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Capital Structure Decisions

Unit - 2

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Capital Structure
 Capital Structure refers to the combination or mix of debt
and equity which a company uses to finance its long term
operations
 Raising of capital from different sources and their use in
different assets by a company is made on the basis of
certain principles that provide a system of capital so that
the maximum rate of return can be earned at a minimum
cost. This sort of system of capital is known as capital
structure.
 Capital structure of a company refers to the composition
or make – up of its capital. It includes all long term capital
resources as well as short term capital resources

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Forms/patterns of capital structure
 Equity shares only
 Equity and preference shares
 Equity shares and debentures
 Equity shares, preference shares and debentures

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Importance
 Increases the value of a firm
 Capital structure determine the risk assumed
by the firm
 It determines the cost of capital of the firm
 It affects the flexibility and liquidity of the firm
 It affects the control of owners on the firm
 Works as a base for the financial decision

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Factors Influencing Capital
Structure
 Internal Factors
 External Factors

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Internal Factors
 Size of Business
 Nature of Business
 Regularity and Certainty of Income
 Assets Structure
 Age of the Firm
 Desire to Retain Control
 Future Plans
 Operating Ratio
 Trading on Equity
 Period and Purpose of Financing
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External Factors
 Capital Market Conditions
 Nature of Investors
 Statutory Requirements
 Taxation Policy
 Policies of Financial Institutions
 Cost of Financing
 Seasonal Variations
 Economic Fluctuations
 Nature of Competition
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Optimal Capital Structure
 That capital structure or combination of debt &
equity that leads to the maximum value of firm.
 The optimal or the best capital structure implies
the most economical and safe ratio between
various types of securities.
 It is that mix of debt and equity which maximizes
the value of the company and minimizes the cost
of capital.

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Essentials of a Sound or Optimal
Capital Structure
 Minimum Cost of Capital
 Minimum Risk
 Maximum Return
 Maximum Control
 Safety
 Simplicity
 Flexibility
 Attractive Rules
 Commensurate to Legal Requirements
 Sufficient liquidity
 Avoidance of unnecessary restrictions
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Theories of Capital Structure
 Net Income (NI) Theory
 Net Operating Income (NOI) Theory
 Traditional Theory
 Modigliani-Miller (M-M) Theory
 Trade-off Theory
 Signaling Theory

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Net Income (NI) Theory
 This theory was propounded by “David Durand” and is also
known as “Fixed ‘Ke’ Theory”.
 The capital structure decision is relevant for the valuation
of the firm, a change in the financial leverage will lead to a
change in the value of firm
 According to this theory a firm can increase the value of
the firm and reduce the overall cost of capital by
increasing the proportion of debt in its capital structure to
the maximum possible extent.

It is due to the fact that debt is, generally a cheaper source of funds
because:
• (i) Interest rates are lower than dividend rates due to element of risk,
• (ii) The benefit of tax as the interest is deductible expense for income tax
purpose. 11
Net Income Approach : effect of leverage on cost of
capital
Y
C
O
S Ke
T
O
F
C Ko
A
P Kd
I
T
A
l O Degree of Leverage X

Here, Ke = cost of Equity, Kd = cost of Debt, Ko = overall cost12


Assumptions of NI Theory
 The ‘Kd’ ( cost of debt) is cheaper than the
‘Ke’ ( cost of equity).
 Income tax has been ignored.
 There will be no corporate taxes.
 The ‘Kd’ and ‘Ke’ remain constant.
 The risk perception of investors is not
changed by the use of debt.
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Computation of the Total Value of
the Firm

Total Value of the Firm (V) = S + D


Where,
S = Market value of Shares = EBIT-I = E
Ke Ke
D = Market value of Debt = Face Value
E = Earnings available for equity shareholders
Ke = Cost of Equity capital or Equity capitalization
rate.
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Computation of the Overall Cost of
Capital or Capitalization Rate
 Ko = EBIT
V

Where,

Ko = Overall Cost of Capital or Capitalization


Rate
V = Value of the firm
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Net Operating Income Theory (NOI)
 This theory was propounded by “David Durand”
and is also known as “Irrelevant Theory”.
 This is just opposite to Net Income Approach
 According to this theory, the total market value of
the firm (V) is not affected by the change in the
capital structure and the overall cost of capital
(Ko) remains fixed irrespective of the debt-equity
mix.
 Any change in capital structure of the company
does not affect the market value of the firm &
overall cost remains constant.
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The NOI Approach : effect of leverage
on cost of capital
C Ke
O
S
T
O
F Ko
C
A
P
I
Kd
T
A
l
Degree of Leverage

