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Capital Structure Theories
Capital Structure And Value• Capital structure decision is one
of the key decisions that focuses on finding the capital structure with the objective of maximisation of value of the firm.
• It is perhaps the key strategic decision that has occupied much of the time and attention of academicians and managers alike.
• The issue revolves around the question of an optimal capital structure, if there is any.
Common Assumptions for the Analysis
• Following assumptions are required to arrive at optimal capital structure– To analyse effects of capital
structure one form of capital needs to be replaced with another form
–Maximisation of value of the firm is consistent with maximisation of shareholders’ wealth
–Optimal capital structure is one that minimises WACC
– Earning levels remain constant
Target Capital Structure• Target capital structure is the debt
equity ratio deemed most appropriate by the management.
• Target capital structure is determined
by several factors like • taxes, • Interest,
– And practical issues like • market practices, • lenders’ perspectives, and • industry norms.
Net Income Approach • Assumes that capitalisation of
the firm is based on the net income derived by each supplier of capital discounted at fixed rates irrespective of levels of debt.
E+ DEBIT=
firm theof ueMarket valsuppliers capital all toEarnings=kWACC;
.E
I-EBIT=equity of ueMarket val
rsshareholdeequity for Earnings=k Equity; ofCost
Di=
debt of ueMarket valInterest=kDebt; ofCost
e
d
o
Net Income Approach Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance Equity (Book Value)Debt (Book Value)
900.00100.00
500.00500.00
100.00900.00
Capitalisation RateEquity, keDebt, kd
20%10%
20%10%
20%10%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 50.00 90.00
EBT 490.00 450.00 410.00
Net Income ApproachCapitalization Rates
EBT 490.00 450.00 410.00
Taxes Assumed no taxes
Earnings available to shareholders
490.00 450.00 410.00
Market value of debt (I/kd)
100.00 500.00 900.00
Market value of equity (EBIT – I - Taxes)/ke
2,450.00 2,250.00 2,050.00
Total Value of the firm 2,550.00 2,750.00 2,950.00
Overall capitalisation rate (k)
19.61% 18.18% 16.95%
Net Income Approach
Rates of Return ke
k
kd
0 D/E
Net Income ApproachOptimal Capital Structure
• Net Income approach assumes that capitalisation rates are constant and increasing debt would – reduce overall capitalization rate
(WACC), and – increase the value of the firm.
• Optimal capital structure under net income approach is 100% debt
DEDk
DEEkk de
Net Operating Income Approach Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance Equity (Book Value)Debt (Book Value)
900.00100.00
500.00500.00
100.00900.00
Capitalisation RateDebtOverall
10%20%
10%20%
10%20%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 50.00 90.00
EBT 490.00 450.00 410.00
Net Operating Income Approach• Under net operating income approach the
cost of equity rises so as to compensate the reduced cost of debt keeping the overall capitalisation rate constant.
Scenario A : ke = 20 + (20 - 10) x 100/2400 = 20.42%
Scenario B : ke = 20 + (20 - 10) x 500/2000 = 22.50%
Scenario C : ke = 20 + (20 - 10) x 900/1600 = 25.63%
ED)k-(k+k= d00ek
Net Operating Income Approach Capitalization Rates
• Under net operating income approach no capital structure is optimal, alternatively all capital structures are optimal.
NET OPERATING INCOME APPROACH: CAPITALISATION RATES
Rates ofReturn
ke
k0 k
kd
0 D/E
de kDE
DkDEEk
0
Traditional Approach• Initially the cost of capital for the firm will fall
as cheaper debt replaces expensive equity.• Even though the cost of equity rises with
increased debt the advantages of debt would outweigh the increased cost of equity.
• Beyond a certain level of leverage the cost of equity starts rising disproportionately, more than offsetting the advantage of debt, raising the overall cost of capital for the firm.
• Since cost of capital falls initially and then starts rising there exists a point where cost of capital would be least.
• This point of least cost of capital would maximise the value of the firm and is the optimal capital structure.
Traditional Approach Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance Equity (Book Value)Debt (Book Value)
900.00100.00
500.00500.00
100.00900.00
Capitalisation RateDebtEquity
10%20%
11%20%
12%30%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 55.00 108.00
EBT 490.00 445.00 392.00
Traditional ApproachCapitalization Rates
• With increasing level of debt the overall cost of capital falls initially because cost of debt is less than the cost of equity, thereafter it rises because equity holders expect greater returns due to increasing perceived risk from the debt holders. Rates of
Return c = optimal capital structureke
k0 k kd
O C D/E
Modigliani And Miller (MM) Theory – Without Taxes
• Capital structure is irrelevant.
• The value of levered firm and unlevered firm would be equal.
VU = VL
MM Proposition IIWithout Taxes
• With increasing leverage the cost of equity rises exactly to offset the advantage of reduced cost of debt.
• To keep the value of the firm constant.
• The cost of equity for varying levels of debt is given by: E
Dkkkk de )-( 00
MM Theory – Arbitrage• MM Proposition of irrelevance of
capital structure is based on the principle of arbitrage i.e. the discrepancy in valuation of levered firm and unlevered firm would be set right by investors by selling the overvalued and buying the undervalued asset.
