presentation 1 - capital structure

8/3/2019 Presentation 1 - Capital Structure

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MEANING :

Capital structure is the proportion of debt,preference and equity shares on a firms balancesheet.

TOTAL CAPITALI. Equity capital Equity share capital Preference

share cap Retained earnings Share premium

II. Debt capital Term loans Debentures Deferred

payment liabilities Other long term debt.


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Optimum capital structure

Is the capital structure at which the weightedaverage cost of capital is minimum andthereby maximum value the firm.

The optimum capital structure minimizes thefirms overall cost of capital and maximizes thevalue of the firm.

Optimum capital structure is also referred as appropriate capital structure and soundcapital structure


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Factors determining capital structure

FACTORS

Intern

al

* 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


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Theories ofcapital structure

Basic assumptions:

1. There are only two sources of funds used by a firm: perpetual risk less debt andordinary shares.

2. There are no corporate taxes. This assumption is removed later.

3. 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.4. The total assets are given and do not change. The investment decisions are inother words assumed to be constant.

5. The total financing remains constant. The firm can change its degree of leverage(capital structure) either by selling shares and use the proceeds to retiredebentures or by raising more debt and reduce the cost of equity capital.

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

7. All investors are assumed to have same subjective probability distribution of thefuture expected EBIT for a given firm.

8. Business risk is constant over time and is assumed to be independent of itscapital structure and financial risk.

9. Perpetual life of the firm.


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Theories ofcapital structure

Net Income NI approach

Net Operating Income NOI approach

Modigliani Miller MM approach Traditional approach.


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Net Income approach

This approach is given by Durand David

Assumptions: this approach is based on threeassumptions

There are no taxes

Cost of debt is less than the cost of equity

Use of debt does not change the risk perception

of the investor. According to this approach, the capital structure

decision is relevant to the valuation of the firm.


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A change in the capital structure causes a overallchange in the cost of capital and also in the total valueof the firm.

A higher debt content in the capital structure means ahigh financial leverage and this results in the decline inthe overall weighted average cost of capital andtherefore there is increase in the value of the firm.

Thus with the cost of debt and the cost of equity beingconstant, the increased use of debt (increase inleverage), will magnify the share holders earnings and,thereby, the market value of the ordinary shares.


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Net Income= EBIT-I or earnings available to equityshare holders.

Value of the firm= market value of debt+ market

value of equity. over all cost of capitalization (ko) = EBIT/V or (ko)

= ki (B/V) + ke (S/V)

Ki= cost of debt

Ke= cost of equity

B= total market value of debt

S= total market value of equity


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Netoperatingincome approach

This is another theory suggested by Durand

NOI approach is opposite to NI approach

According to NOI approach value of the firm is

independent of its capital structure it meanscapital structure decision is irrelevant to thevaluation of the firm

Any change in leverage will not lead to any

change in the total value of the firm and themarket price of the shares as well as the overallcost of capital is independent of the degree ofleverage


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Assumptions

The investors see the firm as a whole and thuscapitalize the total earnings of the firm to find thevalue of the firm as a whole

The overall cost of capital (ko) of the firm is constantand depends upon the business risk which also isassumed to be unchanged

The cost of debt (kd) is also constant

There is no tax The use of more and more debt in the capital structure

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


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Prepositions

NOI approach is based on the following prepositions:

Overall cost of capital/ capitalization rate (ko) is constant:this approach argues that the overall capitalization rate ofthe 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) / ke + Bt

B= value of debt

The split of the capitalization between debt and equity istherefore not significant


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Residual valueofequity :

The value of equity is the residual value which

is determined by deducting the total value ofdebt (B) from the total value of the firm (V)

(S) = V-B

S= value of equity V= value of firm

B = value of debt


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Changein costofequity capital

The equity capitalization rate or cost of equity capital(Ke) increases with the degree of leverage.

The increase in the proportion of debt in the capitalstructure relative to equity shares would lead to anincrease in the financial risk to the ordinaryshareholders.

