Chapter 12Chapter 12

CAPITAL STRUCTURE CAPITAL STRUCTURE AND FIRM VALUATIONAND FIRM VALUATION

LEARNING OBJECTIVESLEARNING OBJECTIVES

• Give the capital structure equation

• Define optimum capital structure and list its features

• Name the capital structure theories

• List out the general assumptions of capital structure theories

• Discuss the NI approach

• Explain the NOI approach

• Critically evaluate MM Theory of capital structure

• Say why is Traditional Theory is called Neutral structure

Capital Structure TheoriesCapital Structure Theories• The total capital structure theories can be categorised into two

relevant and irrelevant theories.

The following are the main theories/Approaches of capital structure:

1. Net income (theory) Approach (Relevant)

2. Net operating income Approach (Irrelevant)

3. Modigliani and Miller Approach (Irrelevant)

4. Traditional Approach (Neutral)

Assumption of Capital Structure TheoriesAssumption of Capital Structure Theories

1. Firm uses only two sources of funds: perceptual riskless debt and equity;

2. There are no corporate or income: or personal tax;3. The dividend payout ratio is 100% [There are no retained earnings];4. The firm’s total assets are given and do not change [Investment

decision is assumed to be constant].5. The firm’s total financing remains constant. [Total capital is same, but

proportion of debt and equity may be changed];6. The firm’s operating profits (EBIT) are not expected to grow;7. The business risk is remained constant and is independent of capital

structure and financial risk;8. All investors have the same subject probability distribution of the

expected EBIT for a given firm; and9. The firm has perpetual life;

Definitions used in Capital StructureDefinitions used in Capital StructureE = Total market value of equityD = Total market value of debtV = Total market value of the firm I = Annual interest payment

NI = Net income or equity earningsNOI = Net operating income Ki = pre-tax cost of debt Cost of debt (Ki) = ×100 Cost of equity (Ke) = or Ko+ [Ko–Ki] D

E Cost of Capital (Ko) = WdKi + WeKe or [EBIT V] ×100 Value of the Firm (V) = EBIT Ko

NIE

ID

Net Income ApproachNet Income Approach

• NI Approach: A change in the proportion in capital structure will lead to a corresponding change in Ko and V.

• Assumptions

(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change the risk perception of investors.

(iv) Cost of debt and cost of equity remains constant;

E = NI ÷ KeE = NI ÷ Ke

E

DDegree Of Leverage

N I Approach (Contd…..)N I Approach (Contd…..)

Net Operating Income Approach (NOI)Net Operating Income Approach (NOI)

NOI Approach: Says that there is no relation between capital structure and Ko and V.

Assumptions

(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. (See Fig. 11.2)

(ii) The market capitalises the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity;

(iii) The market value of equity is residue [i.e., Total value of the firm minus market value of debt)

(iv) The use of debt funds increases the received risk of equity investors, there by ke increases

(v) The debt advantage is set off exactly by increase in cost of equity.

(vi) Cost of debt (Ki) remains constant

(vii) There are no corporate taxes.

NOI (Contd.)NOI (Contd.)

V = EBIT Ko

E = V-D

E

DDegree Of Leverage

Modigliani-Miller ApproachModigliani-Miller ApproachMM Approach: Total value of firm is independent of its capital structure

Assumptionsa.Information is available at free of costb.The same information is available for all investorsc.Securities are infinitely divisibled.Investors are free to buy or sell securitiese.There is no transaction costf.There are no bankruptcy costsg.Investors can borrow without restrictions as the same terms on which a firm can borrowh.Dividend payout ratio is 100 percenti.EBIT is not affected by the use of debt

MM Approach (Contd.)MM Approach (Contd.)

Proposition:I. Ko and V are independent of capital structureII. Ke = to capitalisation rate of the pure equity plus a premium

for financial risk.Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt)

III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.

MM Approach [Proposition: I]• Arbitrage Process: Refers to an act of buying an asset or security in

one market at lower price and selling it is an other market at higher price.

• Steps in working out Arbitrage ProcessStudents need to keep in mind the following three steps in working of arbitrage process.Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return).Step 2: Calculation of Savings in Investment by moving from levered firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm.

Step 3: Calculation of Increased Income, by investing total funds available.

Limitations of MM ApproachLimitations of MM Approach• Investors cannot borrow on the same terms and conditions of a

firm• Personal leverage is not substitute for corporate leverage• Existence of transaction cost• Institutional restriction on personal leverage• Asymmetric information• Existence of corporate tax

MM Approach: with Corporate Taxes• MM Approach with tax says affects value of the firm

VL = VU + Dt

Where VL = Value of levered firm

VU = Value of unlevered firm,

D = Amount of Debt

t = Tax rate

• In other words value of levered firm (VL) is equal to the market to the market value of unlevered firm VU plus the discounted present value of the tax saving resulting from tax - deductibility a interest payments.(7) Symbolically

• VL = VU + pv of tax shield

Traditional ApproachTraditional Approach

• Traditional Approach is midway between NI and NOI theories

• Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital

Traditional Approach Traditional Approach (Contd.)(Contd.)

Main propositionsThe following three are the main propositions of traditional approach(11)

1. The pretax cost of debt (Ki) remains more or less constant up to a certain degree of leverage and /but rises thereafter of an increasing rate

2. The cost of equity capital (Ke) remains more or less constant rises slightly up to a certain degree of leverage and rises sharper there after, due to increased perceived risk.

3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It(a) Decreases up to a certain point level of degree of leverage

[stage I increasing firm value];(b) Remains more or less unchanged for moderate increase in leverage

thereafter [stage II optimum value of firm], and (c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].

Traditional approach Traditional approach (contd.)(contd.)

E

D