capital structure theory 2

CAPITAL STRUCTURE THEORY

CAPITAL STRUCTURE AND VALUE

‘Capital structure decision is one of the key decisions that focuses on finding the capital structure with the objective of maximization of value of the firm.

‘It is perhaps the key strategic decision that has occupied much of the time and attention of

academicians and managers alike ‘The issue revolves around the question of an optimal capital structure, if there is any

COMMON ASSUMPTIONS FOR THE ANALYSIS

‘Following assumptions are required to arrive at optimal capital structure - To analyse effects of capital structure one

form of capital needs to be replaced with another form

- Maximisation of value of the firm is consistent with maximisation of shareholders’ wealth

- Optimal capital structure is one that minimises WACC

- Earning levels remain constant

TARGET CAPITAL STRUCTURE

‘Target capital structure is the debt equity ratio deemed most appropriate by the management.

‘Target capital structure is determined by several factors like

• taxes, • interest

-And practical issues like • market practices, • lenders’ perspectives and • industry norms

NET INCOME APPROACH

Net Income (NI) approach

‘assumes that capitalisation of the firm is based on the net income derived by each supplier of capital discounted at fixed rates irrespective of levels of debt

Interest i Cost of Debt; r = = d Market value of debt D

Earnings for equity shareholde rs EBIT - i Cost of Equity; r = = e Market value of equity E

Earnings to all capital suppliers EBIT WACC; r = =

Market value of the firm D + E

NET INCOME APPROACH

Scenario A Scenario B Scenario C

Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance Equity (Book Value) 900.00 500.00 100.00 Debt (Book Value) 100.00 500.00 900.00

Capitalisation Rate Equity, re 20% 20% 20% Debt, rd 10% 10% 10%

EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

NET INCOME APPROACH

EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00 shareholders

Market value of debt 100.00 500.00 900.00 (I/rd)

Market value of equity 2,450.00 2,250.00 2,050.00 (EBIT - I - Taxes)/re

Total Value of the firm 2,550.00 2,750.00 2,950.00

Overall capitalisation rate 19.61% 18.18% 16.95% (r)

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Capital Structure - Theory

Graphical View NIA

ke

kokd

Debt

Cost

kd

ke, ko

NET INCOME APPROACH

‘Net Income approach assumes that capitalisation rates are constant and increasing debt would reduce overall capitalization rate (WACC) and increase the value of the firm ‘Optimal capital structure under net income approach is 100% debt

E D r = r + r e d E + D E + D

TRADITIONAL APPROACH

‘Traditional approach recognises the advantage of debt only up to certain level. Any increase in debt beyond a point causes cost of equity to rise.


‘ Initially the cost of capital for the firm will fall as cheaper debt replaces expensive equity.

• Even though the cost of equity rises with increased debt the advantages of debt would outweigh the increased cost of equity.

• Beyond a certain level of leverage the cost of equity starts rising disproportionately, more than offsetting the advantage of debt, raising the overall cost of capital for the firm.

• Since cost of capital falls initially and then starts rising there exists a point where cost of capital would be least.

• This point of least cost of capital would maximise the value of the firm and is the optimal capital structure.

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Project Cost 1,000.00 1,000.00 1,000.00


Capitalisation Rate Debt 10% 11% 12% Equity 20% 20% 30%

EBIT 500.00 500.00 500.00

Interest (I) 10.00 55.00 108.00

EBT 490.00 445.00 392.00

19 Capital Structure - Theory


EBT 490.00 445.00 392.00


Earnings available to 490.00 445.00 392.00 shareholders (EAT)


Market value of Equity 2,450.00 2,225.00 1,307.00 (EAT/re)

Value of the Firm, V 2,550.00 2,725.00 2,207.00

Capitalisation rate, WACC 19.61% 18.35% 22.65% (EBIT/V)

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Traditional Approach

ke

ko

kd

Debt

CostWith increasing level of debt the overall cost of capital falls initially because cost of debt is less than the cost of equity, thereafter it rises because equity holders expect greater returns due to increasing perceived risk from the debt holders.

