capital structure theories (1)

Capital Structure

• Capital Structure concept• Capital Structure planning• Concept of Value of a Firm• Significance of Cost of

Capital (WACC)

Capital Structure Coverage –

• Capital Structure theories – Net Income Net Operating Income Modigliani-Miller Traditional Approach

Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions)Maximization of shareholders’ wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company.Planning a capital structure is a highly psychological, complex and qualitative process.It involves balancing the shareholders’ expectations (risk & returns) and capital requirements of the firm.

Capital Structure

Planning the Capital Structure Important Considerations – Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share.

Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends.

Risk: insolvency risk associated with high debt component. Control: avoid dilution of management control, hence debt

preferred to new equity shares. Flexible: altering capital structure without much costs &

delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and

principal.

Value of a firm depends upon earnings of a firm and its cost of capital (i.e. WACC).

Earnings are a function of investment decisions, operating efficiencies, & WACC is a function of its capital structure.

Value of firm is derived by capitalizing the earnings by its cost of capital (WACC). Value of Firm = Earnings / WACC

Thus, value of a firm varies due to changes in the earnings of a company or its cost of capital, or both.

Capital structure cannot affect the total earnings of a firm (EBIT), but it can affect the residual shareholders’ earnings.

Value of a Firm – directly co-related with the maximization of shareholders’ wealth.

Factors Determining Capital Structure

Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

Factors Determining Capital Structure Degree of control- In a company, it is the directors who are so

called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure flexible, the company should go for issue of debentures and other loans.


Choice of investors- The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.

Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in period of boom and inflation, the company’s capital should consist of share capital generally equity shares.


Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.

Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.


Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Particulars Rs.Sales (A) 10,000

(-) Cost of goods sold (B) 4,000

Gross Profit (C = A - B) 6,000

(-) Operating expenses (D) 2,500

Operating Profit (EBIT) (E = C - D) 3,500

(-) Interest (F) 1,000

EBT (G = E - F) 2,500

(-) Tax @ 30% (H) 750

PAT (I = G - H) 1,750

(-) Preference Dividends (J) 750

Profit for Equity Shareholders (K = I - J) 1,000

No. of Equity Shares (L) 200

Earning per Share (EPS) (K/ L) 5

An illustration of

Income Statement

ASSUMPTIONS – Firms use only two sources of

funds – equity & debt. No change in investment decisions

of the firm, i.e. no change in total assets.

100 % dividend payout ratio, i.e. no retained earnings.

Business risk of firm is not affected by the financing mix.

No corporate or personal taxation. This assumption is removed later.

Investors expect future profitability of the firm.

Capital Structure Theories

Capital Structure Theories – A) Net Income Approach (NI) Net Income approach (By Durand) proposes that

there is a definite relationship between capital structure and value of the firm.

The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm.

NI approach assumptions –o NI approach assumes that a continuous increase in

debt does not affect the risk perception of investors.o Cost of debt (Kd) is less than cost of equity (Ke) [i.e.

Kd < Ke ]o Corporate income taxes do not exist.

Capital Structure Theories – A) Net Income Approach (NI) As per NI approach, higher use of debt capital will

result in reduction of WACC. As a consequence, value of firm will be increased.

Earnings (EBIT) being constant and Ko (Weighted average cost of capital) is reduced, the value of a firm will always increase.

Thus, as per NI approach, a firm will have maximum value at a point where WACC is minimum, i.e. when the firm is almost debt-financed.

Capital Structure Theories – A) Net Income Approach (NI)

According to net income approach, the value of the firm and the value of equity are determined as given below:

Value of Firm (V) = S + B Where, S= Market value of Equity

B= Market Value of Debt Market Value of Equity (S) = NI/Ke

Where, NI = Net income available for equity shareholders

Ke = Equity capitalisation rate Overall capitalisation rate(Ko) = EBIT/V

Where, EBIT= Earnings before interest & taxV= Value of firm


ke

kokd

Debt

Cost

kd

ke, ko

As the proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces.

Calculate the value of Firm and WACC for the following capital structuresEBIT of a firm Rs. 200,000. Ke = 10%Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000

Kd = 6%

Particulars case 1 case 2 case 3EBIT 200,000 200,000 200,000 (-) Interest 30,000 42,000 12,000 EBT 170,000 158,000 188,000

Ke 10% 10% 10%Value of Equity 1,700,000 1,580,000 1,880,000 (EBT / Ke)

Value of Debt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%(EBIT / Value) * 100


Capital Structure Theories – B) Net Operating Income (NOI) Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach.

