Capital structure irrelevance theory

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Capital structure irrelevance theory

  1. 1. By: Hassan Jan Habib
  2. 2.   Capital structure is the proportion of debt and preference and equity shares on a firm’s balance sheet.  Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value of the firm. Capital Structure
  3. 3.   Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital (k0) and valuation (V ). The four important theories are: 1. Net income (NI) approach, 2. Net operating income (NOI) approach, 3. Modigliani and Miller (MM) approach and 4. Traditional Approach Capital structure theories
  4. 4.   There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.  There are no corporate taxes. This assumption is removed later.  The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings.  The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant. Assumptions
  5. 5.   The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the equity capital.  The operating profits (EBIT) are not expected to grow.  Business risk is constant over time and is assumed to be independent of its capital structure and financial risk.  Perpetual life of the firm. Cont’d
  6. 6.   The essence of this approach is that capital structure decision of a corporate does not affect its cost of capital and valuation, and, hence, irrelevant. Net Operating Income (NOI) Approach
  7. 7.   The NOI Approach is based on the following propositions.  Overall cost of capital/ capitalization Ratio(K◦) is constant  Residual Value of Equity  Changes in cost of equity capital  Optimum Capital Structure Propositions
  8. 8.   Market Price of Share  Cost of Debt  Explicit Cost  Implicit Cost Cont’d 5 10 15 0 0.5 1.0 Degree of Leverage (B/V) Leverage and Cost of Capital (NOI Approach) X Y Ke,kiandk0(%) k0 ki ke 20 25 k0 and ki remain unchanged as the degree of leverage changes, but as the degree of leverage increases, the ke increases continuously.
  9. 9.  Modigliani-Miller (MM) Approach  P resented by Modigliani and Miller in 1958  Modigliani and Miller (MM) concur with NOI and provide a operational justification for the irrelevance of capital structure.
  10. 10.   They maintain that the cost of capital and the value of the firm do not change with a change in leverage. x (in Rs) v k0(%) Degree of Leverage (B/V) Leverage and Cost of Capital (MM Approach) V0 k0
  11. 11.   The overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure  The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage  The discount rate for investment purposes is completely independent of the way in which an investment is financed. Propositions
  12. 12.   Perfect capital markets: The implication of a perfect capital market is that  investors are free to buy/sell securities  investors can borrow without restrictions on the same terms and conditions as firms can  there are no transaction costs  information is perfect, that is, each investor has the same information which is readily available to him without cost and  investors are rational and behave accordingly. Assumptions
  13. 13.   Given the assumption of perfect information and rationality, all investors have the same expectation of firm’s net operating income (EBIT) with which to evaluate the value of a firm.  Business risk is equal among all firms within similar operating environment.  The dividend payout ratio is 100 per cent.  There are no taxes. (This assumption is removed later) Assumptions
  14. 14. MM’s Proposition 1  The market value of any firm is independent of its capital structure.  If a company has a given set of assets, changing debt to equity will change the way net operating income is divided between lenders and shareholders but will not change the value of the company.  Value of a company is given by: 0 annual net operating income V k
  15. 15.  According to the MM hypothesis, this situation cannot continue for long time, as the arbitrage process, based on the substitutability of personal leverage for corporate leverage, will operate and the values of the two firms will be brought to an identical level. Proof of Proposition 1
  16. 16.  Example:  Suppose two firms one Levered “L” and the other unlevered “U” identical by nature i.e. capital, and profits falling in the same risk class but having different capital structure and Market value. L U Equity 100,000 150,000 8% Debentures 50,000 - Market price per share Rs. 13 Rs. 10 EBIT Rs. 20,000 Rs. 20,000 Same amount Of capital Same Profit
  17. 17.   Suppose there is an investor “Mr. X”, holding 10% shares of Levered firm “L”  Since the market value of L is greater than U, where as profit is the same  So, Mr. X will sell his 10% shares in firm L =Rs. 13,000  And will raise a personal loan in the same proportion i.e. 10% =Rs. 50,000×10% =Rs. 5000  Total cash in hand is: Rs. 13,000+5000= Rs.18,000  He will invest that amount in shares of firm U. which amounts to 12% of total shares in firm U
  18. 18.  L U EBIT Rs. 20,000 Rs. 20,000 Less: Interest (4000) - EBT/NI 16,000 20,000 Dividend 10% i.e. 1600 12% i.e. 2400 Profit earned by Mr. X from Unlevered firm = Rs. 2400 Less: Interest to be paid on loan(50,000×8%) = (400) Total profit earned = Rs. 2000 Arbitrage process will continue till the share prices of Firm L fall and Firm U’s rises. So as to make the market prices of both firms identical

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