Capital structure theories

• Capital Structure concept
• Capital Structure planning
• Concept of Value of a Firm
• Significance of Cost of
Capital (WACC)
Capital Structure
Coverage –
• Capital Structure theories –
 Net Income
 Net Operating Income
 Modigliani-Miller
 Traditional Approach

Capital Structure
Capital structure can be defined as the mix of owned capital (equity,
reserves & surplus) and borrowed capital (debentures, loans from
banks, financial institutions)
Optimal capital structure maximizes the value of the firm and reduces
the cost of capital.
Maximization of shareholders’ wealth is prime objective of a financial
manager. The same may be achieved if an optimal capital structure is
designed for the company.
Planning a capital structure is a highly psychological, complex and
qualitative process.
It involves balancing the shareholders’ expectations (risk & returns)
and capital requirements of the firm.

Planning the Capital Structure
Important Considerations –
 Return: ability to generate maximum returns to the shareholders,
i.e. maximize EPS and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt
preferred to new equity shares.
 Flexible: altering capital structure without much costs & delays,
to raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.

Value of a Firm – directly co-related with
the maximization of shareholders’ wealth.
 Value of a firm depends upon earnings of a firm and its
cost of capital (i.e. WACC).
 Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
 Value of firm is derived by capitalizing the earnings by its
cost of capital (WACC). Value of Firm = Earnings / WACC
 Thus, value of a firm varies due to changes in the earnings
of a company or its cost of capital, or both.
 Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings.

Particulars Rs.
Sales (A) 10,000
(-) Cost of goods sold (B) 4,000
Gross Profit (C = A - B) 6,000
(-) Operating expenses (D) 2,500
Operating Profit (EBIT) (E = C - D) 3,500
(-) Interest (F) 1,000
EBT (G = E - F) 2,500
(-) Tax @ 30% (H) 750
PAT (I = G - H) 1,750
(-) Preference Dividends (J) 750
Profit for Equity Shareholders (K = I - J) 1,000
No. of Equity Shares (L) 200
Earning per Share (EPS) (K/L) 5
An illustration of
Income Statement

Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds –
equity & debt.
 No change in investment decisions of
the firm, i.e. no change in total assets.
 100 % dividend payout ratio, i.e. no
retained earnings.
 Business risk of firm is not affected by
the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of
the firm.

Effects of Financial Leverage
• Business risk:
– The variability of future net cash flows attributed to the
nature of the company’s operations (the risk faced by
shareholders if the company is financed only by equity).
• Financial risk:
– The risk involved in using debt as a source of finance.
• Effects of financial leverage:
– Expected rate of return on equity is increased.
– Variability of returns to shareholders increases.
– Increasing leverage involves a trade-off between risk
and return.
12-8

Terminology used in Capita Structure
• B = Total market value of debt
• S = Total market value of equity
• V = Total market value of the firm B+S
• NOI = Net operating Income (EBIT)
• NI = Net Income
• I = annual interest amount
• K = overall cost of capital (WACC), marginal cost of capital
• Kd = cost of debt capital
• Ks = cost of equity
• Ks = NI/S=NOI-I/S
• k =Kd X B/V + Ks X S/V
• V =EBIT or NOI/K

Capital Structure Theories –
A) Net Income Approach (NI)
• A) Net Income Approach (NI)
• B) Net operating income (NOI)
• C) Traditional Approach
• D) Modigliani – Miller Model (MM)

 Developed by David Durand in 1952 AD
 The cost of debt and cost of equity capital remains
unchanged when leverage ratio varies as a result WACC
declines as the leverage ratio increases
 Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.
 The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.

NI approach assumptions –
o NI approach assumes that a continuous
increase in debt does not affect the risk
perception of investors. So Kd ,Ks remains
same.
o Cost of debt (Kd) is less than cost of equity (Ke)
[i.e. Kd < Ke ]
o WACC decreases as leverage increase
o Corporate income taxes do not exist.

