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Capital Structure Theories
Capital Structure Theories
Assumptions
1.
2.
3.
4.
5.
6.
According to NI approach
both the cost of debt and the
cost
of
equity
are
independent of the capital
structure;
they
remain
constant regardless of how
much debt the firm uses. As
a result, the overall cost of
capital declines and the firm
value increases with debt.
This approach has no basis
in reality; the optimum
capital structure would be
100 per cent debt financing
under NI approach.
Cost
ke, ko
ke
ko
kd
kd
Debt
Cost
ke
ko
kd
Debt
Traditional Approach
The
traditional
approach
argues that moderate degree of
debt can lower the firms
overall cost of capital and
thereby, increase the firm value.
The initial increase in the cost
of equity is more than offset by
the lower cost of debt. But as
debt increases, shareholders
perceive higher risk and the
cost of equity rises until a point
is reached at which the
advantage of lower cost of debt
is more than offset by more
expensive equity.
Cost
ke
ko
kd
Debt
Cost
ko
Debt
MM's Proposition I
Arbitrage Process
Consider two zero-growth firms in every
respect that firm NL has no financial
leverage while firm L has Rs.30,000 of
12% debt outstanding.
As per traditional approach, L may have a
higher total value and a lower WACC than
NL.
Arbitrage Process..
(Additional Information)
Particulars
Rs.(NL)
Rs.(L)
10,000
10,000
Int
Interest on Debt
3,600
Inc
10,000
6,400
ke
15%
16%
66,667
40,000
30,000
66,667
70,000
ko
0.15
0.143
D/S
Debt-to-Equity Ratio
0.75
Arbitrage Process
(Same situation will not continue as ARBITRAGE will drive the total
values of the two firms together to a common one)
Arbitrage Process.
Personal Investment
Suppose you have 1% stock in L.
1. Sell the stock in L for Rs.400.
2. Borrow Rs.300 @12%(equal to 1% debt of L).
So total capital for investment= Rs.(400+300)
= Rs.700.
3. Buy 1% share in NL for Rs.666.67 & still have
(Rs.700-666.67) =Rs.33.33for other
investments.
Prior to this transaction:
Your return was 16%on your investment of
Rs.400 in L. This was Rs.400 X 16%= Rs.64
Arbitrage Process..
After the transaction
1. Your return from NL is @ 15% on Rs.666.67 =
Rs.100
2. You have to pay interest on personal
borrowings @ 12% on Rs.300 = Rs.36
3. Your net rupee income = Rs.(100-36)= Rs.64
in NL, which is the same return as it was for L.
4. Your personal cash investment = Rs.(666.67
loan of 300)= Rs.366.67, which is Rs.33.33
less than the previous investment in L i.e.
Rs.400(L) Rs.366.67(NL) = Rs.33.33
Arbitrage Process..
Subsequent Actions:
1.
2.
Arbitrage
Levered Firm (L):
Vl Sl Dl 60,000 50,000 110,000
kd interest rate 6%; NOI X 10,000
Arbitrage..
Return from Levered Firm:
Investment 10% 110, 000 50, 000 10% 60, 000 6 , 000
Return 10% 10, 000 6% 50, 000
Alternate Strategy:
1. Sell shares in L: 10% 60,000 6,000
2. Borrow (personal leverage): 10% 50,000 5,000
3. Buy shares in U : 10% 100,000 10,000
Return from Alternate Strategy:
Investment 10,000
Return 10% 10,000 1,000
Less: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Cash available 11,000 10,000 1,000
MMs Proposition II
The cost of equity for a
levered firm equals the
constant overall cost of
capital plus a risk premium
that equals the spread
between the overall cost of
capital and the cost of debt
multiplied by the firms debtequity ratio. For financial
leverage to be irrelevant, the
overall cost of capital must
remain constant, regardless
of the amount of debt
employed. This implies that
the cost of equity must rise
as financial risk increases.
