Capital Structure Theories

29-04-2010Dr. Mercia Selva Malar

Capital Structure Capital structure refers to the mix or proportion of

different sources of finance (debt and equity) to total capitalisation.

Optimal capital structure: The firm should select such a financing mix which maximises its value/ the shareholders’ wealth (or minimises its overall cost of capital)

Elements of Capital Structure

Capital Mix Maturity and Priority Terms and Conditions Currency Financial Innovations Financial Market Segments

Elements of Capital Structure

Capital Mix: The mix of debt and equity capital. Debt ratio, debt-service coverage ratio and the funds flow statement are used to analyse the capital mix.

Elements of Capital Structure

Maturity and Priority: Equity is the most permanent. Among debt CP has shortest maturity and public debt longest. Capitalised debt, Secured debt, etc. are available.

Firms try to become risk neutral by matching the maturity of assets and liabilities.

Elements of Capital Structure

Terms and Conditions: On debt servicing On risk reduction

Elements of Capital Structure

Currency: Overseas Borrowings less costlier Conversion cost

Elements of Capital Structure

Financial Innovations: To circumvent restrictions Hybrid instruments, securitization, etc.

Elements of Capital Structure

Financial market segments Debt: Public debt or private debt

market Debt: Long term or short term Debt: Domestic, International, Euro

Framework of Capital Structure

FRICT Analysis Flexibility – Within the debt capacity –

minimum cost, with delay or immediately for profitable projects

Risk – Excessive use of debt magnifies risk Income – Most advantageous to owners Control – Minimum risk of loss of control Timing – Feasible to implement at current and

future conditions of the capital market

Capital Structure Theories Explains the theoretical relationship between

capital structure, overall cost of capital (ko) and valuation (V).

The four important theories are: Net Income Approach (NI) Net Operating Income Approach (NOI) Modigliani and Miller Approach (MM) Traditional Approach

Net Income Approach (NI) Capital structure is relevant as it affects the ko

and V of the firm Core of the approach: As the ratio of less

expensive source of funds increases in the capital structure, ko decreases and V of the firm increases.

With a judicious mix of debt and equity a firm can evolve an optimum capital structure at which ko would be the lowest and the V of the firm highest and the market price per share the maximum

Net Income Approach (NI)Assumptions

No corporate tax Cost of debt is less than cost of equity Use of debt does not change the risk

perception of investors

If the firm is using equity capital alone , the composite cost of capital will be equal to Ke and the value of the firm will be minimum.

Net operating Income Approach (NOI)

NOI approach is diametrically opposite to the NI approach.

Essence: Capital structure decision of a corporate does not affect its cost of capital and hence irrelevant

Net operating Income Approach (NOI)

The market value of the firm is ascertained by capitalizing the net operating income at the composite cost of capital (Ko) which is considered to be constant

V= EBIT

Ko S= V-B S= Value of equity, V= Total value of firm, B= Total value of debt

Net operating Income Approach (NOI) Argument

An increase in the proportion of debt in the capital structure would lead to an increase in the financial risk to the equity holders. To compensate for the increased risk, they would require a higher rate of return (ke) on their investment. As a result, the advantage of the lower cost of debt would be neutralised by the increase in the cost of equity.

Components of the cost of debt

Explicit Implicit Therefore the real cost of debt and

equity would be the same and there is nothing like an optimum capital structure

Modigliani and Miller Approach

They concur with NOI Provide a behavioral justification for the

irrelevance of capital structure They maintain that the cost of capital and

the value of the firm do not change with the change in leverage

MM Proposition I

The firm’s market value is not affected by capital structure; any combination of debt and equity is as good as any other

Arbitrage Process

Arbitrage or switching will take place to enable investors to engage in the personal or homemade leverage as against the corporate leverage to restore equilibrium in the market.

Assumptions of MM I Perfect capital markets Characteristics:1. Investors are free to buy and sell

securities2. Investors can borrow without

restrictions at the same terms as firms do

3. Investors behave rationally

Assumptions of MM I

Homogeneous risk classes Characteristics: Firms operate in similar business

conditions Firms have similar operating risk

Assumptions of MM I

Risk: Operating risk is defined in terms of the Net Operating Income

No taxes Full payment: 100 per cent

dividend pay out

MM Proposition II

Borrowing increase shareholder return, but increases financial risk . The increased financial risk via increased cost of equity exactly offsets the increased return; thus leaving the position of shareholders unchanged

Criticism of MM Hypothesis

Lending and borrowing discrepancy

Non-sustainability of personal and corporate leverages

Transaction costs Institutional restrictions Existence of corporate tax

Traditional Approach