As per NOI approach, value of a firm is not dependent upon its capital structure.

Assumptions – o WACC is always constant, and it depends on the

business risk.o Value of the firm is calculated using the overall

cost of capital i.e. the WACC only.o The cost of debt (Kd) is constant.o Corporate income taxes do not exist.

Capital Structure Theories – B) Net Operating Income (NOI) NOI propositions (i.e. school of thought) –

The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (Ke)

A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt (Kd )

In other words, the finance mix is irrelevant and does not affect the value of the firm.

Capital Structure Theories – B) Net Operating Income (NOI)

The NOI approach believes that the market value of the firm as a whole for a given risk complexions. Thus for a given value of EBIT, the value of the firms remains the same irrespective of the capital compositions, and instead depends on the overall cost of capital.

Value of Firm (V) = EBIT/Ko Where, EBIT = Earnings before interest and tax

Ko = Overall Cost of capital Value of Equity (S) = V – B

Where, V = Value of firm B = Value of debt

Equity capitalisation rate(Ke) = (EBIT-I)/(V-B) Where, V = Value of firm EBIT= Earnings before interest

& tax B = Value of debt I= Interest

Capital Structure Theories – B) Net Operating Income (NOI) Cost of capital

(Ko) is constant. As the

proportion of debt increases, (Ke) increases.

No effect on total cost of capital (WACC)

ke

ko

kd

Debt

Cost

Calculate the value of firm and cost of equity for the following capital structure -EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)

Particulars Option I Option II Option IIIEBIT 200,000 200,000 200,000

WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000

Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%

Capital Structure Theories – B) Net Operating Income (NOI)

Capital Structure Theories – C) Modigliani – Miller Model (MM)According to Modigilani & Miller cost of capital is independent of capital structure and there is no optimal value. According to them, under competitive conditions and perfect markets, the choices between equity financing and borrowing does not affect firms market value because the individual investor can alter investment to any mix of debt and equity the investor desires. MM argues that a company’s WACC remains unchanged at all levels of gearing, implying that no optimal capital structure exist for a particular company.

Assumptions1. The MM theory is based on the following assumptions:

1. The capital market is assumed to be perfect. It means that both investors and individuals can borrow unlimited

amounts at the same rate of interest. There are no limits of borrowing.

2. The investors are free to sell and buy securities and are well informed about the risk and return involved in different securities. All securities are infinitely divisible.

3. There are no transaction costs. There are no brokerage or other transaction cost.

4. The debt is less expensive than equity. Increase in debt will increase the financial risk of the firm and expectations of equity holders will be more. Thus the average cost of capital will remain constant for all levels of leverage.

5. There is no benefit of debt financing other than reduction in corporate income taxes due to tax shield of interest payments of debt.

6. Interest rates are equal between borrowing and lending for firms as well as individuals.

7. The firms investments and cash flows are assumed to be constant.

9. The stock market is perfectly competitive.10. The investors are rational and expect other investors

to behave rationally.11. The dividend payout ratio is 100% i.e. there are no

retained earnings.

Capital Structure Theories – C) Modigliani – Miller Model (MM)MM Model proposition –

o Value of a firm is independent of the capital structure.

o Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC).

o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt

= Expected EBIT Expected WACC

MM Theory : No Taxation

The debt is less expensive than equity. An increase in debt will increase the required rate of return on equity. With the increase in the level of debt, there will be higher level of interest payments affecting the cash flows of company. Then equity shareholders demand for more returns. The increase in cost of equity is just enough to offset the benefit of low cost debt, and consequently average cost of capital is constant for all levels of leverage.

There are three basic propositions of MM approach:

Propositions I : 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 at all degrees of leverage. The total value is given by capitalizing the expected stream of operating earning s at a discount rate appropriate for its risk class. WACC is independent of the debt/equity ratio

and equal to the cost of capital which the firm would have with no gearing in its capital structure.

Proposition 2This asserts that the rate of return required by shareholders increases linearly as the D/E ratio increases i.e. the cost of equity increases exactly in line with any increase in gearing to precisely offset any benefits conferred by the use of apparently cheap debt. MM went on arguing that the expected return on the equity of a geared company is equal to the return on equity stream plus a risk premium dependent on the capital structure.

Proposition 3MM theory’s third proposition asserts that the cut off rate for new investment will in all cases be average cost of capital and will be unaffected by the type of security used to finance the investment. The cut off rate for investment purposes is completely independent of the way in which an investment is financed. This implies a complete separation of investment and financing decisions of the firm.