Cost
ke
ko
kd
Debt
MM's Proposition I
MM Propositions I and II
MM Proposition I :
X
V
ko
X
ko
V
MM Proposition II :
X kd D
ke
S
ke ko (ko k d )D/S
Leverage benefit
LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES
Corp
Corp
Pers
Pers
tax
tax on div
tax on div
tax on int
Unlev
0%
0%
0%
0%
Lev
0%
0%
0%
0%
Unlev
35%
10%
0%
0%
Lev
35%
10%
0%
0%
PBIT
Int
PBT
Corp tax
PAT
Div
Div tax
Tol corp tax
2500
0
2500
0
2500
2500
0
0
2500
700
1800
0
1800
1800
0
0
2500
0
2500
875
1625
1477
148
1023
2500
700
1800
630
1170
1064
106
736
Div income
Pers tax on div
AT div income
Int income
Pers tax on int
AT int income
AT total income
Net leverage benifit
2500
0
2500
0
0
0
2500
1800
0
1800
700
0
700
2500
0
1477
0
1477
0
0
0
1477
1064
0
1064
700
0
700
1764
287
Lev
0%
0%
0%
0%
Unlev
35%
10%
0%
0%
Lev
35%
10%
0%
0%
Unlev
35%
10%
20%
0%
Lev
35%
10%
20%
0%
Unlev
35%
10%
20%
20%
Lev
35%
10%
20%
20%
Unlev
35%
10%
20%
30%
Lev
35%
10%
20%
30%
2500
0
2500
0
2500
2500
0
0
2500
700
1800
0
1800
1800
0
0
2500
0
2500
875
1625
1477
148
1023
2500
700
1800
630
1170
1064
106
736
2500
0
2500
875
1625
1477
148
1023
2500
700
1800
630
1170
1064
106
736
2500
0
2500
875
1625
1477
148
1023
2500
700
1800
630
1170
1064
106
736
2500
0
2500
875
1625
1407
148
1023
2500
700
1800
630
1170
1064
106
736
Div income
2500
Pers tax on div
0
AT div income
2500
Int income
0
Pers tax on int
0
AT int income
0
AT total income
2500
Net leverage benifit
1800
0
1800
700
0
700
2500
0
1477
0
1477
0
0
0
1477
1064
0
1064
700
0
700
1764
287
1477
295
1182
0
0
0
1182
1064
213
851.2
700
0
700
1551
370
1477
295
1182
0
0
0
1182
1064
213
851.2
700
140
560
1411
230
1407
281
1126
0
0
0
1126
1064
213
851.2
700
210
490
1341
216
Corp tax
Corp tax on div
Pers tax on div
Pers tax on int
PBIT
Int
PBT
Corp tax
PAT
Div
Div tax
Tol corp tax
Financial Distress
Financial distress arises when a firm is not able to
meet its obligations to debt-holders.
For a given level of debt, financial distress occurs
because of the business (operating) risk . with
higher business risk, the probability of financial
distress becomes greater.
Determinants of business risk are:
Shareholderbondholder conflicts
Shareholder value is created either by increasing the value of the
firm or by reducing the the value of its bonds. Increasing the risk
of the firm or issuing substantial new debt are ways to redistribute
wealth from bondholders to shareholders. Shareholders do not
like excessive debt.
Agency Costs
Agency costs are the costs of the monitoring and control
mechanisms.
Agency costs of debt include the recognition of the possibility of
wealth expropriation by shareholders.
Agency costs of equity include the incentive that management has
to expand the firm beyond the point at which shareholder wealth is
maximised.
Financial Distress
Maximum value of firm
Costs of
financial distress
Market Value
of The Firm
PV of interest
tax shields
Value of
unlevered
firm
Debt
Optimal amount
of debt
Return
Risk
Flexibility
Capacity
Control
Approaches to Establish
Appropriate Capital Structure
EBITEPS approach for analyzing the impact of debt
on EPS.
Valuation approach for determining the impact of debt
on the shareholders value.
Cash flow approach for analyzing the firms ability to
service debt.
Focus of cash flow analysis
Practical Considerations in
Determining Capital Structure
Control
Widely-held Companies
Closely-held Companies
Flexibility
Loan Covenants
Early Repay ability
Reserve Capacity
Marketability
Market Conditions
Flotation Costs
Capacity of Raising Funds
Agency Costs