Here, Ke = cost of Equity, Kd = cost of Debt, Ko = overall cost


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Assumptions of NOI Theory
 The split of total capitalization between debt and
equity is not essential or relevant.
 The equity shareholders and other investors i.e.
the market capitalizes the value of the firm as a
whole.
 The business risk at each level of debt-equity mix
remains constant. Therefore, overall cost of capital
also remains constant.
 The corporate income tax does not exist.
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Computation of the Total Value of
the Firm

V = EBIT
Ko

Where,
V = Value of the firm
Ko = Overall cost of capital

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Market Value of Equity Capital
S=V–D

Where,
S = Market Value of Equity Capital
V = Value of the Firm
D = Market value of the Debt

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Cost of Equity Capital
 Ke = EBIT – I X 100
S
Where,
Ke = Equity capitalization Rate or Cost of
Equity
I = Interest on Debt
S = Market Value of Equity Capital ( V – D)
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Traditional Theory
 This theory was propounded by Ezra Solomon, also known as
“Intermediate approach”
 This is a compromise between the two extremes of NI & NOI
approach
 According to this theory, a firm can reduce the overall cost of
capital or increase the total value of the firm by increasing
the debt proportion in its capital structure to a certain limit.
Because debt is a cheap source of raising funds as
compared to equity capital.
 The manner in which the overall cost of capital and value of
the firm reacts to changes in the degree of financial
leverage is divided into three stages.
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Effects of Changes in Capital
Structure on ‘Ko’ and ‘V’

As per Ezra Solomon:


• First Stage: The use of debt in capital
structure increases the ‘V’ and decreases
the ‘Ko’.
• Because ‘Ke’ remains constant or rises slightly
with debt, but it does not rise fast enough to
offset the advantages of low cost debt.
• ‘Kd’ remains constant or rises very negligibly.
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Effects of Changes in Capital
Structure on ‘Ko’ and ‘V’
 Second Stage: During this Stage, there is a
range in which the ‘V’ will be maximum and
the ‘Ko’ will be minimum.
• Once the firm has reached a certain degree of
financial leverage, increase in leverage does
not affect the Ko & V of the firm.
• Because the increase in the ‘Ke’, due to added
financial risk completely offset the advantage
of using low cost of debt capital.
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Effects of Changes in Capital
Structure on ‘Ko’ and ‘V’
 Third Stage: The ‘V’ will decrease and the
‘Ko’ will increase.
• Because further increase of debt in the capital
structure, beyond the acceptable limit
increases the financial risk.
• Kd would also rise because the lender will also
raise the rate of interest as they may require
compensation for the higher risk.

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Traditional approach
Y
Ke

Ko

Kd

Range of optimal
Capital structure

O A B X 26
Computation of Market Value of
Shares & Value of the Firm

S = EBIT – I
Ke

V=S+D

Ko = EBIT
V
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Modigliani-Miller Theory
 This theory was propounded by Franco Modigliani
and Merton Miller.
 M & M hypothesis is identical with the NOI
approaches if taxes are ignored. When corporate
taxes are assumed to exist, their hypothesis is
similar to NI Approach.
 They have given two approaches
• In the Absence of Corporate Taxes
• When Corporate Taxes Exist

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In the Absence of Corporate Taxes
 According to this approach the ‘V’ and its ‘Ko’ are
independent of its capital structure.
 The debt-equity mix of the firm is irrelevant in
determining the total value of the firm.
 Because with increased use of debt as a source of
finance, ‘Ke’ increases and the advantage of low
cost debt is offset equally by the increased ‘Ke’.
 In the opinion of them, two identical firms in all
respect, except their capital structure, cannot
have different market value or cost of capital due
to Arbitrage Process.
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Assumptions of M-M Approach
 Perfect Capital Market
 No Transaction Cost
 Homogeneous Risk Class: Expected EBIT of all the
firms have identical risk characteristics.
 Investors act rationally
 Risk in terms of expected EBIT should also be
identical for determination of market value of the
shares
 Cent-Percent Distribution of earnings to the
shareholders
 No Corporate Taxes: But later on in 1969 they 30
removed this assumption.
Assumptions Contd……….
 All cash flows are perpetuities
• Perpetual debt is issued, firms have zero growth, and
expected EBIT is constant over time
 No agency or financial distress costs (e.g.,
bankruptcy)
 No transaction costs
 The cut – off point of investment in a firm is
capitalization rate
 All debt is risk less, and both individuals and
corporations can borrow unlimited amounts of
money at the risk-free rate
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MM Models: MM with Zero Taxes
 Proposition I
VL = VU
• Value of firm is INDEPENDENT of its leverage
• VL = value of levered firm, VU = Value of Unlevered firm
• Proof (in general)
– If two companies differ only in way they are financed and their
market values, then investors would sell shares of the higher-
valued firm, and buy those of the lower-valued firm.
– This would continue until they had exactly the same market value.
– Arbitrage cannot exist in equilibrium.
– So, VL = VU
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MM Models: MM with Zero Taxes
 Proposition II
rsL = rsU + Risk premium
As firm’s use of debt increases, its cost of equity
also increases
 I and II together
• More debt does NOT increase firm value because
benefits of cheaper debt are offset by increase in
riskiness and cost of equity
• Without taxes, capital structure is IRRELEVANT
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MM Models: MM with Zero Taxes