 As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value
at a point where WACC is minimum, i.e. when the firm is
almost debt-financed.

0% 20.93% 50% 100%
B 0 4500 12000 30000
S 20000 17000 12000 0
V 20000 21500 24000 30000
Kd 8% 8% 8% 8%
Ks 12% 12% 12% 12%
K 12% 11.16% 10% 8%
NOI 2400
Kd 8%
Ks 12%
Debt 4500

As the proportion of
debt (Kd) in capital
structure increases,
the WACC (Ko)
reduces.
ke
ko
kd
Debt
Cost
kd
ke,ko

Value of Firm, V
0
Debt
V= B+S

B) Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact opposite
of the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent upon
its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.

 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ks)
A higher cost of equity (Ks) nullifies(offset) the advantages
gained due to cheaper cost of debt (Kd)
In other words, the finance mix is irrelevant and does not
affect the value of the firm.

0% 20.93% 50% 99%
B 0 4500 12000 23760
S 24000 19500 12000 240
V 24000 24000 24000 24000
Kd 8% 8% 8% 8%
Ks 10% 10.46% 12% 208%
K 10% 10% 10% 10%
NOI 2400
Kd 8%
Ks 10%
Debt 4500

 Cost of capital (Ko)
is constant.
 As the proportion
of debt increases,
(Ke) increases.
 No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost

Value of Firm, V
0
Debt
V =B +S

C) Traditional Approach
 The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches.
 Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
 As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.

The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk (financial risk) and hence Ke increases. Kd also rises due
to higher debt, WACC increases & value of firm decreases.

 Cost of capital (Ko)
is reduces initially.
 At a point, it settles
 But after this point,
(Ko) increases, due
to increase in the
cost of equity. (Ke)
ke
ko
kd
Debt
Cost

EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%

27
Debt/
Assets
kd Expected
EPS
Estimated
Beta
ks = [kRF +
(kM – kRF)βs]
Estimated
Price
Resulting
P/E Ratio
WACC
0% - $2.40 1.50 12.0% $20.00 8.33 12.00%
10 8.0% 2.56 1.55 12.2 20.98 8.20 11.46
20 8.3 2.75 1.65 12.6 21.83 7.94 11.08
30 9.0 2.97 1.80 13.2 22.50 7.58 10.86
40 10.0 3.20 2.00 14.0 22.86 7.14 10.80
50 12.0 3.36 2.30 15.2 22.11 6.58 11.20
60 15.0 3.30 2.70 16.8 19.64 5.95 12.12
All earnings paid out as dividends, so EPS = DPS.
Assume that kRF = 6% and kM = 10%. Tax rate = 40%.
WACC = wdkd(1 - T) + wsks
= (D/A) kd(1 - T) + (1 - D/A)ks
At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%
Stock Price and Cost of Capital Estimates
with Different Debt/Assets Ratios

D) Modigliani – Miller Model (MM)
 Franco Modigliani and Merton Miller(1958) both Nobel
Prize winners in financial economics, have had a profound
influence on capital structure theory
 Two Economists who demonstrated that with perfect
financial markets capital structure is irrelevant.
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioral justification in
favor of the NOI approach (personal leverage)

Assumptions –
o Perfect Capital Market:- Capital markets are perfect
and investors are free to buy, sell, & switch between
securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with
the firms.
o Investors are rational & informed of risk-return of all
securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention

Modigliani and Miller Analysis
• Assumptions:
– Capital markets are perfect.
– Companies and individuals can borrow at the
same interest rate.
– There are no taxes.
– There are no costs associated with the
liquidation of a company.
– Companies have a fixed investment policy so
that investment decisions are not affected by
financing decisions.

MM Model proposition –
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC

MM Model proposition –
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.

33
M&M No Tax: Result
• A change in capital structure does not matter to
the overall value of the firm.
Equity, $1000,
100%
Equity,
$700,
70%,
Equity,
$1000,
100%
Debt
$300,
30%,
Debt
$600,
60%,
Equity,
$400,
40%,
Total Firm Value = S+B
Does not change (the pie is the same size in each case, just the slices are different).

