Ch 6

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Ch 6

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

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