capital structure decisions - icai knowledge · pdf fileuis the capital structure at which the...

Capital Structure Decisions CA Navin Khandelwal

CAIPCC/Paper3/FinMgt/FinDecisions/CapitalStructure

Learning Objectives:

uA “Capital structure” uAn optimal capital structure uValue of firm uEBIT-EPS uBreak Even or Indifference Analysis uConstructing and interpreting an EBIT-EPS chart uTest learning by illustrative examples

Optimum Capital Structure

u Is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value the firm.

uThe optimum capital structure minimizes the firms overall cost of capital and maximizes the value of the firm.

uOptimum capital structure is also referred as “ appropriate capital structure”

Optimum capital structure

Factors determining Capital Structure

Theories of capital structure

Basic assumptions: • There are only two sources of funds used by a firm: perpetual

risk less 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.

• The operating profits (EBIT) are not expected to grow.

Factors determining capital structure

Factors

Internal •Cost of capital

•Risk factor •Control factor

•Objectives •Constitution of the company •Attitude of the management

External •Economic conditions

•Interest rates •Policy of lending

•Tax policies

•Statutory restrictions

Theories of capital structure

Theories of capital structure…. Contd.

• 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 cost of equity capital.

• All investors are assumed to have same subjective probability distribution of the future expected EBIT for a given firm.

• Business risk is constant over time and is assumed to be independent of its capital structure and financial risk.

• Perpetual life of the firm.

Approaches to Capital Structure

Approaches to Capital Structure

uNet Income NI approach uNet Operating Income NOI approach uModigliani Miller MM approach uTraditional approach

Net Income Approach

Net Income Approach uThis approach is given by ‘Durand David’

u There are no taxes

u Cost of debt is less than the cost of equity

u Use of debt does not change the risk perception of the investor.

uAccording to this approach, the capital structure decision is relevant to the valuation of the firm.

uAssumptions: this approach is based on three assumptions

uA change in the capital structure causes a overall change in the cost of capital and also in the total value of the firm.

Net Income Approach uA higher debt content in the capital structure means a

high financial leverage and this results in the decline in the overall weighted average cost of capital and therefore there is increase in the value of the firm.

uThus with the cost of debt and the cost of equity being

constant, the increased use of debt (increase in leverage), will magnify the share holders earnings and, thereby, the market value of the ordinary shares.

uNI Net Income= EBIT-I or earnings available to equity share holders.

uValue of the firm: market value of debt + market value of equity.

Net Income Approach

Ki = cost of debt Ke = cost of equity

B = Total market value of DEBT S = Total market value of EQUITY

Overall cost of capitalization (ko) EBIT/V or (ko) = ki (B/V) + ke (S/V)

Net Income Approach

uNet income approach view of capital structure:

Average cost of capital

Cost of debt

Cost of equity

Cost of capital

Degree of leverage

Net Operating Income NOI approach

Net Operating Income Approach uThis is another theory suggested by Durand

uAccording to NOI approach value of the firm is

independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm

uAny change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage

uNOI approach is opposite to NI approach

Net Operating Income Approach: Assumptions uThe investors see the firm as a whole and thus

capitalize the total earnings of the firm to find the value of the firm as a whole

uThe overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchanged

uThe cost of debt (kd) is also constant

uThere is no tax uThe use of more and more debt in the capital structure

increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke)

NOI Approach: Propositions

Overall cost of capital/ capitalization rate (ko) is constant: NOI approach argues that the overall capitalization rate of the

firm remains constant for all degrees of leverage. The value of the firm given the level of EBIT is determined by:

V= EBIT/ko EBIT= earnings before interest and tax Ko= overall cost of capital or V=EBIT(1-t) + Bt ke B= value of debt

NOI approach is based on the following prepositions:

NOI Approach: Prepositions

Residual value of equity The value of equity is the residual value which is determined by

deducting the total value of debt (B) from the total value of the firm (V)

S = V-B S= value of equity V= value of firm B = value of debt

NOI approach is based on the following prepositions:

NOI Approach: Prepositions

uThe cost of equity capital (Ke) increases with the degree of leverage.

uThe increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders.

uTo compensate for the increased risk to the ordinary shareholders would expect a higher rate of return on their investment.

uThe increase in the equity capitalization rate would match in the increase in debt equity ratio.

Change in cost of equity capital

Optimal Capital Structure


uThe total value of the firm is unaffected by its capital structure.

uNo matter what the degree of leverage is the total value of the firm remain constant.

uThe market price of shares will also not change with the change in debt equity ratio.

uThere is nothing such as optimum capital structure any capital is optimum according to NOI approach.

bhushan

Degree of leverage

Cost of capital

ke

ko

ki


Modigliani Miller Approach

Modigliani Miller (MM) Approach

uThe M.M thesis relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI approach.

uThe NOI approach does not provide operational or

behavioral justification for the irrelevance of the capital structure.

uThe significance of M.M approach lies in the fact that it

provides behavioral justification for constant overall cost of capital and therefore total value of firm.

