Capital structure

CAPITAL STRUCTURE:
THEORY AND POLICY

LEARNING OBJECTIVES
• Understand the theories of the relationship between
capital structure and the value of the firm
• Highlight the differences between the Modigliani-Miller
view and the traditional view on the relationship between
capital
• structure and the cost of capital and the value of the firm
• Focus on the interest tax shield advantage of debt as
well as its disadvantage in terms of costs of financial
distress
• Explain the impact of agency costs on capital structure
• Discuss the information asymmetry and the pecking
order theory of capital structure
• Study the determinants of capital structure in practice
Overview of Management

INTRODUCTION
• The objective of a firm should be directed
towards the maximization of the firm’s
value.
• The capital structure or financial leverage
decision should be examined from the
point of its impact on the value of the firm.


Capital Structure Theories:
–
–
–
–
–

Net operating income (NOI) approach.
Traditional approach and Net income (NI) approach.
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal taxes.
Trade-off theory: costs and benefits of leverage


Net Income (NI) Approach
•

According to NI
approach both the cost
of debt and the cost of
equity are independent
of the capital structure;
they remain constant
regardless of how much
debt the firm uses. As a
result, the overall cost of
capital declines and the
firm value increases
with debt. This approach
has no basis in reality;
the optimum capital
structure would be 100
per cent debt financing
under NI approach.

The effect of leverage on the cost
of
capital under NI approach


Traditional Approach
•

The traditional approach
argues that moderate degree
of debt can lower the firm’s
overall cost of capital and
thereby, increase the firm
value. The initial increase in
the cost of equity is more
than offset by the lower cost
of debt. But as debt
increases, shareholders
perceive higher risk and the
cost of equity rises until a
point is reached at which the
advantage of lower cost of
debt is more than offset by
more expensive equity.

Cost
ke

ko

kd

Debt

The traditional theory on the
relationship between capital structure
and the firm value has three stages:
• First stage: Increasing value
• Second stage: Optimum value
• Third stage: Declining value


Criticism of the Traditional View
• The contention of the traditional theory, that
moderate amount of debt in ‘sound’ firms does
not really add very much to the ‘riskiness’ of the
shares, is not defensible.
• There does not exist sufficient justification for the
assumption that investors’ perception about risk
of leverage is different at different levels of
leverage


• IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES


MM Approach Without Tax:
Proposition I
•

MM’s Proposition I is that, for
firms in the same risk class,
the total market value is
independent of the debt-equity
mix and is given by
capitalizing the expected net
operating income by the
capitalization rate (i.e., the
opportunity cost of capital)
appropriate to that risk class


MM’s Proposition I: Key
Assumptions
•
•
•
•
•

Perfect capital markets
Homogeneous risk classes
Risk
No taxes
Full payout


The cost of capital under MM
proposition I


Net Operating Income (NOI)
Approach
• According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firm’s capital structure. In the
absence of taxes, an individual holding all the
debt and equity securities will receive the same
cash flows regardless of the capital structure
and therefore, value of the company is the
same.
• MM’s approach is a net operating income
approach.


Arbitrage Process
• Suppose two identical firms, except for their capital
structures, have different market values. In this situation,
arbitrage (or switching) will take place to enable
investors to engage in the personal or homemade
leverage as against the corporate leverage, to restore
equilibrium in the market.
• On the basis of the arbitrage process, MM conclude that
the market value of a firm is not affected by leverage.
Thus, the financing (or capital structure) decision is
irrelevant. It does not help in creating any wealth for
shareholders. Hence one capital structure is as much
desirable (or undesirable) as the other.

MM’s Proposition II
• Financial leverage causes two opposing effects: it
increases the shareholders’ return but it also increases
their financial risk. Shareholders will increase the
required rate of return (i.e., the cost of equity) on their
investment to compensate for the financial risk. The
higher the financial risk, the higher the shareholders’
required rate of return or the cost of equity.
• The cost of equity for a levered firm should be higher
than the opportunity cost of capital, ka; that is, the levered
firm’s ke > ka. It should be equal to constant ka, plus a
financial risk premium.

Cont…
• To determine the levered firm's cost of
equity, ke:

Cost of equity under the MM


Criticism of the MM Hypothesis
• Lending and borrowing rates discrepancy
• Non-substitutability of personal and
corporate leverages
• Transaction costs
• Institutional restrictions
• Existence of corporate tax


• RELEVANCE OF CAPITAL STRUCTURE:
THE MM HYPOTHESIS UNDER CORPORATE TAXES


• MM show that the value of the firm will
increase with debt due to the deductibility
of interest charges for tax computation,
and the value of the levered firm will be
higher than of the unlevered firm.


Example: Debt Advantage: Interest Tax Shields
•

Suppose two firms L and U are identical in all respects except that firm L is
levered and firm U is unlevered. Firm U is an all-equity financed firm while
firm L employs equity and Rs 5,000 debt at 10 per cent rate of interest. Both
firms have an expected earning before interest and taxes (or net operating
income) of Rs 2,500, pay corporate tax at 50 per cent and distribute 100 per
cent earnings as dividends to shareholders.