NET OPERATING INCOME APPROACH

Net Operating Income (NOI) approach - assumes that value of the firm remains

constant because overall capitalisation rate remains constant

‘Net operating income approach states that value of the firm is determined by the earning capacities of the assets and not by how are they acquired.

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Project Cost 1,000.00 1,000.00 1,000.00


Capitalization Rate Debt 10% 10% 10% Overall 20% 20% 20%

EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00


EBT 490.00 450.00 410.00


Earnings available to 490.00 450.00 410.00 shareholders (EAT)


Market value of firm 2,500.00 2,500.00 2,500.00 (EBIT/r)

Value of equity (E) 2,400.00 2,000.00 1,600.00

Equity capitalisation rate 20.42% 22.50% 25.63% (EAT/E)



‘Under net operating income approach the cost of equity rises so as to compensate the reduced cost of debt keeping the overall capitalisation rate constant.

D r = r + (r - r ) e 0 0 d E

Scenario A : re = 20 + (20 - 10) x 100/2400 = 20.42% Scenario B : re = 20 + (20 - 10) x 500/2000 = 22.50% Scenario C : re = 20 + (20 - 10) x 900/1600 = 25.63%

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ke

ko

kd

Debt

Cost

Under net operating income approach no capital structure is optimal, alternatively all capital structures are optimal.

MODIGLIANI AND MILLER (MM) THEORY - WITHOUT TAXES

MM Proposition I without taxes

‘Capital structure is irrelevant. ‘The value of levered firm and unlevered firm would be equal.

VU = VL

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Key Assumptions

Perfect capital market Homogeneous risk class No taxes No transaction cost Full payout


MM’s Proposition II without taxes

‘With increasing leverage the cost of equity rises exactly to offset the advantage of reduced cost of debt ‘To keep the value of the firm constant. ‘The cost of equity for varying levels of debt is given by:

D r = r + ( r - r ) e 0 0 d E



ke

ko

kd

Debt

Cost

MM's Proposition II

MM’s Proposition states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.


MM’s Proposition III without taxes

“the cut-off rate for investment purposes will in all cases be WACC and will be completely unaffected by the type of security issued to finance the investment”.

E D WACC for levered firm = r + r e d E + D E + D

D r = r + (r - r ) e 0 0 d E

0

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MODIGLIANI AND MILLER (MM) THEORY - ARBITRAGE

‘MM Proposition of irrelevance of capital structure is based on the principle of arbitrage i.e. the discrepancy in valuation of levered firm and unlevered firm would be set right by investors by selling the overvalued and buying the undervalued asset

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Financial Data of Levered Firm, CODEQ and Unlevered Firm, ALLEQ Figures in Rs.

ALLEQ CODEQ

EBIT 5,00,000 5,00,000

Interest @ 10% - 1,00,000

EBT 5,00,000 4,00,000

Taxes (Assumed no taxes) - -

EAT 5,00,000 4,00,000

Market value of debt - 10,00,000

Market value of equity, 25,00,000 20,00,000 capitalisation rate 20%

Value of the firm 25,00,000 30,00,000

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Earnings to equity suppliers Market value of the equity of ALLEQ =

r Dividend 5,00,000

= = = Rs. 25,00,000 r 0.2

Earnings to equity suppliers Market value of equity of CODEQ =

r Dividend 4,00,000

= = = Rs. 20,00,000 r 0.2

Interest Market value of debt of CODEQ =

r d

1,00,000 = = Rs.10,00,0 00

0.10

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‘ An investor owns 10% of CODEQ. Realising that ALLEQ is going cheap, he decides to sell his holding in CODEQ. He realises Rs. 2,00,000 (10% of the market value he holds).

‘ In order to keep his risk profile identical to that of CODEQ he borrows an amount equal to 10% of debt of CODEQ.

‘ The cost of his borrowing is assumed identical to that of CODEQ i.e. 10%.

‘ He borrows Rs. 1,00,000 (10% of the value of debt of CODEQ).

