capital structure and firm evalution

7/31/2019 capital structure and firm evalution

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Give the capital structure equation

Define optimum capital structure and list itsfeatures

Name the capital structure theories

List out the general assumptions of capitalstructure theories

Discuss the NI approach

Explain the NOI approach Critically evaluate MM Theory of capital

structure

Traditional Theory


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The total capital structure theories can be categorized

into two relevant and irrelevant theories.The following are the main theories/Approaches ofcapital structure:

1. Net income (theory) Approach (Relevant)

2. Net operating income Approach (Irrelevant)

3. Modigliani and Miller Approach (Irrelevant)

4. Traditional Approach (Neutral)


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1. Firm uses only two sources of funds: perceptualriskless debt and equity;

2. There are no corporate or income: or personaltax;

3. The dividend payout ratio is 100% [There are no

retained earnings];

4. The firms total assets are given and do notchange [Investment decision is assumed to be

constant].


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5. The firms total financing remains constant.[Total capital is same, but proportion of debt andequity may be changed];

6. The firms operating profits (EBIT) are notexpected to grow;

7. The business risk is remained constant and isindependent of capital structure and financial risk;

8. All investors have the same subject probabilitydistribution of the expected EBIT for a givenfirm; and

9. The firm has perpetual life;


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E = Total market value of equity

D = Total market value of debt

V = Total market value of the firm

I = Annual interest payment

NI = Net income or equity earnings

NOI = Net operating income

Ki = pre-tax cost of debt


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NI Approach: A change in the proportion in capitalstructure will lead to a corresponding change in Ko

and V.

Assumptions:

(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change

the risk perception of investors.

(iv) Cost of debt and cost of equity remains constant;


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E

D

Degree Of Leverage

N I Approach (Contd..)


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NOI Approach: Says that there is no relation between capital

structure and Ko and V. Assumptions:

(i) Overall Cast of Capital (Ko) remains unchanged for alldegrees of leverage. (See Fig. 11.2)

(ii) The market capitalises the total value of the firm as a wholeand no importance is given for split of value of firm betweendebt and equity;

(iii) The market value of equity is residue [i.e., Total value of thefirm minus market value of debt)

(iv) The use of debt funds increases the received risk of equityinvestors, there by ke increases

(v) The debt advantage is set off exactly by increase in cost ofequity.

(vi) Cost of debt (Ki) remains constant

(vii)There are no corporate taxes.


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V = EBIT Ko

E = V-D

E

DDegree Of Leverage


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MM Approach: Total value of firm is independent of its

capital structure

Assumptions:

a. Information is available at free of cost

b. The same information is available for all investorsc. Securities are infinitely divisibled. Investors are free to buy or sell securitiese. There is no transaction costf.

There are no bankruptcy costsg. Investors can borrow without restrictions as thesame terms on which a firm can borrow

h. Dividend payout ratio is 100 percenti. EBIT is not affected by the use of debt


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Proposition:

I. Ko and V are independent of capital structure

II. Ke to capitalisation rate of the pure equity plus apremium for financial risk.

Ke increases with the use of more debt. Increased Keoff set exactly the use of a less expensive source offunds (debt)

III.The cut of rate for investment purposes is completelyindependent of the way in which an investment isfinanced.


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Arbitrage Process: Refers to an act of buying an asset or security in onemarket at lower price and selling it is an other market at higher price.

Steps in working out Arbitrage Process

Students need to keep in mind the following three steps in working ofarbitrage process.

Step 1:Investors Current Position: In this step there is a need to find

out the current investment and income (return).

Step 2: Calculation of Savings in Investmentby moving from leveredfirm 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 incomewill be same which was earning in previous firm.

Step 3: Calculation of Increased Income, by investing total fundsavailable.


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Investors cannot borrow on the same terms andconditions of a firm

Personal leverage is not substitute for corporate

leverage Existence of transaction cost

Institutional restriction on personal leverage

Asymmetric information

Existence of corporate tax


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MM Approach with tax says affects value of the firmVL = VU + Dt

Where VL = Value of levered firm

VU = Value of unlevered firm,

D = Amount of Debtt = Tax rate

In other words value of levered firm (VL) is equal to themarket to the market value of unlevered firm VU plus thediscounted present value of the tax saving resulting from tax -

deductibility a interest payments.(7) Symbolically

VL = VU + pv of tax shield


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Traditional Approach is midway between NI and NOI theories

Traditional approach says judicious use of debt helps increse

value of firm and reduce cost of capital


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Main propositionsThe following three are the main propositions oftraditional approach

1. The pretax cost of debt (Ki) remains more or less

constant upto a certain degree of leverage and/but rises thereafter of an increasing rate

2. The cost of equity capital (Ke) remains more orless constant rises slightly upto a certain degreeof leverage and rises sharper there after, due toincreased perceived risk.


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The over all cost of capital (Ko), as a result ofthe behavior of pre-tax cost of debt (Ki) and

cost of equity (Ke) behavior the followingmanner: It

(a) Decreases upto a certain point level ofdegree of leverage [stage I increasing firmvalue];

(b) Remains more or less unchanged formoderate increase in leverage thereafter[stage II optimum value of firm], and

(c) Rises sharply beyond certain degree ofleverage [stage III decline in firm value].


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E

D

capital structure and firm evalution

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