Capital Structure Theories Notes

CAPITAL STRUCTURE THEORIES INTRODUCTION:

The capital structure of a company refers to a containation of the long-term finances used by the firm. The theory of  capital structure is closely related to the firm’s cost of capital. The decision regarding the capital structure or the financial leverage or the financing wise is based on the objective of achieving the maximization of shareholders wealth. To design capital structure, we should consider the following two propositions: i! "ealth maximization is attained. ii! #est approximation to the optimal capital structure. Factors Determining Capital Structure

$! %inimization of &is': a! (apital structure must be consistent with business ris'. b! )t should result in a certain level of financial ris'. *! (ontrol: )t should reflect the management’s philosophy of control over the firm. +! lexibility: )t refers to the ability of the firm to meet the reuirements of the changing situations. ! /rofitability: )t should be profitable from the euity shareholders point of view. 0! 1olvency: The use of excessive debt may threaten the solvency of the company. Process o Capital Structure Decisions

THEORIES OF CAPITAL STRUCTURE:

2uity and debt capital are the two major sources of long-term funds for a firm. The theories on capital structure suggest the proportion of euity and debt in the capital structure. Assumptions

i. ii. iii. iv. v. vi. vii. viii.

There are only two sources of funds, i.e., the euity and the debt, having a fixed interest. The total assets of the firm are given and there would be no change in the investment decisions of the firm. 2#)T 2arnings before )nterest 3 Tax!456/ 5et 6perating /rofits! of the firm are given and is expected to remain constant. &etention &atio is 5)7, i.e., total profits are distributed as dividends. 8$99 dividend pay-out ratio; The firm has a given business ris' which is not affected by the financing wise. There is no corporate or personal tax. The investors have the same subjective probability distribution of expected operating profits of the firm. The capital structure can be altered without incurring transaction costs. )n discussing the theories of capital structure, we will consider the following notations: 2 < %ar'et value of the 2uity = < %ar'et value of the =ebt > < %ar'et value of the irm < 2 ?= ) < Total )nterest /ayments T < Tax &ate 2#)T456/ < 2arnings before )nterest and Tax or 5et 6perating /rofit /@T < /rofit after Tax =9 < =ividend at time 9 i.e. now! =$ < 2xpected dividend at the end of Aear $. /o < (urrent %ar'et /rice per share /$ < 2xpected %ar'et /rice per share at the end of Aear $. B d < (ost of =ebt after Tax 8 ) $ C T!4=; B e < (ost of 2uity 8= 94/; B 9 < 6verall cost of capital i.e., "@(( = 2 = 2 B d= ? B e2 2#)T < B d  -------- ! ? B e  -------- ! < B d  ---- ! ? B e  ------ ! < --------------- < --------=?2 =?2 > > > > Dierent T!eories o Capital Structure

$! *! +! !

5et )ncome 5)! approach 5et 6perating )ncome 56)! @pproach Traditional @pproach %odigliani-%iller %odel a. without taxes  b. with taxes.

Net Income Approac!

@s suggested by =avid =urand, this theory states that there is a relationship between the (apital 1tructure and the value of the firm. @ssumptions $! Total (apital reuirement of the firm are given and remain constant *! Bd  D B e +! Bd  and B e are constant ! Bo  decreases with the increase in leverage.

Cost

ke, ko

ke

ko kd

kd

Debt

Illustration:

2arnings #efore )nterest of Tax 2#)T! )nterest 2uity 2arnings 2! (ost of 2uity B e! (ost of =ebt B d! 2 %ar'et >alue of 2uity < -----

Firm A *,99,999 *,99,999 $* $9 $E,EE,EEF

Firm " *,99,999 09,999 $,09,999 $* $9 $*,09,999

B e ) %ar'et >alue of =ebt < ------B e Total >alue of the irm 82?=;   2#)T 6verall cost of capital B 9! < ----------------2?=

 5il

0,99,999

$E,EE,EEF $*

$F,09,999 $$.+

Net Operating Income #NOI$ Approac!

@ccording to =avid =urand, under 56) approach, the total value of the firm will not be affected by the composition of capital structure. Assumptions

$! B9  and B d is constant. *! Be  will change with the degree of leverage. +! There is no tax.

Cost ke

ko kd

Debt

Illustration

@ firm has an 2#)T of &s. 0,99,999 and belongs to a ris' class of $9. "hat is the cost of 2uity if it employs G debt to the extent of +9, 9 or 09 of the total capital fund of &s. *9,99,999H Solution: %&' E,99,999 $,99,999 0,99,999 $9 09,99,999 ,99,999 +E,999 ,E,999 $9.00

=ebt &s.! 2uity &s.! 2#)T &s.! B o >alue of the irm >! &s.! 2#)T4B o! >alue of 2uity 2! &s.! >C=! )nterest I E &s.!  5et /rofit 2#)TC)nt.! &s.! B e 5/42!

(&' G,99,999 $*,99,999 0,99,999 $9 09,99,999 *,99,999 G,999 ,0*,999 $9.FE

Tra*itional Approac!:

)t ta'es a mid-way between the 5) approach and the 56) approach. @ssumptions i! The value of the firm increases with the increase in financial leverage, upto a certain limit only. ii! Bd is assumed to be less than Be.

B e (ost of  (apital !

B o B d

6

)&' $9,99,999 $9,99,999 0,99,999 $9 09,99,999 9,99,999 E9,999 ,9,999 $$

6ptimal (apital 1tructure

 

7everage =egree!

/art )

B e (ost of  (apital !

B o B d

6

 

/

&ange of 6ptimal (apital 1tructure

7everage =egree!