‘ To keep his position same as before he acquires 10% of ALLEQ by investing Rs. 2,50,000 (10% of market value of ALLEQ).

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Cash flow and returns for investor swapping position Rs. Swapping

position - Cash flow

Initial cash flow Selling 10% of CODEQ +2,00,000 Borrowing +1,00,000 Investing 10% in ALLEQ - 2,50,000 Surplus (Deficit) cash + 50,000

If invest in If invest in CODEQ ALLEQ

Returns 10% of shareholders’ fund 40,000 50,000 Less: Borrowing cost - 10,000 Net Income 40,000 40,000

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Assumptions and Limitations of MM’s Theory of Irrelevance

‘Identical expectations of earnings ‘All earnings are distributed‘No transaction cost

‘Free and instantaneous flow of information

‘Absence of taxes

‘Replication of leverage in personal capacity, the home made leverage

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MM’s APPROACH WITH CORPORATE TAXES

Financial Data of Levered and Unlevered Firms under Taxes

Rs.

ALLEQ CODEQ

EBIT 5,00,000 5,00,000

Interest @ 10% - 1,00,000

EBT 5,00,000 4,00,000

Taxes @ 40% 2,00,000 1,60,000

EAT 3,00,000 2,40,000

Earnings available to suppliers 3,00,000 3,40,000 of debt and equity

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VL = VU + T x D EBIT ( 1 T )

V = U r 0

V = V + Value of Tax Shield L U

EBIT x (1 T) T x D x r d = + r r 0 d

EBIT (1 T) = + TD

r 0


‘MM Proposition II under taxes recognises that with increasing debt the cost of equity would rise though at a lesser rate than what it would in the absence of taxes

D r = r + ( 1 T )( r r ) e 0 0 d E

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‘MM Proposition III under taxes recognizes that with increasing debt the cost of capital too would rise though at a lesser rate than what it would in the absence of taxes

E D WACC = r + r ( 1 - T ) L e d D + E D + E

9 10 = 26 67 + 10 ( 1 - 0 4 )

19 19 = 15 79 %

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‘ In the presence of corporate tax the optimal capital structure would be 100% debt according to MM propositions

M & M POSITION (with taxes) M & M POSITION (With Taxes) VALUE OF THE FIRM CAPITALISATION RATES

Rates of Value Return

re VL

PVTS=TxD r0 r

VU

rd(1-T)

D/E D/E

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MM’s THEORY OF IRRELEVANCE

MMs Propositions - With and Without Corporate Taxes

Without Taxes With Taxes

Proposition I VL = VU VL = VU + PVTS Value of the firm VL = E + D VU = EBIT (1-T)/r0

Proposition II D D ( 1 - T ) Cost of equity r = r + ( r - r ) r = r + ( r - r ) e 0 0 d e 0 0 d E E

WACCU = WACCL = r0 PV TS Proposition III WACC = WACC ( 1 - ) L U D + E Cost of capital D D E D ( 1 - T) WACC ;r = r + r

e d WACC ;r = r + r E + D E + D L e d E + D E + D

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MILLER’s MODEL

‘With personal taxes the value of the tax shield declines by the amount of personal taxes

‘Differential personal tax rates on interest and dividend and capital gains makes debt beneficial for the firm as long as

(1 - td)>(1-T) (1-te) Net tax advantage of debt = (1 - td) - (1 - T) (1 - te)

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MILLER’s MODEL

Miller’s Model incorporates personal taxes to determine the value of the firm and substantiates the MM proposition with taxes when personal taxes are equal on dividend income and interest incomes.

Value of All Equity Firm

Cash flow to equity holders =

Post tax cost of equity, r (1 - t ) 0 e

EBIT(1 - T)(1 - t ) e = r (1 - t ) 0 e

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LEVERAGE AND FINANCIAL DISTRESS

‘MMs and Miller propositions suggest capital structure in favour of debt but is not observed in practice. ‘Along with the advantage of tax shield the debt also brings with it the cost of financial distress and agency cost of debt, which offset the tax advantages

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capital structure theory 2

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