•

You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered firm
L’s investors are ahead of the unlevered firm U’s investors by Rs 250. You
may also note that the tax liability of the levered firm L is Rs 250 less than
the tax liability of the unlevered firm U. For firm L the tax savings has
occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5 ×
(0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus


,

Value of Interest Tax Shield
•
•

•
•

Interest tax shield is a cash inflow to the firm and therefore, it is valuable.
The cash flows arising on account of interest tax shield are less risky than
the firm’s operating income that is subject to business risk. Interest tax
shield depends on the corporate tax rate and the firm’s ability to earn
enough profit to cover the interest payments.
The corporate tax rates do not change very frequently.
Under the assumption of permanent debt, the present value of the present
value of interest tax shield can be determined as follows:


Value of the Levered Firm


Value of the levered firm


Implications of the MM Hypothesis with
Corporate Taxes
• The MM’s “tax-corrected” view suggests that,
because of the tax deductibility of interest
charges, a firm can increase its value with
leverage. Thus, the optimum capital structure is
reached when the firm employs almost 100 per
cent debt.
• In practice, firms do not employ large amounts
of debt, nor are lenders ready to lend beyond
certain limits, which they decide.

Why do companies not employ extreme level
of debt in practice?
• First, we need to consider the impact of both corporate
and personal taxes for corporate borrowing. Personal
income tax may offset the advantage of the interest tax
shield.
• Second, borrowing may involve extra costs (in addition
to contractual interest cost)—costs of financial distress—
that may also offset the advantage of the interest shield.


FINANCIAL LEVERAGE AND CORPORATE AND
PERSONAL TAXES
•
•
•
•

•
•

Companies everywhere pay corporate tax on their earnings. Hence,
the earnings available to investors are reduced by the corporate tax.
Further, investors are required to pay personal taxes on the income
earned by them.
Therefore, from investors’ point of view, the effect of taxes will
include both corporate and personal taxes.
A firm should thus aim at minimizing the total taxes (both
corporate and personal) to investors while deciding about
borrowing.
How do personal income taxes change investors’ return and value?
It depends on the corporate tax rate and the difference in the
personal income tax rates of investors.


Limits to Borrowings
•

The attractiveness of borrowing depends on corporate tax rate, personal tax
rate on interest income and personal tax rate on equity income.

•

The advantage of borrowing reduces when corporate tax rate decreases, or
when the personal tax rate on interest income increases, or when the
personal tax rate on equity income decreases.

•

When will a firm stop borrowing?

•

A firm will stop borrowing when (1 – Tpd) becomes equal to (1 – Tpe) (1 – T).
Thus, the net tax advantage of debt or the interest tax shield after personal
taxes is given by the following:


Corporate and Personal Tax Rates in India

• In India, investors are required to pay tax at a
marginal rate, which can be as high as 30 per
cent.
• Dividends in the hands of shareholders are taxexempt.
• Capital gains on shares are treated favourably.
• In India, companies are required to pay dividend
tax at 15 per cent (as in 2010) on the amount
distributed as dividend.

Combined Income of Investors: Unequal Personal Tax
Rates


Miller’s Model
– To establish an optimum capital structure both corporate and
personal taxes paid on operating income should be minimised.
The personal tax rate is difficult to determine because of the
differing tax status of investors, and that capital gains are only
taxed when shares are sold.
– Merton miller proposed that the original MM proposition I holds in
a world with both corporate and personal taxes because he
assumes the personal tax rate on equity income is zero.
Companies will issue debt up to a point at which the tax bracket
of the marginal bondholder just equals the corporate tax rate. At
this point, there will be no net tax advantage to companies from
issuing additional debt.
– It is now widely accepted that the effect of personal taxes is to
lower the estimate of the interest tax shield.

Miller’s Model
After-tax earnings of Unlevered Firm:
T

X = X (1 − T )(1 − Te )
Value of Unlevered Firm:
Vu =

X (1 − T )(1 − Te )
ku

After-tax earnings of Levered Firm:
T

X = ( X − kd D)(1 − T )(1 − Te ) + kd D(1 − Td )
= X (1 − T )(1 − Te ) + kd D (1 − Td ) − kd D (1 − Td )(1 − Te )
Value of Levered Firm:
Vl =

X (1 − T )(1 − Te ) kd D [ (1 − Td ) − (1 − T )(1 − Te ) ]
+
ku (1 − Te )
kd (1 − Tb )

 (1 − T )(1 − Te ) 
= Vu + D 1 −
(1 − Tb ) 



Aggregate supply and demand for borrowing


• THE TRADE-OFF THEORY: COSTS OF FINANCIAL
DISTRESS AND AGENCY COSTS


Financial Distress
• Financial distress arises when a firm is not able to meet
its obligations to debt-holders.
• For a given level of debt, financial distress occurs
because of the business (operating) risk . with higher
business risk, the probability of financial distress
becomes greater. Determinants of business risk are:
–
–
–
–
–
–

Operating leverage (fixed and variable costs)
Cyclical variations
Intensity of competition
Price fluctuations
Firm size and diversification
Stages in the industry life cycle


Costs of Financial Distress
• Financial distress may ultimately force a company to
insolvency. Direct costs of financial distress include
costs of insolvency.
• Financial distress, with or without insolvency, also has
many indirect costs. These costs relate to the actions
of employees, managers, customers, suppliers and
shareholders.