/art ))

Tra*itional +ie,point on t!e Relations!ip -et,een Le+erage. Cost o Capital an* t!e /alue o t!e Firm 0o*igliani 1 0iller #00$ H2pot!esis

The %odigliani C %iller hypothesis is identical with the net operating )ncome approach. %odigliani and %iller  argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by the changes in capital structure. )n other words, capital structure decisions are irrelevant and value of the firm is independent of  debt C euity mix. "asic Propositions

% - % Jypothesis can be explained in terms of two propositions of %odigliani and %iller. They are: i.

ii.

The overall cost of capital B6! and the value of the firm are independent of the capital structure. The total mar'et value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that ris'  class. The financial ris' increases with more debt content in the capital structure. @s a result cost of euity Be! increases in a manner to offset exactly the low C cost advantage of debt. Jence, overall cost of capital remains the same. Assumptions o t!e 00 Approac!

i! ii! iii! iv! v!

$. There is a perfect capital mar'et. (apital mar'ets are perfect when investors are free to buy and sell securities, they can borrow funds without restriction at the same terms as the firms do, they behave rationally, they are well informed, and there are no transaction costs. *. irms can be classified into homogeneous ris' classes. @ll the firms in the same ris' class will have the same degree of financial ris'. +. @ll investors have the same expectation of a firm’s net operating income 2#)T!. . The dividend payout ratio is $99, which means there are no retained earnings. 0. There are no corporate taxes. This assumption has been removed later.

Preposition I

@ccording to % C %, for the firms in the same ris' class, the total mar'et value is independent of capital structure and is determined by capitalizing net operating income by the rate appropriate to that ris' class. /roposition ) can be expressed as follows: K 56 ) > < 1 ?= < -------- < ---------B o B o "here, > < the mar'et value of the firm 1 < the mar'et value of euity = < the mar'et value of debt @ccording the proposition ) the average cost of capital is not affected by degree of leverage and is determined as follows: K B o < ---> @ccording to % C%, the average cost of capital is constant as shown in the following igure.

Cost

ko

Debt MM's Proposition I

Ar-itrage Process

@ccording to % C%, two firms identical in all respects except their capital structure cannot have different mar'et values or different cost of capital. )n case, these firms have different mar'et values, the arbitrage will ta'e place and euilibrium in mar'et values is restored in no time. @rbitrage process refers to switching of investment from one firm to another. "hen mar'et values are different, the investors will try to ta'e advantage of it by selling their  securities with high mar'et price and buying the securities with low mar'et price. The use of debt by the investors is 'nown as personal leverage or homemade leverage. #ecause of this arbitrage process, the mar'et price of securities in higher valued mar'et will come down and the mar'et price of securities in the lower valued mar'et will go up, and this switching process is continued until the euilibrium is established in the mar'et values. 1o, % C%, argue that there is no possibility of different mar'et values for identical firms. Re+erse 3or4ing o Ar-itrage Process

@rbitrage process also wor's in the reverse direction. 7everage has neither advantage nor disadvantage. )f an unlevered firm with no debt capital! has higher mar'et value than a levered firm with debt capital! arbitrage  process wor's in reverse direction. )nvestors will try to switch their investments from unlevered firm to levered firm so that euilibrium is established in no time. Thus, % C % proved in terms of their proposition ) that the value of the firm is not affected by debt-euity mix. Proposition II

% C %’s proposition )) defines cost of euity. @ccording to them, for any firm in a given ris' class, the cost of euity is eual to the constant average cost of capital B o! plus a premium for the financial ris', which is eual to debt C  euity ratio times the spread between average cost and cost of debt. Thus, cost of euity is: = B e < B o ? B o C B d! x -----1 "here, B e < cost of euity =41 < debt C euity ratio % C % argue that B o will not increase with the increase in the leverage, because the low C cost advantage of debt capital will be exactly offset by the increase in the cost of euity as caused by increased ris' to euity shareholders. The crucial part of the % C % Thesis is that an excessive use of leverage will increase the ris' to the debt holders which results in an increase in cost of debt B o!. Jowever, this will not lead to a rise in B o. % C % maintains that in such a case B e will increase at a decreasing rate or even it may decline. This is because of the reason that at an increased leverage, the increased ris' will be shared by the debt holders. Jence Bo remain constant. This is illustrated in the igure given below:

B e

B o

 

(ost of (apital percent!

B d

6

7everage

K

Criticism o 0 0 H2pot!esis

The arbitrage process is the behavioural and operational foundation for % % Jypothesis. #ut this process fails the desired euilibrium because of the following limitations. $. &ates of interest are not the same for the individuals and firms. The firms generally have a higher credit standing because of which they can borrow funds at a lower rate of interest as compared to individuals. *. Jome C %ade leverage is not a perfect substitute for corporate leverage. )f the firm borrows, the ris' to the shareholder is limited to his shareholding in that company. #ut if he borrows personally, the liability will be extended to his personal property also. Jence, the assumption that personal or home C made leverage is a  perfect substitute for corporate leverage is not valid. +. The assumption that transaction costs do not exist is not valid because these costs are necessarily involved in  buying and selling securities. . The wor'ing of arbitrage is affected by institutional restrictions, because the institutional investors are not allowed to practice home C made leverage. 0. The major limitation of % C % hypothesis is the existence of corporate taxes. 1ince the interest charges are tax deductible, a levered firm will have a lower cost of debt due to tax advantage when taxes exist. 0 1 0 H2pot!esis Corporate Ta5es

%odigliani and %iller later recognized the importance of the existence of corporate taxes. @ccordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximising debt component in the capital structure. @ccording to this approach, value of a firm can be calculated as follows:   2#)T >alue of Lnlevered firm >u! < --------) - t! Bo "here, 2#)T < 2arnings before interest and taxes Bo < 6verall cost of capital t < Tax rate. ) < )nterest on debt capital