Capital Structure Theories – C) Modigliani – Miller Model (MM)MM Model proposition –

o As per MM, identical firms (except capital structure) will have the same level of earnings.

o As per MM approach, if market values of identical firms are different, ‘arbitrage process’ will take place.

o In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.

MM Model without taxes (In Brief)

The firms capital structure is irrelevant. The WACC is the same no matter what mixture of debt

and equity is used to finance the firm., and Cost of Equity (Ke) = Ko +(Ko-Kd)D/E. It implies that

cost of equity rises as the firm increases use of debt.

MM Theory : With Taxation

The value of levered firm is equal to the value of unlevered firm + the present value of the interest tax shield i.e.,

Vl = Vu+D(t)So debt financing is advantageous and it increases the

value of firm. The WACC of the firm decreases, as the firm relies

more and more on debt financing. The cost of equity, Ke= Ko+(Ko-Kd)(D/E)(1-t)Where Ko is the WACC of the unlevered firm.

Capital Structure Theories – C) Modigliani – Miller Model (MM)Levered Firm

•Value of levered firm = Rs. 110,000 •Equity Rs. 60,000 + Debt Rs. 50,000•Kd = 6 % , EBIT = Rs. 10,000, •Investor holds 10 % share capital

Un-Levered Firm•Value of un-levered firm = Rs. 100,000 (all equity)•EBIT = Rs. 10,000 and investor holds 10 % share

capital

Capital Structure Theories – C) Modigliani – Miller Model (MM)

Return from Levered Firm:10 110,000 50 000 10% 60,000 6 000

10% 10,000 6% 50,000 1,000 300 700

Alternate Strategy:

1. Sell shares in : 10% 60,000 6,0002. Borrow (personal leverage):

Investment % , ,

Return

L

10% 50,000 5,000

3. Buy shares in : 10% 100,000 10,000Return from Alternate Strategy:

10,00010% 10,000 1,000

: Interest on personal borrowing 6% 5,000 300Net return 1,000 300 700Ca

U

InvestmentReturnLess

sh available 11,000 10,000 1,000

Capital Structure Theories – D) Traditional Approach The NI approach and NOI approach hold extreme

views on the relationship between capital structure, cost of capital and the value of a firm.

Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches.

Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum.

As per this approach, a best possible mix of debt and equity will maximize the value of the firm.

Capital Structure Theories – D) Traditional ApproachThe approach works in 3 stages – 1) Value of the firm increases with an increase in borrowings

(since Kd < Ke). As a result, the WACC reduces gradually. This phenomenon is up to a certain point.

2) At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate.

3) Increase in debt beyond this point increases shareholders’ risk (financial risk) and hence Ke increases. Kd also rises due to higher debt, WACC increases & value of firm decreases.

Capital Structure Theories –D) Traditional Approach

ke

ko

kd

Debt

Cost Cost of capital

(Ko) is reduces initially.

At a point, it settles

But after this point, (Ko) increases, due to increase in the cost of equity. (Ke)

EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt tothe extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%. For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case IIDebt component - 300,000 500,000 Rate of interest 0% 10% 12%EBIT 150,000 150,000 150,000 (-) Interest - 30,000 60,000 EBT 150,000 120,000 90,000 Cost of equity (Ke) 16% 17% 20%Value of Equity (EBT / Ke) 937,500 705,882 450,000 Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000 WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%

Capital Structure Theories – D) Traditional Approach

1.A firm is expected to generate net operating earnings of Rs.20,00,000 which market capitalizes at that rate ke, at 20%. Assume that it has Rs. 25,00,000 in debt at 16% interest, given this information, calculate value of firm using NI Approach.

2. Assuming no taxes and given the earning before interest and taxes(EBIT), Interest (I), at 10% and equity capitalization rate (K), below, calculate the total market value of each firm Using NI Approach:

Firms EBIT I KX 2,00,000 20,000 12%Y 3,00,000 60,000 16%Z 5,00,000 2,00,000 15%W 6,00,000 2,40,000 18%

Also determine the weighted average cost of capital for each firm.

3. (a) A company expects a net income of Rs.80,000. It has Rs. 2,00,000 , 8% Debentures. The equity capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization rate according to Net Income Approach (ignoring tax).(b) If the debenture debt is increases to Rs. 3,00,000, what shall be the value of firm.

