Theories of Capital Structure

Theories of Capital Structure

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Meaning of an Optimum Capital Structure  –

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One that Makes the EPS maximum or the value of  the firm Maximum Reduces the cost at which the capital Raised

The objective of the firm therefore should be to select that financing option or the D/E mix that leads to the Maximization of Value or  Minimization of the cost of Capital of the firm f irm

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Theories of Capital Structure

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Capital Structure Theories  –

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Relevant Theories •

There exists an “OPTIMAL CAPITAL STRUCTURE”

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“Net Income Approach”

Irrelevant Irrelevant Theories Theor ies •

•

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There is nothing such as Optimal Capital Structure Any capital structure is as good as any other capital structure Net Operating Income Approach

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Capital Structure •

Assumptions 1. Firm Firm Empl Employ oyss onl only y 2 sour source cess of of Capit Capital al 1.

Debt Debt and and Equ Equit ity y. There There is no pref prefer eren ence ce Shar Shares es

2. Ther There e are are no cor corpo porrat ate e tax( tax( rem remov oved ed lat later er)) 3. The The Div Divid iden end d pa payout out rat ratio io is 1.

4. Firms total assets don’t change 5. EBIT does not change 6. The firms firms tota totall financ financing ing remai remains ns const constan ant. t. The firm can change its capital structure by 1.

Redee edeemi ming ng the the debe debent ntur ure e by iss issui uing ng sha share ress

2.

Rais Raisin ing g mor more e deb debtt and and buy buy bac back k equ equit itie iess thus thus Financial Management Management Lec by JPS reducing shares.

Capital Structure Net Income Approach • Given By David Durand • Total value of the firm changes with the change in the capital structure of the firm • As per this approach the cost of debt< Cost of Equity • Total Value of the firm = Market Value of Debt+ Market Value of Equity • V= S+B • S = Market Value of Equity(Shares) • S= EATES/Ke • B = Market Value of Debt ( Borrowings) • Overall Cost of Capital = EBIT/Total Value of the Firm

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Capital Structure •

How to calculate the Market Value of the Firm

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Example  –

A Ltd is expecting an EBIT of RS 1 Lakhs. The capital structure of company consists of 4 lakhs debentures @ 10%.The cost of equity capitalization ke is 12.5%.Calculate the total value of the firm and also the overall cost of capital.

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Earnings Statement of the COMPANY 3

Earning Before Interest and Tax (EBIT)

Rs 1,00,000

4

Less Interest on the Debentures(10% on 4 lakhs)

40,000

5

EBT (Earnings before Tax)

Rs 60,000

6

Less Tax

NIL

7

Earnings after Tax Or Profit After Tax (PAT)

RS 60,000

8

Less Dividend to Pref. Share Holders

NIL

9

Earnings Available to Equity Share Holders (EATES)

RS 60,000

10

Market Value of Equity (EATES/Ke)

60,000/.125= Rs 4,80,000

11

Market Value of Debt

4,00,000

12

Total Value of the Firm(10+11)

8,80,000

Ko

1,00,000/8,80,000 Financial Management Lec

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Capital Structure •

How to calculate the overall cost of Capital?  –

Earnings/Total Value of the firm

 –

EBIT/Total Value of the Firm

 –

Ko = 1,00,000/8,80,000 =

11.3%

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Capital Structure •

Effect of change in the D/E ratio on the Market value of the firm and on the overall cost of  capital  –

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The same company decides to raise 1 lakh Rs by issuing debentures @10% and reducing the share capital by an equal amount. Calculate the total value of the firm and also the overall cost of  capital. Debt has Increased and Equity has decreased

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Earnings Statement of the COMPANY 3

Earning Before Interest and Tax (EBIT)

Rs 1,00,000

4

Less Interest on the Debentures(10% on 5 lakhs)

50,000

5

EBT (Earnings before Tax)

Rs 50,000

6

Less Tax

NIL

7

Profit After Tax (PAT)

RS 50,000

8

Less Dividend to Pref. Share Holders

NIL

9

Earnings Available to Equity Share Holders (EATES)

RS 50,000

10

Market Value of Equity (EATES/Ke)

50,000/.125= Rs 4,00,000

11

Market Value of Debt

5,00,000

12

Total Value of the Firm(10+11)

9,00,000

31

Ko (EBIT/Total Value of the firm)