MM Theory – Arbitrage
ALLEQ CODEQ
EBIT 5,00,000 5,00,000
Interest @ 10% - 1,00,000
EBT 5,00,000 4,00,000
Taxes (Assumed no taxes) - -
EAT 5,00,000 4,00,000
Market value of debt - 10,00,000
Market value of equity, capitalisation rate 20%
25,00,000 20,00,000
Value of the firm 25,00,000 30,00,000
MM Theory - Arbitrage
25,00,000 Rs. 0.2
5,00,000k
Dividend=
ksuppliersequity toEarnings=ALLEQ ofequity theof ueMarket val
20,00,000 Rs. 0.2
4,00,000k
Dividend=
ksuppliersequity toEarnings=CODEQ ofequity of ueMarket val
00Rs.10,00,0=0.10
1,00,000=
kInterest=CODEQ ofdebt of ueMarket val
d
MM Theory – Arbitrage• An investor owns 10% of CODEQ. Since ALLEQ is
cheap, he sells holding in CODEQ and realizes Rs. 2,00,000 (10% of the market value he holds).
• To keep his risk profile identical to that of CODEQ he borrows an amount equal to 10% of debt of CODEQ.
• The cost of his borrowing is assumed identical to that of CODEQ i.e. 10%.
• He borrows Rs. 1,00,000 (10% of the value of debt of CODEQ).
• To keep position same he acquires 10% of ALLEQ by investing Rs. 2,50,000 (10% of market value of ALLEQ).
MM Theory – ArbitrageCash flow and returns for investor swapping position Rs. Swapping position - Cash flow
Initial cash flowSelling 10% of CODEQBorrowing Investing 10% in ALLEQSurplus (Deficit) cash
+2,00,000+1,00,000- 2,50,000+ 50,000
If invest in CODEQ
If invest in ALLEQ
Returns10% of shareholders’ fundLess: Borrowing costNet Income
40,000
-40,000
50,00010,00040,000
Assumptions and LimitationsMM’s Theory of Irrelevance • Identical expectations of earnings. • All earnings are distributed. • No transaction cost. • Free and instantaneous flow of
information.• Absence of taxes. • Replication of leverage in personal
capacity, the home made leverage.
MM Theory - With Taxes
ALLEQ CODEQ
EBIT 5,00,000 5,00,000
Interest @ 10% - 1,00,000
EBT 5,00,000 4,00,000
Taxes @ 40% 2,00,000 1,60,000
EAT 3,00,000 2,40,000
Earnings available to suppliers of debt and equity
3,00,000 3,40,000
MM TheoryValue of Firm With Taxes
VL = VU + T x D
0
)1(r
TEBITVU
TD+k
T)(1EBITk
k x D x T+k
T)(1 x EBIT=
ShieldTax of Value+V=V
0
d
d
0
UL
MM TheoryValue of Firm With Taxes
VL = VU + T x D
0
)1(k
TEBITVU
TD+k
T)(1EBITk
k x D x T+k
T)(1 x EBIT=
ShieldTax of Value+V=V
0
d
d
0
UL
MM TheoryCapitalization Rates With
Taxes• In the presence of corporate tax the
optimal capital structure would be 100% debt according to MM propositions
M & M POSITION (with taxes) VALUE OF THE FIRM
Value VL
PVTS=TxD
VU
D/E
M & M POSITION (With Taxes) CAPITALISATION RATES
Rates ofReturn
ke
k0 k
kd(1-T)
D/E
MM Theory Of IrrelevanceMMs Propositions – With and Without Corporate Taxes
Without Taxes With Taxes
Proposition I Value of the firm
VL = VU
VL = E + DVL = VU + PVTS
VU = EBIT (1-T)/k0
Proposition II Cost of equityProposition III Cost of capital
WACCU = WACCL = k0
EDkkkk de )-( 00
ETDkkkk de
)-1()-( 00
DETDk
DEEkkWACC
EDPVWACCWACC
deL
TSUL
)-1(;
)-1(
DEDk
DEDkkWACC de
;
Cost Of Financial Distress & Agency Cost
• Costs of financial distress tend to decrease the value of the firm offsetting some of the advantage of tax shield of debt.– Agency Cost of Debt – High amount of debt is against the
principles of capital budgeting and encourages managers to take undue risk to increase the welfare of shareholders at the expense of debt holders.
– Agency cost of debt relate to the conflict of interest between debt holders and shareholders.
Trade Off Theory Of Capital Structure
TRADE OFF THEORYCOST OF FINANCIAL DISTRESS AND TAX SHIELD
Market value of the firmCost of financial distress and agency
Value of the firm
Value of tax shield
Value of unlevered firm
Optimal capital Debt/Equity structure
Donaldson’s Pecking Order Theory
• Donaldson study suggests the pecking order of financing specifies that firms 1.will finance from internal accruals, then2.raise debt or convertible debt, and finally 3.resort to issue of equity.
• Pecking order theory relies on the assumption that mobilization of fresh capital is not greeted with cheers in the capital markets.
Signalling, Asymmetric Information Theory
• Contradiction in Donaldson’s pecking order and trade off models can be explained partially on the information asymmetry that exists between shareholders and managers of the firm.
Free Cash Flow Hypothesis
• Free cash flow hypothesis states that managers would have tendency to waste if cash available is high. Debt would reduce the availability of free cash flow and therefore check indiscretion.