Value of Firm,
V ($)

VU VL

Debt ($)
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MM Models: MM with Zero Taxes

Cost of
Capital (%) Ke

Ko
Kd

Debt/Value
Ratio (%)
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MM Models: Summary of MM with
Zero Taxes
 MM prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected
by its financing mix
• Capital structure is IRRELEVANT!
• Any increase in ROE resulting from financial
leverage is exactly offset by the increase in risk
• In other words, with zero taxes, the increase in the
return to shareholders from the use of debt is
exactly offset by the increase in risk
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MM Models: MM with Corporate
Taxes
 Corporate tax laws favor debt financing
• Which Result
– More EBIT goes to investors and less to taxes when leverage is
used
 Proposition I
VL = VU + TD

TD = discounted present value of the tax savings


resulting from the tax deductibility of the interest
charges.
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MM Models: MM with Corporate
Taxes
 Proposition II
rsL = rsU + (rsU - rd)(1-T)(D/S)
 Notes
• VL does not equal VU
• rsL increases with leverage at a slower rate
when corporate taxes are considered

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MM Models: MM with Corporate
Taxes
Value of Firm, V ($)

VL
TD
VU

Debt
($)
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MM Models: MM with Corporate
Taxes

Cost of
Capital (%)
Ke

Ko
Kd(1 - T)

Debt/Value
Ratio (%)
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Criticisms of MM & Miller Models
 Main objections
• Assumptions too strict and not realistic
• Ignores costs of financial distress and agency
costs
 Note though that firms did increase their
use of debt after MM

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Trade-Off Model
 Recognize that costs of financial distress and
agency costs are real
• Financial distress costs (includes bankruptcy)
– Direct costs
– Lawyer’s fees, court costs, administrative expenses, assets
disappear or become obsolete
– Indirect costs
– Managers make short run decisions, customers and
suppliers may impose costs
• More debt, more likely to experience distress
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Trade-Off Model
• Agency costs
– Stockholders (thus management) want risk while bondholders do
not
– Use covenants to align interests
» Costs: monitoring to ensure they are followed, also may hamper
business
– In essence, lost efficiency and monitoring costs reduce advantage of debt
 Given agency costs and financial distress
VL = VU + TD - (PV of expected costs of financial distress)
- (PV of agency costs)
• No precise statement about optimal structure

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Trade-Off Model
A: Value of firm with no
leverage
B: MM value of firm
(VL=VU+TD)
V ($) C: Actual firm value
B
D: Optimal debt level
F E: PV of tax shelter (TD)
E F: Financial distress and
agency costs
VU A
C

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D Debt ($)
Trade-Off Model
 Implications
• Greater business risk, greater expected distress costs
– Optimal debt level?
• Tangible, marketable assets versus intangible assets
– Optimal debt level?
• Firms in highest tax bracket
– Optimal debt level?
 Intuitive but empirical support is MIXED

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So, what can we say about
optimal capital structures?
 Debt has tax benefits, so firms should use some
debt
 Financial distress and agency costs limit debt
usage
• Distress costs higher for firms with intangible assets
 Because of asymmetric information, firms will
follow pecking order
 Because of asymmetric information, firms should
maintain reserve for borrowing
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Target Capital Structure
 Choose structure which maximizes the
value of the stock
 Again, must use judgement
 Some tools
• Financial forecasting models can help show
how capital structure changes are likely to
affect stock prices, coverage ratios, and so on

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