4. The operating income of a firm is Rs. 50,000. The cost of debt is 10%. Outstanding debt is Rs. 2,00,000. If the overall cost of capital is 12.5%, what would be the total value of the firm and the equity capitalization rate?

5. (a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate according to Net Operating Income Approach.(b) If the debenture debt is increased to Rs. 7,50,000. What will be the effect on the value of the firm and equity capitalization rate?

6. Summer Ltd. And Winter Ltd. are identical in all respects including risk factor except for Debt/ Equity Mix. Summer Ltd. having issued 12% debentures of Rs. 30 lakhs, while winter Ltd. issued only equity capital. Both the companies earn 24% before interest and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for an all equity company.Compute the value of summer Ltd. and Winter Ltd. using (i) Net Income Approach and (ii) Net operating income approach.

7. (a) A firm has EBIT of Rs. 40,000. The firm has 10% debentures of Rs. 1,00,000 and its current equity capitalization rate is 16%. Calculate current value of firm and overall cost of capital using traditional approach.(b) If firm is considering to increase its leverage issuing additional Rs. 50,000 debenture and using the proceeds to retire that amount of equity. However if firm increases proportion of debt Ki would rise to 11% and Ke to 17%. What will be the effect on the value of the firm and overall capitalization rate?(c) If firm is considering to increase its leverage issuing additional Rs. 1,00,000 debenture and using the proceeds to retire that amount of equity. Due to increased financial risk , Ki would rise to 12.5% and Ke to 20%. What will be the effect on the value of the firm and overall capitalization rate?

8. Companies U and L are identical in every aspect, except that the former does not use debt in its capital structure, while the later employs Rs. 6,00,000 of 15% debt. Assuming that:

a.All the MM assumptions are metb.Corporate tax rate is 50%c.The EBIT is Rs. 2,00,000d.The equity capitalization of the unlevered company is 20%,

What will be the value of firms U & L? Also determine the weighted average cost of capital for both the firms.

9. The following is the data regarding two companies ‘X’ and ‘Y’ belonging to the same equivalent risk class:

Company X Company Y

Number of ordinary Shares 90,000 1,50,000

Market Price per share Rs. 1.2 Rs. 1

6% Debentures 60,000 ------

Profit before interest Rs. 18000 Rs. 18000

All profit after debentures interest are distributed as dividends. Explain how under Modigilani & Miller approach, an investor holding 10% of shares in Company ‘X’ will be better off in switching his holding to Company ‘Y’.

(MU MMS 2010)

10. The two companies, Q & R, belong to an equivalent risk class. These two firms are identical in every respect except that Q company is unlevered while Company R has 10% debentures of Rs. 30 lakh. The other relevant information regarding their valuation and capitalization rates are as follows:

Particulars Firm P Firm QEBIT 7,50,000 7,50,000Less: Interest 3,00,000EATESH 7,50,000 4,50,000Ke 0.15 0.2Market Value of Equity (S) 50,00,000 22,50,000Market Value of Debt (B) 30,00,000Total Value of Firm (V=S+B) 50,00,000 52,50,000Implied overall cost of capital(Ko) 0.15 0.143Debt Equity Ratio (B/S) 0 1.33

a. An investor owns 10% equity share of company Q. Show the arbitrage process and the amount by which he could reduce his outlay through the use of leverage.

b. According to Modigilani & Miller, when will this arbitrage process come to an end?

11. The companies ACC Cements and Dalmia Cements belong to same risk class and are identical in every fashion except ACC Cements uses debt while Dalmia Cement does not. The leveraged company has Rs.9,00,000 debenture carrying 10% rate of interest. Both firms earn 20% before interest and taxes on their total assets of Rs. 30 lakhs. Assume perfect capital market, rational investors and so on; Both companies pay tax at 40% and capitalization rate for an all equity company is 15%.

You are required to:a.Compute the value of the two firms using the Net Income and

Modigilani-Miller Approach.b.Using the M.M. approach, Compute the overall capitalization

rate for both the companies.(MU MMS 2011)

12. Following information is available from the books of XYZ Ltd:

Rs. in LakhsSales 500Cost of Raw Materials 200Labour cost of manufacturing 100Interest on Borrowings 60

The capitalization rate for debt is 10% and the capitalization rate for the entire firm is 12.5%. Assuming that the firm does not retain any earnings and there is no tax, As per NOI approach:

a.What is the total market value of firm?

b.What is the market value of debt of the firm?

c.What is the market value of the equity of the firm?

d.What is the equity capitalization rate?(MU MMS 2009)

capital structure theories (1)

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