11.1%

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Capital Structure  –

 –

The same company decides to raise 1 lakh Rs by issuing equity shares and redeem the debentures with the amount received by raising the equity shares. Calculate the total value of the firm and also the overall cost of capital. Debt has Decreased and Equity has Increased

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Earnings Statement of the COMPANY 3

Earning Before Interest and Tax (EBIT)

Rs 1,00,000

4

Less Interest on the Debentures(10% on 3 lakhs)

30,000

5

EBT (Earnings before Tax)

Rs 70,000

6

Less Tax

NIL

7

Profit After Tax (PAT)

RS 70,000

8

Less Dividend to Pref. Share Holders

NIL

9

Earnings Available to Equity Share Holders (EATES)

RS 70,000

10

Market Value of Equity (EATES/Ke)

70,000/.125= Rs 5,60,000

11

Market Value of Debt

3,00,000

12

Total Value of the Firm(10+11)

8,60,000

31

Ko (EBIT/Total Value of the firm)

11.6%

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Capital Structure •

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•

Before changing the D/E mix.  –

MV of Firm = 8,80,000

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Over all Cost of Capital = 11.3%

After changing the D/E mix. ( Increasing the Debt Component)  –

MV of Firm = 9,00,000

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Over all Cost of Capital = 11.1%

After changing the D/E mix. ( Decreasing the Debt Component)  –

MV of Firm = 8,60,000

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Over all Cost of Capital = 11.6%

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Net Income Approach

Cost of Capital

Kd Ko Ke

D/E Ratio ( Gearing Ratio)

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Net Operating Income Approach •

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Other Extreme of the Capital Structure theories As per this approach there is nothing as “Optimal Capital Structure” Increasing the debt content in the capital Structure does not change the Overall cost of capital of the firm and the value of  the firm does not change

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Thus Over all cost of Capital and MV of Firm Does not change

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Additional Assumptions of NOI •

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Overall Cost of Capital of the company remains constant irrespective of the D/E mix in the capital structure The market value of the equity is calculate by deducting the value of debt from the total value of the firm The increase in the low cost debt increase the riskiness of the company and thus there is a corresponding increase in the cost of  equity so that the total coast of capital remains constant Financial Management Lec

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Net Operating Income Approach •

As per this approach  –

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Overall Cost of Capital of the company remains constant irrespective of the D/E mix in the capital structure Market Value of the firm will remain constant , irrespective if any capital structure In NUT SHELL we can say that there is nothing as “OPTIMAL CAPITAL STRUCTURE”

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Steps in NOI

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Value of the Firm = EBIT/ Ko

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Value of Equity = Total Value of the firm-Total Value of Debt S = V-B

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Capital Structure •

Example  –

A Ltd is expecting an EBIT of RS 1 Lakhs. The capital structure of company consists of 4 lakhs debentures @ 10%.The overall cost of capital k o is 12.5%.Calculate the total value of the firm and the total value of equity. Also find K e

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Total value of Firm = EBIT/ ko

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V = Rs 8,00,000

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B= 4,00,000

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S = V-B = 4,00,000 Financial Management Lec

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Capital Structure •

How to find Ke

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Ke = EATES/Market Value of Equity

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= 60,000/4,00,000 = 15%

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So for this firm  –

V= 8,00,000

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Ko = 12.5%

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Ke = 15%

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Kd = 10%

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Capital Structure  –

 –

The same company decides to raise 1 lakh Rs by issuing debentures @10% and reducing the share capital by an equal amount. Calculate the total value of the firm .Overall cost of capital remains same at 12.5%.Find market value of the firm and Equity capitalization Rate. Debt has Increased and Equity has decreased

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Capital Structure  –

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Since as per this approach the Ko and MV of the firm remains constant MV of Firm = EBIT/Ko = 1,00,000/.125 = RS 8,00,000

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MV of Debt = Rs 5,00,000

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MV of Equity = RS 3,00,000 ( 8,00,00-5,00,000)

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Ke = EATES/MV of Equity = 50,000/3,00,000 = 16.67%

So the effect of increasing the debt component is  –

No Change in the overall value of the firm

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No change in Ko (Overall cost of Capital is constant)

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Ke increases from 15% to 16.67 % Financial Management Lec

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Capital Structure  –

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Ko (Overall cost of Capital is constant) why? It is the weighted average of Kd and Ke