Levered Firm
• Value of levered firm = Rs. 110,000
• Equity Rs. 60,000 + Debt Rs. 50,000
• Kd= 6 % , EBIT = Rs. 10,000,
• Investor holds 10 % share capital
Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all equity)
• EBIT = Rs. 10,000 and investor holds 10 % share capital

( ) ( )
( )
Return from Levered Firm:
10 110,000 50 000 10% 60,000 6 000
10% 10,000 6% 50,000 1,000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
= − = =
= − × = − =  
× =
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
× =
× =
=
= × =
= × =
= − =
sh available 11,000 10,000 1,000= − =

36
Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROIC (NI+Int)/TA] 9.0% 11.0%
ROE (NI/Equity) 9.0% 10.8%

37
Why does leveraging increase return?
• More cash goes to investors of Firm L.
– Total dollars paid to investors:
 U: NI = $1,800.
 L: NI + Int = $1,080 + $1,200 = $2,280.
– Taxes paid:
 U: $1,200
 L: $720.
• In Firm L, fewer dollars are tied up in equity.

38
Impact of Leverage on Returns if
EBIT Falls
Firm U Firm L
EBIT $2,000 $2,000
Interest 0 1,200
EBT $2,000 $800
Taxes (40%) 800 320
NI $1,200 $480
ROIC 6.0% 6.0%
ROE 6.0% 4.8%

39
Impact of Leverage on Returns if
EBIT Rises
Firm U Firm L
EBIT $4,000 $4,000
Interest 0 1,200
EBT $4,000 $2,800
Taxes (40%) 1,600 1,120
NI $2,400 $1,680
ROIC 12.0% 14.0%
ROE 12.0% 16.8%

40
Capital Structure Theory
• MM theory
– Zero taxes
– Corporate taxes
– Corporate and personal taxes
• Trade-off theory
• Signaling theory
• Pecking order
• Debt financing as a managerial constraint
• Windows of opportunity

41
Modigliani-Miller (MM) Theory:
Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800
CF to shareholder $3,000 $1,800
CF to debtholder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical for both firms.

42
MM Results: Zero Taxes
• MM assume: (1) no transactions costs; (2) no restrictions or
costs to short sales; and (3) individuals can borrow at the same
rate as corporations.
• MM prove that if the total CF to investors of Firm U and Firm L
are equal, then arbitrage is possible unless the total values of
Firm U and Firm L are equal:
– VL = VU.
• Because FCF and values of firms L and U are equal, their
WACCs are equal.
• Therefore, capital structure is irrelevant.

43
MM Theory: Corporate Taxes
• Corporate tax laws allow interest to be deducted, which
reduces taxes paid by levered firms.
• Therefore, more CF goes to investors and less to taxes when
leverage is used.
• In other words, the debt “shields” some of the firm’s CF from
taxes.

44
M&M with Corporate Taxes
• When corporate taxes are introduced, then
debt financing causes a positive benefit to
the value of the firm.
• The reason for this is that debt interest
payments reduce taxable income and thus
reduce taxes.
– Thus with debt, there is more after-tax cash flow
available to security holders (equity and debt)
than there is without debt.
– Thus the value of the equity and debt securities
combined is greater.

45
MM Result: Corporate Taxes
• MM show that the total CF to Firm L’s
investors is equal to the total CF to Firm U’s
investor plus an additional amount due to
interest deductibility:
– CFL = CFU + rdDT.
• What is value of these cash flows?
– Value of CFU = VU
– MM show that the value of rdDT = TD
– Therefore, VL = VU + TD.
• If T=40%, then every dollar of debt adds 40
cents of extra value to firm.

46
Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
TD
MM relationship between value and debt when
corporate taxes are considered.