“Perfect capital market” u Securities are infinitely divisible u Investors are free to buy/ sell securities u Investors can borrow without restrictions on the same

terms and conditions as the firm can u There are no transactions costs u Information is perfect, that is each investor has same

information which is readily available to him without cost; &

u Investors are rational and behave accordingly.

MM Approach: Assumptions

MM Approach: Assumptions.. Contd... uGiven the assumption of perfect information and

rationality all investors have the same expectations of firm net operating income (EBIT) with which to evaluate the value of a firm

uBusiness risk is equal among all the firm within similar operating environment, that means all the firms can be divided into “equivalent risk class”.

uThe term equivalent/homogeneous risk class means that the expected earnings have identical risk characteristics and firm within an industry are assumed to have same risk characteristics

uThe dividend payout ratio 100% uThere are no taxes. (This assumption is removed later)

MM Approach: Propositions

There are three basic proposition of M.M approach. Preposition One

The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure, the ko and V are

constant for all degrees of leverages. the total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class.

V=EBIT ko

“V is determined by the assets in which the company has invested and not how those assets are financed”

Degree of leverage (B/V)

V

Ko %

MM Approach: Proposition 1

MM Approach: Propositions Proposition 2

The second proposition of M.M approach is that the ke is equal to the capitalization rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalization rate (ke) and (ki) times the ratio of debt to equity.

In other words “ke increases in the manner to offset exactly the use of a less expensive source of funds represented by debt” or

The rate of return required by the shareholders increases linearly as the debt/equity ratio is Increased.

Ke(L) = Ke(u)+[(ke(u)-ki)*D/E]

Proposition Three The cut-off rate for the investment purpose is completely

independent of the way in which an investment is financed. The cut off rate for investment will be in all cases the WACC .

MM Approach: Propositions

Criticism of MM approach

uRisk perception uConvenience uCost uInstitutional restrictions uDouble leverage uTransaction cost uTaxes

Traditional Approach

Traditional approach : WHY? uThe net income approach (NI) as well as net operating income

approach(NOI) represent two extremes as regards the theoretical relationship b/w:

“Capital Structure” “Weighted Average Cost of Capital”

“Value of the firm” uNI Approach: Use of debt in the capital structure will always

affect the overall cost of capital and the total valuation NOI approach: argues- “capital structure is totally irrelevant” uThe MM Approach supports the NOI approach. But the

assumptions of MM approach are of doubtful validity.

uThe traditional approach is the midway between the NI and NOI approaches.

u It partakes of some features of both these approaches. “Thus also known as Intermediate approach”

u It resembles or agrees with the NI approach in arguing that cost of capital and total value of the firm are not independent of the capital structure. But it dose not agree with the view that the value of firm will necessarily increase at all degrees of leverage .

Traditional approach : WHY?


u It shares a feature with NOI approach also that beyond a certain degree of leverage, the overall cost increases leading to decrease in the total value of the firm. And it differs with NOI approach in that it dose not argue that the weighted average cost of capital is constant for all degrees of leverage.

uThe crux of traditional view relating to leverage and valuation is that through judicious use of debt-equity proportions, a firm can increase its total value and there by reduce its over all cost of capital.

uThe rationale behind this view is that debt is relatively cheaper source of funds as compared to ordinary shares.


uWith a change in the leverage, that is , using more debt in place of equity, a relatively cheaper source of fund replaces a source of fund which has relatively higher cost. This obviously causes a decline in the over all cost of capital.

u If the debt-equity ratio is raised further, the firm would become financially more risky to the investors who will penalize the firm by demanding a higher equity capitalization rate (ke). But the increase in ke may not be so high to neutralize the benefit of using cheaper debt.


If, however, the debt is increased further two things are likely to happen:

owing to increased financial risk ke will record a substantial rise

(ii) the firm would become very risky to creditors who also would be compensated by a higher return such that ki

will rise


uThe use of debt beyond a certain point will, therefore, have the effect of raising the weighted average cost of capital and conversely reducing the total value of the firm.

uThus up to a point the use of debt will favorably affect the value of the firm; beyond that point use of debt will adversely affect the value of the firm. At that level of debt-equity ratio, the capital structure is an optimal capital structure.

Over all cost of capital and optimum leverage

WACC

Cost of equity Ke

Cost of debt Ki

Optimum level of capital

Cost of capital

Degree of leverage

Overall Cost of Capital & Value of Firm

Market value

Value of firm

Value of equity

Value of debt

Optimum level of capital

Degree of leverage

EBIT-EPS analysis

uEBIT-EPS analysis should be considered logically as the first step in the direction of designing a firm’s capital structure.

uEBIT-EPS analysis shows the impact of various financing alternatives on EPS at various levels of EBIT.