Ko = wd Kd + we Ke •

Wd = Proportion of Debt in total capital ( B/V)

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We= Proportion of Equity in total capital (S/V)

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Wd + We=1

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Kd = After tax cost of capital. = Kd (before tax) (1-t)

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Ke = Cost of Equity

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Verify this

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Ko = 10% X ( 5,00,000/8,00,000) + 16.67% ( 3,00,000/8,00,000) = 12.5%

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NOI Summary  –

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As debt component increases the cost of Equity increases so that the overall cost of capital remains constant.Why? As per NOI as the proportion of the debt in the capital Structure increases the company becomes more risky in the eyes of the investors and thus they require more return on the equity., while in case of NI approach the company can go on borrowing without having any impact on the cost of equity. This is the basic difference in the two approaches. Financial Management Lec

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Net Operating Income Approach

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MM Approach Kd

Ke

B/V

8.0

10

0

8.0

10

.1

8.6

11

.2

9.0

12

.3

12

15

.5

15

18

.6

Determine the which capital structure is suitable for the firm.Tax rate is 50%

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Modigiliani –Miller Approach  –

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Similar to NOI Approach, In fact a “Behavioural Explanation” of the NOI approach

Basic difference between NOI and MM is that NOI is purely Definitional /Conceptual while MM is the explanation of that concept As per this approach also there is nothing as “Optimal Capital Structure” and thus one firm can not have a value greater than the other , just because it has a different capital structure

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MM Approach •

Assumptions of MM Approach  –

Capital Markets are perfect •

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Investors are free to buy and sell securities Investors can buy without restrictions on the same rate as corporate ( This concept is called the “Home made Leverage”)

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Investors are well informed

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Investors behave rationally

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No Transaction costs

Firms can be grouped in to “RISK CLASSES”, which means all firms in the same risk class have the same business risk

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DP ratio is 1

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No Corporate Taxes

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MM Approach •

Basic premise of the approach  –

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No Matter how you divide up the capital structure of a firm in debt and equity it does not impact the valuation of the firm It tries to explain the above mentioned statement by a process Called “ARBITRAGE”

Arbitrage process is called the “operational   justification” of MM What is “Arbitrage” •

Selling the security of overvalued firm and buying the security of undervalued firm , which are other wise identical in nature” Financial Management Lec

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MM Approach •

Effect of Arbitrage Process  –

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It restores “Equilibrium” Basically it implies that if “two firms are similar in all respect except there capital structure then the market price of their shares can (Values of the firms) not remain different for long The Investors sell the overvalued firm and start buying the undervalued firm .why? Because they see an opportunity to make abnormal profits by doing this This process continues till their prices become equal They are brought to the same level by the process of  “Arbitrage” Thus it is based on the concept of arbitrage MM explain that the valuation of the two firms, who are same in all respect Financial Management Lec bybe JPS same. ,other than D/E ration, will always

MM Approach •

How Arbitrage Works

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Example  –

Let two firms A and B are “identical” in all respects except for the D/E ratio. Firm A has 10% debentures of Rs 50,000 debentures while firm B is an all equity firm. The EBIT for both companies is Rs 10,000 .Equity Capitalization Rate for A is 16% while for B is 12.5 %.Calculate the MV of  Each of the firms

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MM Approach Firm A(D+E)

B( All Equity)

EBIT

10,000

10,000

interest

5000

Nil

EATES

5,000

10,000

Ke

16%

12.5%

MV of Equity

31,250

80,000

MV of Debt

50,000

Nil

Total Value of the firm

81,250

80,000

Ko (Overall cost of capital) EBIT/Total Value of Firm

10,000/81250= 12.3%

10,000/80000 = 12.5%

Overvalued firm

Under Valued firm

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MM Approach •

Working of the Arbitrage Process  –

An investor has 10% stake in Company A

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Equity Share for the investor = 10% 31250m = RS 3125

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His return on investment from A = 16% of 3125= Rs

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Risk Exposure is also 10% = Rs 5000

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He decides to invest 10% in company B

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In order to invest in B total money needed = Rs 8000

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500

Investor wants the risk exposure in firm B should not be more than Rs 5000.

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He creates debt by borrowing Rs 5000.( Home Made Leverage)

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Spends his own equity = Rs 3000

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Return = 12.5% of RS 8000 = Rs 1000 less Rs 500 = RS 500

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