To compensate for the increased risk to the ordinary

shareholders would expect a higher rate of return ontheir investment.

The increase in the equity capitalization rate wouldmatch in the increase in debt equity ratio.


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Ke = Ko + (Ko-Ki) (B/S) or Ke= EBIT-I/V-B


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Costofdebt

The cost of debt (Ki) has two parts

Explicit cost

Implicit cost hidden cost

Explicit cost is the rate of interest paid by

debt. Implicit cost is the increase in the cost of

equity due to increase in debt.


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Optimal capital structure

The total value of the firm is unaffected by itscapital structure.

No matter what the degree of leverage is the

total value of the firm remain constant.

The market price of shares will also notchange with the change in debt equity ratio.

There is nothing such as optimum capitalstructure any capital is optimum according toNOI approach.


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Modigliani Miller Approach

The M.M thesis relating to the relationshipbetween the capital structure, cost of capital andvaluation is akin to the NOI approach.

The NOI approach does not provide operationalor behavioral justification for the irrelevance ofthe capital structure.

The significance of M.M approach lies in the fact

that it provides behavioral justification forconstant overall cost of capital and therefore totalvalue of firm.


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Assumptions

a) Perfect capital market-

1. Securities are infinitely divisible

2. Investors are free to buy/ sell securities

3. Investors can borrow without restrictions on thesame terms and conditions as the firm can

4. There are no transactions costs

5. Information is perfect, that is each investor has

same information which is readily available tohim without cost and

6. Investors are rational and behave accordingly.


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b) Given the assumption of perfect information andrationality all investors have the same expectations of firmnet operating income (EBIT) with which to evaluate thevalue of a firm

c) Business risk is equal among all the firm within similaroperating environment, that means all the firms can bedivided into equivalent risk class. The termequivalent/homogeneous risk class means that theexpected earnings have identical risk characteristics andfirm within an industry are assumed to have same riskcharacteristics

d) The dividend payout ratio 100%

e) There are no taxes. This assumption is removed later


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Basic prepositions

There are three basic preposition of M.M approach.

Preposition 1

The overall cost of capital (ko) and the value of the firm

(V) are independent of its capital structure, the ko andV are constant for all degrees of leverages. the totalvalue is given by capitalizing the expected stream ofoperating earnings at a discount rate appropriate for itsrisk class.

V=EBIT / ko

V is determined by the assets in which the companyhas invested and not how those assets are financed


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MM theory : Arbitrage

MM theory :

Proposition 1: The basic premise of MMapproach is that given the above assumptions the

total value of a firm must be constant irrespectiveof degree of leverage (debt-equity ratio) similarly,the cost of capital as well as the market price ofshares must be the same regardless of the

financing-mix. The operational justification for the MM

hypothesis is the Arbitrage process.


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Arbitrage

The term arbitrage refers to an act of buying anasset/security in one market (at lower price) andselling it in another market (at higher price) toderive benefits from the price differentials

The increase in demand will force up the price oflower priced goods and increase in supply willforce down the price of the high priced goods.

MM argues that the process of arbitrage willprevent the different market values for equivalentfirms, simply because of capital structuredifference.


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Arbitrageprocess

The investor of the firm whose value is higher(overvalued)will sell their shares and instead buy the shares of the firmwhose value is lower (undervalued)

The behavior of investors will have the effect of

(i) increasing the share prices (value) of the firm whoseshares are being purchased;

(ii) lowering the share prices (value) of the firm whoseshares are being sold .

This will continue till the market prices of both the firms

become identical . The use of debt by the investor for arbitrage is called as

Home MadeorPersonal leverage


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Limitations or CriticismofMM

approach

Risk perception

Convenience

Cost

Institutional restrictions

Double leverage

Transaction cost Taxes


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Risk perception

In the first place, the risk perceptions of personal andcorporate leverage are different.

The risk exposure to investor is greater with personalleverage than with corporate leverage.