This analysis is useful for two reasons uThe EPS is the measure of firms performance given the P/E

ratio, the larger the EPS the larger would be the value of the firm

uThe EBIT-EPS analysis information can be extremely useful to finance manager in arriving at an appropriate financing decision.

EBIT -EPS Analysis

u In general, the relationship between EBIT and EPS is as follows

EPS= (EBIT-I) (1-t) N

Where EPS= earning per share

EBIT= earnings before interest and tax I= interest

t= tax N= number of equity shares

Break even EBIT level or Indifference point

uThe breakeven EBIT for two alternative financing plans is the level of EBIT for which the EPS is the same under both the financing plans.

(EBIT-I) (1-t) = (EBIT-I) (1-t) N N

Financial breakeven

u It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. interest and preference dividends.

It denotes the level of EBIT for which the firms EPS just equals to zero.

u If EBIT is less than financial break even point, then EPS will be negative uBut if the expected level of EBIT exceeds than that of break even point more fixed costs financing instruments can be inducted in the capital structure otherwise the use of equity will be preferred.

Choices for CAPITAL STRUCTURE

DEBT+EQUITY+PREFERENCE

DEBT PREFERENCE

DEBT EQUITY

DEBT EQUITY

PREFERENCE

EQUITY

PREFERENCE

Illustrative Examples

Total Capital Required Rs. 10,00,000 EBIT Rs. 500,000

Assume Corporate Tax 50% Case – 1 Only Debt Case – 2 Only Equity Case – 3 Only Preference Case – 4 Debt + Equity Case – 5 Equity + Preference Case - 6 Debt+Preference Case – 7 Debt+Equity+Preference

Illustrative Examples- Case 1- Only Debt

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 100,000 PBT(Profit Before Tax) Rs. 400,000

(-) Tax @ 50% Rs. 200,000 PAT(Profit After Tax) Rs. 200,000

Illustrative Examples- Case 2- Only Equity

EBIT Rs. 500,000

(-) Interest @ 10% Nil PBT(Profit Before Tax) Rs. 500,000


No. of Eq. Shareholders 100,000 EPS (Earning/Share) Rs. 2.50/Share

Illustrative Examples- Case 3- Only Preference

EBIT Rs. 500,000

(-) Interest @ 10% Nil PBT(Profit Before Tax) Rs. 500,000


(-) Pref. Dividend @ 10% Rs. 100,000 NPAT (Net PAT) Rs. 150,000

Illustrative Examples- Case 4- Debt + Equity

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 50,000 PBT(Profit Before Tax) Rs. 450,000


No. of Eq. Shareholders 50,000 EPS (Earning/Share) Rs. 4.50/Share

Illustrative Ex.- Case 5- Equity + Preference

EBIT Rs. 500,000

(-) Interest @ 10% NIL

EBT(Earning Before Tax) Rs. 500,000

(-) Tax @ 50% Rs. 250,000

EAT(Earning After Tax) Rs. 250,000

(-)Preference dividend Rs. 50,000

NPAT Rs. 200,000

/No. of Equity share 50,000

EPS Rs. 4

Illustrative Ex.- Case 6- Debt + Preference

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 50,000

EBT(Earning Before Tax) Rs. 450,000

(-) Tax @ 50% Rs. 225,000

EAT(Earning After Tax) Rs. 225,000

(-)Preference dividend Rs. 50,000

NPAT Rs. 175,000

Illus. Ex.- Case 7- Debt + Equity +Preference

EBIT Rs. 500,000

(-) Interest @ 10% Rs. 20,000 EBT(Earning Before Tax) Rs. 480,000

(-) Tax @ 50% Rs. 240,000 EAT(Earning After Tax) Rs. 240,000 (-)Preference dividend Rs. 30,000

NPAT Rs. 210,000 No. of Equity Share 50,000

EPS Rs. 4.20/Share

Comparison of Results

CASE PAT EPS

Only Debt Rs. 400,000 N.A.

Only Equity Rs. 250,000 Rs. 2.50/Share

Only Preference Rs. 250,000 N.A.

Debt + Equity Rs. 225,000 Rs. 4.50/Share

Equity + Preference Rs. 250,000 Rs. 4.00/Share

Debt+Preference Rs. 225,000 N.A.

Debt+Equity+ Preference

Rs. 240,000 Rs. 4.20/Share

Questions asked in Exams 2 (May 2003)

Calculate the level of EBIT at which EPS indifference point b/w following financing alternatives will occur.

1. Equity Share capital of Rs. 600,000; 12% debentures of Rs. 400,000. 2. Equity Share capital of Rs. 400,000; 14% preference shares of Rs.

200,000 and 12% debentures of Rs. 400,000. Assume the company is in 35% tax bracket and par value of equity share is

Rs. 10 in each case.

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