47
Miller’s Theory: Corporate and Personal
Taxes
• Personal taxes lessen the advantage of corporate debt:
– Corporate taxes favor debt financing since corporations can deduct
interest expenses.
– Personal taxes favor equity financing, since no gain is reported until
stock is sold, and long-term gains are taxed at a lower rate.

48
Miller’s Model with Corporate and
Personal Taxes
VL = VU + 1− D
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)
(1 - Td)

49
Tc = 40%, Td = 30%,
and Ts = 12%.
VL = VU + 1− D
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in debt
raises L’s value by $0.25.
(1 - 0.40)(1 - 0.12)
(1 - 0.30)

50
Conclusions with Personal Taxes
• Use of debt financing remains advantageous, but benefits are less than
under only corporate taxes.
• Firms should still use 100% debt.
• Note: However, Miller argued that in equilibrium, the tax rates of
marginal investors would adjust until there was no advantage to debt.

• Taxes and bankruptcy costs can be viewed as just another
claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy parties, respectively.
• VT = S + B + G + L
• The essence of the M&M
intuition is that VT depends on
the cash flow of the firm;
capital structure just slices the
pie.
The Pie Model Revisited
S
G
B
L

Static Tradeoff Theory of Capital Structure
• In the Pie model
– How much debt you take depends on the tradeoff between G and L
– maximizing the total value of the marketed claims (S+B) is
equivalent to minimizing the total value of the non-marketed claims
(G+L)
– The static tradeoff hypothesis says that the change in firm value
when equity is replaced by debt is the PV of the debt tax shield
minus the PV of increased costs of financial distress
– More generally, the tradeoff theory says the capital structure is
determined by the tradeoff between the benefits and costs of debt
– The optimal amount of debt is when the marginal benefit equals
marginal cost of debt

Another school of Capital Structure: The Pecking Order Theory
• Recap: Theory states that firms prefer to issue debt rather than equity
if internal finance is insufficient.
– Rule 1
 Use internal financing first.
– Rule 2
 Issue debt next, equity last.
• This theory focuses on the timing of security issuance, and relies on
asymmetric information
– Asymmetric information assumes one party possesses more information
than another. e.g., equity holders vs. bond holders on the value of the firm
• Consider a manager of a firm which needs new capital (debt or equity)
– If the manager believes that the stock is currently undervalued, debt would
be better (instead of selling shares for less than their true worth)
– If the manager believes that the stock is currently overvalued, equity would
be better

Pecking order cont’d
• Now consider the investor
– if the investor observes the firm issuing equity, this can be
taken as a signal that the stock is currently overvalued
(“signalling”)
– conversely, a firm issuing debt may be sending a signal that the
stock is currently undervalued
• If the manager takes the investor’s inference into account, then the
choice should always be debt (since if a firm tries to sell equity,
investors will think it is overpriced and won’t buy it unless the price
falls)
• Similarly, investors might be reluctant to buy bonds if they think that
managers are issuing debt because it is currently overvalued
• This leads to the pecking order.

Comparing tradeoff theory with pecking
order theory
• The pecking-order theory is at odds with the trade-off theory:
– There is no target B/S ratio.
– Profitable firms use less debt.
– “Financial slacks” are valuable.
– The pecking order is also consistent with avoiding issue costs and a
desire by managers to avoid publicity

Empirical evidence
• Tradeoff theory
– Empirical evidence which is consistent with the tradeoff theory:
 changes in financial leverage affect firm values
 persistent differences in capital structures across industries
 highly leveraged firms tend to invest less
– Violations: The tradeoff theory fails to explain why many very
profitable firms have low debt
• Pecking order theory:
– Consistent with the observed negative correlation between
operating profits and leverage
– Consistent with profitable firms using less debt

Capital structure theories

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Capital structure theories

Similar to Capital structure theories (20)

More from RajThakuri

More from RajThakuri (20)

Recently uploaded

Recently uploaded (20)

Capital structure theories

Editor's Notes