s- capital strucutre and firm value

8/7/2019 S- Capital Strucutre and Firm Value

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1

CAPITAL STRUCTURE

&

FIRM VALUE


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Outline

Assumptions and Definitions

Net Income Approach

Net Operating Income Approach Traditional Position

Modigliani and Miller Position

Taxation and Capital Structure

Tradeoff Theory

Signaling Theory


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Objective of Capital Structure

Judicious use of different long-term sources

of financing such that overall cost of capitalof the firm does not increase and remains

minimum and constant, thereby maximizing

value of the firm.


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Factors Affecting Capital Structure

1. Leverage

2. Cost of Capital

3. Cash Flow Projections of the firm

4. Size of Company5. Dilution of Control

6. Floatation Cost

7. Lenders Attitude

8. Management Attitude

9. Sales Stability


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ASSUMPTIONS

To examine the relationship between capital structure and

cost of capital, the following simplifying assumptions are

commonly made:

1. No income tax

2. 100 percent dividend payout

3. Identical subjective probability distributions ofoperating income

4. No growth /decline in operating income5. A firm can change its capital structure

instantaneously


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IA nnu al in teres t charges

rD = =

D M ark et va lu e o f d eb t

P Equi ty earn ings

rE = =

E M arket va lue o f equi ty

O O p erat in g i n com e

rA = =

V M arket va lue o f the f i rm

D ErA = rD + rE

D + E D + E

W h a t h a p p en s to rD , rE, and rA w hen f inancia l leverage , D /E, changes?

FOCUS OF ANALYSIS


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NET INCOME APPROACH

According to this approach, rD and rE remain unchanged when D/Evaries. The constancy ofrDand rEwith respect to D/Emeans that rA declines as D/Eincreases.

Rates of

return

rA

rE

rD

D/E


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NET OPERATING INCOME APPROACH

According to this approach the overall capitalization rate (rA) and the cost of debt (rD) remain

constant for all degrees of leverage. Hence

rE= rA + (rA rD) (D/E)

Rates ofreturn

rA

rE

rD

D/E


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MODIGLIANI AND MILLER (MM) POSITION

Assumptions

1. Perfect Capital Market

2. Rational Investors and Managers

3. Homogenous Expectations

4. Equivalent Risk Classes

5. Absence of Taxation


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MM

PROPOSITION I

Firms value is determined by its real assets and not by its

financing methods. Thus capital structure is irrelevant .

Value of unlevered firm = value of levered firm

In perfect market both investments give same return


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MM

PROPOSITION II

Expected rate of return on equity of a levered firm (withdebt) increases in proportion to debt-equity ratio.

At high debt levels the risk of the firm increases. Hence any

combination of D/E is as good as another.

The expected return on equity is equal to the expected rate

of return on assets, plus a premium. The premium is equal

to the debt-equity ratio times the difference between the

expected return on assets and the expected return on debt

rE= rA + (rA rD) (D/E)


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CRITICISMS OF MM THEORY

Real World is characterized by various imperfections

1. Firms and investors pay taxes

2. Bankruptcy costs can be high

3. Agency costs exist

4. Managers tend to prefer a certain sequence of financing

5. Informational asymmetry exists

6. Personal and corporate leverage are not perfectsubstitutes


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Factors Affecting Optimal Capital

Structure of A firm

Favourable Financial Leverage : Rise in cost of

equity with rise in debt is not too fast, it is

moderate.

Income Tax Leverage : The interest payment is

tax deductible

Interest Tax Shield =Interest x tax rate


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Contd..

Market Conditions : Investors reaction to

change in capital structure


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Impact of Corporate Taxes

When taxes are applicable to corporate income, debt financing is

advantageous as interest on debt is a tax-deductible expense.

In general

O ( 1 - tC)

V = + tCD

r

where V = value of the firmO = operating income

tC

= corporate tax rate

r = capitalisation rate applicable to the unlevered firm

D = market value of debt

It means:

Value of levered firm = Value of unlevered firm + Gain from leverage

VL

= VU

+ tCD


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COST OF FINANCIAL DISTRESS

A high level of debt may lead to financial distress that

entails certain costs:

Direct Costs

Delay in liquidation may diminish asset value

Distress sale fetches lower price

Legal and administrative costs are high

Indirect Costs

Managers become myopic

Stakeholders dilute their commitment


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AGENCY COSTS

There is an agency relationship between the

shareholders and creditors of firms that have

substantial amounts of debt. Hence lenders impose

restrictive covenants and monitor the behaviour of the

firm.


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TRADE OFF MODEL


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Contd..

Value of the levered firm = Value of unlevered

firm + tax advantage of debt PV of expected

costs of financial distress PV of agency costs


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Corporate Financing Behaviour

Power companies, refineries use more debt as

their assets are tangible and safe. Software

companies borrow less because their assets

are mostly intangible and somewhat risky.

Theory does not answer why Highly profitable

companies like HLL, Colgate Palmolive use very

little debt


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SIGNALING THEORY

(Why profitable companies use little debt)

Noting the inconsistency between trade-off theory and

the pecking order of financing, Myers proposed a new

theory, called the signaling, or asymmetric information,

theory of capital structure.

A critical premise of the trade-off theory is that all

parties have the same information and homogeneousexpectations. Myers argued that there is asymmetric

information and divergent expectations which explains

the pecking order of financing observed in practice.


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PECKING ORDER OF FINANCING

There is a pecking order of financing which goes as

follows:

Internal finance (retained earnings)

Debt finance

External equity finance

Given the pecking order of financing, there is no well-

defined target debt-equity ratio, as there are two kindsof equity, internal and external. While the internal

equity is at the top of the pecking order, the external

equity is at the bottom.


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