative capital structures(X I1) (1 t) PD (1 + Dt)

=

(X I2) (1 t) PD (1 + Dt)

ES1 ES2

Where: X = EBIT

I1,I2 = Interest under alternatives 1 and 2

t = Tax rate

PD = Preference dividendDt = Preference dividend tax

ES1, ES2 = No. of equity share outstanding under alternative 1 and 2


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Capital Structure Theories

y The total capital structure theories can be categorised intorelevant and irrelevant theories.

The following are the main theories/Approaches of capitalstructure:

1. Net income (theory) Approach (Relevant)

2. Net operating income Approach (Irrelevant)

3. Modigliani and Miller Approach (Irrelevant)

4. Traditional Approach (Neutral)


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Assumption of Capital Sturcture Theories

1. Firm uses only two sources of funds: perceptual riskless debt and equity;

2. There are no corporate or income: or personal tax;

3. The dividend payout ratio is 100% [There are no retained earnings];

4. The firms total assets are given and do not change [Investment decision isassumed to be constant].

5. The firms total financing remains constant. [Total capital is same, butproportion of debt and equity may be changed];

6. The firms operating profits (EBIT) are not expected to grow;

7. The business risk is remained constant and is independent of capitalstructure and financial risk;

8. All investors have the same subject probability distribution of the expectedEBIT for a given firm; and

9. The firm has perpetual life;


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Definitions used in Capital StructureE = Total market value of equity

D = Total market value of debt

V = Total market value of the firm

I = Annual interest payment

NI = Net income or equity earnings

NOI = Net operating income

Kd = pre-tax cost of debt

Cost of debt (Kd) = 100

Cost of equity (Ke) = or Ko+ [KoKd] D or D1/Po

E

Cost of Capital (Ko) = WdKd + WeKe or [EBIT/ V] 100

Value of the Firm (V) = EBIT Ko

NI

E

I

D

z


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y Ko= {D/(D+E)}Kd +{ E/(D+E)}Ke

y = Kd (D/V) + Ke (E/V)

y Ke = Ko Kd (D/V)y (E/V)


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Net IncomeApproach

y NIApproach: A change in the proportion in capital structure

will lead to a corresponding change in Ko and V.

y Assumptions:(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change the risk

perception of investors.(iv) Cost of debt and cost of equity remains constant;


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E = NI Ke

E

DDegree Of Leverage

NIApproach (Contd..)NIApproach (Contd..)


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y The figure shows that Ki or Kd is constant for all levelsof leverage i. for all levels of debt financing

yAs the debt proportion or the financial leveragesincreases , the WACC , Ko decreases as the Kd is lessthan K e

y Ko will never equal toKd as there is no 100% debt

finance


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y However if the firm is 100% equity firm then Ko isequal to Ke

yThe rate of decline in Ko will depend upon the relativeposition ofKd & Ke

y Under NI approach the firm will maximise the value ofthe firm at a point where Ko is minimised

yWith judicious se of debt & equity a can achieve anoptimal capital structure .


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y Kd is lesser than Ke so as the debt proportionincreases the Ko will decrease which will increase the

value of the firm.


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y The expected EBIT of a firm is Rs. 2,00,000 .It has

equity share capital; with Ke @10%& 6% debt of Rs.5,00,000 find out the value of the firm & overall cost ofcapital , WACC


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y NOW if the firm has issued 6% debt of Rs. 7,00,000instead of Rs. 5,00,000 .Find the value of the firm

y

Value of the firm= value of the equity + value of thedebt

y Overall cost of capital =EBIT/V

yWACC= {D/(D+E)}Kd+ {E/(D+E)}Ke


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Net Operating Income Approach (NOI)y NOIApproach: Says that there is no relation between capital structure

and Ko and V.

y Assumptions:

(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of

leverage. (See Fig. 11.2)(ii) The market capitalises the total value of the firm as a whole and no

importance is given for split of value of firm between debt and equity;

(iii) The market value of equity is residue [i.e., Total value of the firm minusmarket value of debt)

(iv) The use of debt funds increases the received risk of equity investors, there

by ke increases(v) The debt advantage is set off exactly by increase in cost of equity.

(vi) Cost of debt (Ki) remains constant

(vii)There are no corporate taxes.


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NOI (Contd.)

V = EBIT Ko

E = V-D

z

E

DDegree Of Leverage


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y In the diagram the cost of debt Kd overall cost ofcapital Ko are constant for all levels of leverages .

y

As the debt proportion or financial leverage increases ,the risk of the shareholder also increases & thus thecost of equityKe also increases

y


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y However increase in Ke is such that overall cost ofcapital remains same .

y

It may be notified that for an all equity firm Ke is justequal to Ko

yAs the debt proportion increases , the Ke also increases.

y However , the overall cost of capital remains samebecause increase in Ke is just sufficient to off set thebenefits of cheaper debt finance


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y The NOI approach considers Ko to be constant &therefore ,there is no optimal capital structure

y

So the capital structure does not matter


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yA firm has EBIT oaf Rs.2,00,000& belongs to risk classof 10% what is the value of cost of equity capital if it

employees 6% debt to the extent of 30%,40%& 50% ofthe total capital of Rs. 10,00,000

y from the following data determine the value of firm P& Q belonging to the homogeneous risk class under

y

NI approachy NOI approach


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y from the following data determine the value of firm P& Q belonging to the homogeneous risk class under

y

NI approachy NOI approach


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Modigliani-MillerApproach

y MMApproach: Total value of firm is independent of itscapital structure

y Assumptions:

a. Information is available at free of costb. The same information is available for all investorsc. Securities are infinitely divisibled. Investors are free to buy or sell securitiese. There is no transaction costf. There are no bankruptcy costsg. Investors can borrow without restrictions as the same terms on

which a firm can borrowh. Dividend payout ratio is 100 percenti. EBIT is not affected by the use of debt


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MMApproach (Contd.)

