23
Capital Structure Theories

Capital Structure Theories

  • Upload
    rupesh

  • View
    219

  • Download
    0

Embed Size (px)

DESCRIPTION

5th sem bba

Citation preview

Capital Structure Theories

Capital Structure TheoriesFactors determining capital structureMinimisation of riskBusiness riskFinancial riskA capital structure is called an efficient capital structure if it keeps the total risk of the firm to a minimum levelControlFlexibility(the ability of the firm to raise additional capital funds whenever needed)

Profitability(to increase the return to the equity share holders)Cost of financing

Optimum capital structureA capital structure will be optimum when the proper mix of equity and debt results in maximising the value of the share. Selection of the right amount of equity and combining it with the right amount of debt increases the market value of the share and helps the company to attain an optimum capital structure

Some of the techniques that will help in achieving an optimal capital structure are:risk and returnCost of financeCorporate taxes

Capital structure theoriesCapital structure theories gives an understanding of the different approaches to debt equity mix and the effect on the value of the share. The basic theories are:Net Income(NI) approachNet Operating Income(NOI) approachTraditional approachModigliani Miller(MM) approachAssumptions of capital structure theoriesThat there are only two sources of funds: equity and debt, which is having fixed interestThe total assets of the firm are given and thr would be no change in the investment decisions of the firmThe firm has a policy of distributing the entire profits among the shareholdersThe operating profits of the company are given and are not expected to grow

The business risk complexion of the firm is given and is constant and is not affected by the financing mixThere is no corporate or personal taxesThe following definitions and notations haveee been usedE = total market value of the equityD = total market value of the debtV = total market value of the firm = D + EI = total interest paymentNOP = net operating profit i.e. EBITNP = net profit or PATD0 = dividend paid by the company at time 0(now) D1 = expected dividend P0 = current market price of the share P1 = expected market price after year 1 kd = after tax cost of debt = I/D ke = after tax cost of equity = D1/P0 Ko = overall cost of capital i.e WACCWACC = [D/(D+E)]Kd + [E/(E+D)]Ke since, D+E = valueTherefore, =

Net Income approachIs given by Durand, states that there is a relationship between capital structure and the value of the firm.The main assumptions are:Total capital requirement of the firm remains constantKd is less than Ke.Both Kd and Ke remain constant and increase in financial leverage does not affect the risk perception of the investorsNet income approachAccording to this approach, there does exist an optimum capital structure. So firm can increase its value and change its capital structure and vice versaSo, higher is the use of debt, lower is the cost of capital and therefore higher is the valueValue of the firm is maximised at 100% leverage but equity must be thereAccording to this approach debt is available at a very cheap rate and in plentyand whole of the demand of debt is meant and it is assumed that the shareholders do not feel that the company is at risk by using more and more debtTherefore, Kd and ke are constant an are parallel to each other(diagram and practical question)Net Operating Income ApproachThe value of the firm is not affected by the increase in debt. Ko is constant at all operating leverage.Therefore, every capital structure is optimum and the overall value of the firm is same. So firms belonging to the same risk class have same value.As firm goes for more and more debt the shareholders demand more returns i.e. ke increases. However, increase in ke is exactly offset by the cheap availability of funds therefore Ko is constant.Assumptions , practical questions , diagram done in classTraditional ApproachAccording to this approach, a firm should make a judicious use of both the debt and equity to achieve a capital structure which may bee called the optimum capital structure. At this capital structure, the WACC of the firm will be minimum and the value of the firm maximum.

The traditional view states that the value of the firm increases with the increase in financial leverage but upto a certain limit only. Beyond this limit, the increase in financial leverage will increaseIts WACC also and hence the value of the firm will decline.Under this approach, Kd is assumed to be less than Ke. Initially ke remains constant upto a certain point with the increase in leverage therefore Ko falls initially. But this position cannot continue when leverage is further increasedThe increase in leverage beyond a limit increases the risk of the equity investors and as a result Ke also starts increasing and Ko will starts rising.Assumptions, diagram, practical question done in classModigliani Miller Model: Extension of the NOI ApproachThis model states that the capital structure and its composition has no effect on the value of the firm. They have shown that financial leverage does not matter and the cost of capital and value of the firm are independent of the capital structure.Main assumptions are:The capital markets are perfect and complete information is available to all the investors free of costThe securities are infinitely divisibleInvestors are rational and well informed about the risk return of all the securitiesThere is no corporate taxThe personal and the corporate leverage are perfect substituteThis model argues that if two firms are alike in all respect except that they differ in respect of their financing pattern and their market value, then the investors will develop a tendency to sell the shares of the overvalued firm and buy the shares of the buy the shares of the under valued firm

This buying and selling pressures continue till the two firms have same market values.The Arbitrage Process:It refers to undertaking by a person of two related actions and steps simultaneously in order to derive some benefit.Ex: buying a security in one market at a lower price and selling the same at a higher price in the other market.Practical applicationdone in class(very important)Critical Evaluation of MM ModelPersonal and corporate leverage are not perfect substitutesDifferent borrowing rates for the corporates and the individualsInconveniences of personal leveragesMM Model with taxesPractical application