The liability of an investor is limited in corporateenterprise. The risk to which he is exposed is limited tohis relative holdings in the company

The liability of an individual borrower is, on the other

hand, unlimited as even his personal property is liableto be used for payment to the creditors.

The risk to the investor with personal borrowings ishigher.


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Convenience

Apart from higher risk exposure the investor

would find the personal leverage

inconvenient.

This is so because with corporate leverage the

formalities and procedures involved in

borrowing are to be observed by the firms.

In case of personal leverage these will be the

responsibility of the investor borrower.


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Cost

Another constraint on the perfect substitutability of personal andcorporate leverage and, hence, the effectiveness of the arbitrageprocess is the relatively high cost of borrowing with personalleverage.

As a general rule, large borrowers with high credit standing can

borrow at a lower rate of interest compared to borrowers who aresmall and do not enjoy high credit standing.

For this reason it is reasonable to assume that a firm can obtain aloan at a cost lower than what a individual investor would have topay

As a result of higher interest charges, the advantage of personalleverage would disappear and the MM assumption of corporateand personal leverage being perfect substitutes would be adoubtful validity


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Institutional restrictions

Yet another problem with the MM hypothesis isthat institutional restrictions stand in the way ofsmooth operation of the arbitrage process.

Several institutional investors such as insurancecompanies, mutual funds, commercial bank andso on are not allowed to engage in personalleverage.

Thus switching the option from the unlevered to

levered firm may not apply to all investors and, tothat extent, personal leverage is an imperfectsubstitute for corporate leverage.


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Double leverage

A related dimension is that in certain situations, thearbitrage process may not actually work.

For instance, when an investor has already borrowedfunds while investing in shares of an unlevered firm.

If the value of that is more than that of a levered firm,the arbitrage process will require selling securities ofthe overvalued firm (unlevered) and purchasing thesecurities of undervalued firm(levered).

Thus, an investor would have double leverage both inpersonal portfolio as well as in the firms portfolio.

The MM assumption will not hold true in such asituation.


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Transaction cost

Transaction cost would effect arbitrage process.

The effect of transaction/flotation cost is that theinvestor would receive net proceeds from the

sale of securities which will be lower than theinvestment holding in the levered/unlevered firm,to the extent of brokerage fees and other costs.

He would therefore have to invest a large amountin the shares of the unlevered/levered firm, than

his present investment, to earn the same returns. This implies that the arbitrage process will be

hampered and will not be effective.


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Taxes

Finally if the corporate taxes are taken into

account, the MM Approach will fail to explain

the relationship between financing

decision(capital structure) and the value of

the firm

MM themselves are aware of it and in fact,

recognized it.


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Traditional approach

In the earlier discussions we have seen that the net incomeapproach (NI) as well as net operating incomeapproach(NOI) represent two extremes as regards thetheoretical relationship between the capital structure, theweighted average cost of capital and value of the firm.

While the NI Approach takes the position that the use ofdebt in the capital structure will always affect the overallcost of capital and the total valuation, the NOI approachargues that capital structure is totally irrelevant.

The MM Approach supports the NOI approach. But theassumptions of MM approach are of doubtful vaidity.


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EBIT-EPS analysis

Keeping in mind the primary objective offinancial management of maximizing themarket value of the firm, the EBIT-EPS analysis

should be considered logically as the first stepin the direction of designing a firms capitalstructure.

EBIT-EPS analysis shows the impact of variousfinancing alternatives on EPS at various levelsof EBIT.


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Financial breakeven

It is the minimum level of EBIT needed to satisfy allfixed financial charges i.e. interest and preferencedividends.

It denotes the level of EB

IT for which the firms EPS justequals to zero.

If EBIT is less than financial break even point, then EPSwill be negative

But if the expected level of EBIT exceeds than that ofbreak even point more fixed costs financinginstruments can be inducted in the capital structureotherwise the use of equity will be preferred.

presentation 1 - capital structure

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