Proposition:

I. Ko and V are independent of capital structure

II.Ke = to capitalisation rate of the pure equity plus a premiumfor financial risk.

Ke increases with the use of more debt. Increased Ke off setexactly the use of a less expensive source of funds (debt)

III.The cut of rate for investment purposes is completelyindependent of the way in which an investment is financed.


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y The MM model argues that if two firms are alike in allrespect except that they differ in respect of their

financial pattern and their market value , then theinvestors will develop the tendency to sell their sharesof the overvalued firm( creating a selling pressure )and to buy the shares of the undervalued firm(creatingdemand pressure )


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y This buying & selling process will continue till boththe firms will have same market value.

y

suppose two co. LEV. & ULEV. these two co.s are alike& identical in all respect except the LEV. Firm has a10% debt of Rs. 30,00,000 in its capital structure . Onthe other hand the ULEV. Is an unlevered form & hasraised the funds only thru equity

y Both have EBIT of Rs. 10,00,000 & the equitycapitalisation rate Ke 20%


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y Under this situation the total value of the firm &WACC will be?


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y The LEV co. has overall cost of capital less & highermarket value i.e. (15.38%


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MMApproach [Proposition:I]

y Arbitrage Process: Refers to an act of buying an asset or security in onemarket at lower price and selling it is an other market at higher price.

y Steps in working outArbitrage Process

Students need to keep in mind the following three steps in working ofarbitrage process.

Step 1: Investors Current Position: In this step there is a need to find outthe current investment and income (return).

Step 2: Calculation of Savings in Investmentby moving from levered firmto unlevered firm. Savings in investment is equals to total funds

[Funds raise by sale of shares plus funds raised by personnelborrowing] minus same percentage of investment. Here the incomewill be same which was earning in previous firm.

Step 3: Calculation of Increased Income, by investing total funds available.


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yWith the same example suppose an investor is holding10% equity of LEV. The value of the ownership will be

y

10% of 35,00,000 i.e 3,50,000y Further out of the total net profit he will earn

y 10% of 7,00,000 = 70,000 (20%return on equity)


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y In order to make an opportunity now he decide toconvert his holding fro LEVto ULEV.

y

But to avail the same position in ULEV he should have5,00,000

y He has Rs.3,50,000so he takes a loan @10% of anamount equals to 3,00,000(i.e .10%of the debt of the

LEV)y Now he is having total funds the proceeds of 3,50,000+

3,00,000)


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y Out of the total 6,50,000 he invests Rs. 5,00,000 in theULEV

y

Assuming that the ULEV continues to earn 10,00,000the net returns available to investors is

y Profit available from ULE V 1,00,000

- Interest payable @10% ( 30,000)

NET RETURN 70,000


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y now the investor has 70,000 + 1,50,000 as a return

y The risk is also same as he has shifted himself from

corporate leverage to personal leverage .


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y The following is the data regarding two companiesX&Y belonging to the same risk

Company X Company Y

Number of equity shares 90,000 1,50,000

Market price per share (Rs.) 1.20 1.00

6% debenture (Rs.) 60,000 -

Profit before interest 18,000 18,000


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yAll profits after interest are distributed as dividends ,

y Explain how under the M&M approach an investor

holding 10% of shares in company X will be better offin switching his holding 10% of shares in company Y


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y The two companies U & L belong to an equivalentrisk class . These two firms are in identical in everyrespect except that U company is unlevered whilecompany L has 10% debentures of Rs. 30 lakhs theother relevant information regarding their valuation &capitalisation rates are as follows


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Particulars Firm U Firm L

NET OPERATING INCOME 750000 7,50,000

Interest on debt - 3,00,000

Earnings to equity holders 7,50,000 4,50,000

Equity capitalisation rate .15 .20

Market value of equity 50,00,000 22,50,000

Market value of debt - 30,00,000

Total value of the firm 50,00,000 52,50,000

Overall capitalisation rate .15 .143

Debt equity ratio 0 1.33


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yAn investor owns 10% equity shares of company Lshow the arbitrage process & the amount by which hecould reduce his out lay through the use of leverage .


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Limitations of MMApproach

y Investors cannot borrow on the same terms and conditions of a

firmy Personal leverage is not substitute for corporate leverage

y Existence of transaction cost

y Institutional restriction on personal leverage

yAsymmetric information

y Existence of corporate tax


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MMApproach: with Corporate Taxes

y MMApproach with tax says affects value of the firm

VL = VU + Dt

Where VL = Value of levered firm

VU = Value of unlevered firm,

D = Amount of Debt

t = Tax rate

y In other words value of levered firm (VL) is equal to the market

to the market value of unlevered firm VUplus the discountedpresent value of the tax saving resulting from tax - deductibilitya interest payments.(7) Symbolically

y VL = VU + pv of tax shield


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Capital Structure Theories FINAL