Cont…


Value of levered firm under corporate
taxes and financial distress

With more and more debt, the costs of financial distress increases
and therefore, the tax benefit shrinks. The optimum point is reached
when the marginal present values of the tax benefit and the financial
distress cost are equal. The value of the firm is maximum at this point.

Agency Costs
• In practice, there may exist a conflict of interest
among
shareholders,
debt
holders
and
management.
• These conflicts give rise to agency problems, which
involve agency costs.
• Agency costs have their influence on a firm’s capital
structure.
– Shareholders–Debt-holders conflict
– Shareholders–Managers conflict
– Monitoring and agency costs

PECKING ORDER THEORY
•

•
•

•
•

The “pecking order” theory is based on the assertion that managers
have more information about their firms than investors. This
disparity of information is referred to as asymmetric information.
The manner in which managers raise capital gives a signal of their
belief in their firm’s prospects to investors.
This also implies that firms always use internal finance when
available, and choose debt over new issue of equity when external
financing is required.
The pecking order theory is able to explain the negative inverse
relationship between profitability and debt ratio within an industry.
However, it does not fully explain the capital structure differences
between industries


Implications:
• Internal equity may be better than
external equity.
• Financial slack is valuable.
• If external capital is required, debt is
better.


CAPITAL STRUCTURE
PLANNING AND POLICY
•

Theoretically, the financial manager should plan an optimum capital
structure for the company. The optimum capital structure is one that
maximizes the market value of the firm.
• The capital structure should be planned generally, keeping in view
the interests of the equity shareholders and the financial
requirements of a company.
• While developing an appropriate capital structure for its company,
the financial manager should inter alia aim at maximizing the longterm market price per share.


Elements of Capital Structure
1.
2.
3.
4.
5.
6.

Capital mix
Maturity and priority
Terms and conditions
Currency
Financial innovations
Financial market segments


•
•
•
•
•

Framework for Capital
Structure:
The FRICT Analysis

Flexibility
Risk
Income
Control
Timing


APPROACHES TO ESTABLISH
TARGET CAPITAL STRUCTURE
1. EBIT—EPS approach for analyzing the impact of debt
on EPS.
2. Valuation approach for determining the impact of debt
on the shareholders’ value.
3. Cash flow approach for analyzing the firm’s ability to
service debt.


EBIT-EPS Analysis
• The EBIT-EPS analysis is a first step in deciding about a
firm’s capital structure.
• It suffers from certain limitations and does not provide
unambiguous guide in determining the level of debt in
practice.

• The major shortcomings of the EPS as a financingdecision criterion are:
– It is based on arbitrary accounting assumptions and does not
reflect the economic profits.
– It does not consider the time value of money.
– It ignores the variability about the expected value of EPS, and
hence, ignores risk.

Valuation Approach
• The firm should employ debt to the point where
the marginal benefits and costs are equal.
• This will be the point of maximum value of the
firm and minimum weighted average cost of
capital.
• The difficulty with the valuation framework is that
managers find it difficult to put into practice.
• The most desirable capital structure is the one
that creates the maximum value.

Cash Flow Analysis
• Cash adequacy and solvency
– In determining a firm’s target capital structure, a key issue
is the firm’s ability to service its debt. The focus of this
analysis is also on the risk of cash insolvency—the
probability of running out of the cash—given a particular
amount of debt in the capital structure. This analysis is
based on a thorough cash flow analysis and not on rules of
thumb based on various coverage ratios.

• Components of cash flow analysis
– Operating cash flows
– Non-operating cash flows
– Financial cash flows


Cash Flow Analysis Versus
EBIT–EPS Analysis
• The cash flow analysis has the following advantages
over EBIT–EPS analysis:
1. It focuses on the liquidity and solvency of the firm over a longperiod of time, even encompassing adverse circumstances.
Thus, it evaluates the firm’s ability to meet fixed obligations.
2. It goes beyond the analysis of profit and loss statement and
also considers changes in the balance sheet items.
3. It identifies discretionary cash flows. The firm can thus prepare
an action plan to face adverse situations.
4. It provides a list of potential financial flows which can be utilized
under emergency.
5. It is a long-term dynamic analysis and does not remain confined
to a single period analysis.


Practical Considerations in
Determining Capital Structure
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack
7. Sustainability and Feasibility
8. Control
9. Marketability and Timing
10. Issue Costs
11. Capacity of Raising Funds


Capital structure

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