Ch 6
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  • 1. Capital Structure Theories
  • 2. In this chapter…
    • Net income and net operating income approaches…
    • Optimal capital structure…
    • Factors affecting capital structure…
    • EBIT/EPS and ROI & ROCE Analysis
    • Capital Structure Policies in practice…
  • 3. Capital Structure…
    • Capital structure includes only long term debt and total stockholder investment.
    • Capital Structure = Long Term Debt + Preferred Stock + Net Worth
    • OR
    • Capital Structure = Total Assets – Current Liabilities.
  • 4. Optimal Capital Structure…
    • It is that capital structure at that level of debt – equity proportion where the market value per share is maximum and the cost of capital is minimum.
    • Features:
      • Profitability
      • solvency
      • Flexibility
      • Conservation
      • control
  • 5. Determinants / Factors affecting Capital Structure…
    • The benefit of debt. Flexibility
    • Control Industry leverage ratios
    • Seasonal variations Degree of competition
    • Industry life cycle. Agency cost
    • Company characteristics Timing of public issue
    • Requirement of investors Period of finance
    • Purpose of finance Legal requirements.
  • 6. Patterns of Capital Structure…
    • Complete equity share capital;
    • Different proportions of equity and preference share capital;
    • Different proportions of equity and debenture (debt) capital an
    • Different proportions of equity, preference and debenture (debt) capital.
  • 7. EBIT – EPS Approach…
    • In this approach, it is analyzed that how sensitive is EPS to the changes in EBIT under different capital structure.
  • 8. ROI – ROE Approach…
    • This approach analyses the relationship between the ROI and ROE for different levels of financial leverage.
  • 9. Theories of Capital Structure…
    • Net Income Approach
    • Net Operating Income Approach
    • Modigliani and Miller Approach [MM Hypothesis]
    • Traditional Approach.
  • 10. Assumptions of Capital Structure Theories…
    • Firm uses only two sources of funds: perceptual riskless debt and equity;
    • There are no corporate or income: or personal tax;
    • The dividend payout ratio is 100% [There are no retained earnings];
    • The firm’s total assets are given and do not change [Investment decision is assumed to be constant].
    • The firm’s total financing remains constant. [Total capital is same, but proportion of debt and equity may be changed];
    • The firm’s operating profits (EBIT) are not expected to grow;
    • The business risk is remained constant and is independent of capital structure and financial risk;
    • All investors have the same subject probability distribution of the expected EBIT for a given firm; and
    • The firm has perpetual life;
  • 11. Definitions used in Capital Structure…
    • E = 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.
    • NOI = Net Operating Income.
    • Ee = Earning Available to Equity Shareholder.
  • 12. Net Income Approach…
    • A change in the proportion in capital structure will lead to a corresponding change in Ko and V.
    • 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;
  • 13. Net Income Approach…
  • 14. Formula used for NI Approach…
    • Net Income [NI] = EBIT – Debenture Interest.
    • Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D]
    • Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke]
    • Cost of Capital [Ko] = EBIT / V * 100
  • 15. Net Operating Income Approach…
    • There is no relation between capital structure and Ko and V.
    • Assumptions:
      • (i) Overall Cast of Capital (Ko) remains unchanged for all degrees of
      • leverage.
      • (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 minus market
      • 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.
  • 16. Net Operating Income Approach…
  • 17. Formula used for NOI Approach…
    • Value of the Firm [V] = EBIT / Ko
    • Market Value of Equity [E] = V – D
    • Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT – I / V - D
  • 18. MM Hypothesis…
    • This approach was developed by Prof. Franco Modigliani and Mertan Miller.
    • According to this approach, total value of the firm is independent of its capital structure.
  • 19. Assumptions…
    • Information is available at free of cost
    • The same information is available for all investors
    • Securities are infinitely divisible
    • Investors are free to buy or sell securities
    • There is no transaction cost
    • There are no bankruptcy costs
    • Investors can borrow without restrictions as the same terms on which a firm can borrow
    • Dividend payout ratio is 100 percent
    • EBIT is not affected by the use of debt
  • 20. Propositions:
    • I. Ko and V are independent of capital structure
    • II. Ke = to capitalisation rate of the pure equity plus a premium for financial risk.
    • Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt)
    • III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.
  • 21. MM Approach [Proposition I] arbitrage Progress:
    • Refers to an act of buying an asset or security in one market at lower price and selling it is an other market at higher price.
    • Steps in working out Arbitrage Process:
    • Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return).
    • Step 2: Calculation of Savings in Investment by moving from levered
    • firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm.
    • Step 3: Calculation of Increased Income , by investing total funds available.
  • 22. Limitations of MM Approach…
    • Investors cannot borrow on the same terms and conditions of a firm
    • Personal leverage is not substitute for corporate leverage
    • Existence of transaction cost
    • Institutional restriction on personal leverage
    • Asymmetric information
    • Existence of corporate tax
  • 23. Traditional Approach…
    • This approach was given by Soloman.
    • This approach is the midway between NI Approach and NOI Approach.
    • Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital
  • 24. Main Prepositions…
    • 1. The pretax cost of debt (Ki) remains more or less constant up to a certain degree of leverage and /but rises thereafter of an increasing rate
    • 2. The cost of equity capital (Ke) remains more or less constant rises slightly up to a certain degree of leverage and rises sharper there after, due to increased perceived risk.
    • 3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It
      • (a) Decreases up to a certain point level of degree of leverage [stage I increasing firm value];
      • (b) Remains more or less unchanged for moderate increase in leverage thereafter [stage II optimum value of firm], and
    • (c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].