The document discusses various theories of capital structure. It begins by defining capital structure as the mix of debt and equity used by a company. It then discusses several theories that attempt to determine an optimal capital structure that maximizes firm value:
1) The net income approach argues that firm value increases with debt levels up to a point, as interest payments are tax deductible.
2) The net operating income approach claims firm value is independent of capital structure.
3) The traditional/intermediate approach finds an optimal structure that balances the costs and benefits of debt.
4) Modigliani-Miller theory initially argued capital structure does not affect firm value under certain assumptions, but later incorporated taxes to
Original Description:
meaning of capital structure
types of capital structure
The document discusses various theories of capital structure. It begins by defining capital structure as the mix of debt and equity used by a company. It then discusses several theories that attempt to determine an optimal capital structure that maximizes firm value:
1) The net income approach argues that firm value increases with debt levels up to a point, as interest payments are tax deductible.
2) The net operating income approach claims firm value is independent of capital structure.
3) The traditional/intermediate approach finds an optimal structure that balances the costs and benefits of debt.
4) Modigliani-Miller theory initially argued capital structure does not affect firm value under certain assumptions, but later incorporated taxes to
The document discusses various theories of capital structure. It begins by defining capital structure as the mix of debt and equity used by a company. It then discusses several theories that attempt to determine an optimal capital structure that maximizes firm value:
1) The net income approach argues that firm value increases with debt levels up to a point, as interest payments are tax deductible.
2) The net operating income approach claims firm value is independent of capital structure.
3) The traditional/intermediate approach finds an optimal structure that balances the costs and benefits of debt.
4) Modigliani-Miller theory initially argued capital structure does not affect firm value under certain assumptions, but later incorporated taxes to
The term capital structure is used to represent the
proportionate relationship between debt and equity. Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions) Maximization of shareholders wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company. Use of long term fixed interest bearing debt and share capital is called financial leverage or trading on equity. Optimal Capital Structure It means the capital structure or the combination of equity & debt that leads to the maximum value of the firm and minimizes the cost of capital. Capital Structure theories Net Income Approach Net Operating Income Approach Traditional Approach Modigliani Miller Approach Trade-off theory Signaling theory Debt financing as a managerial constraint A) Net Income Approach (NI) Durand David suggested this approach Net Income approach proposes that there is a definite relationship between capital structure and value of the firm. The theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital In other words, a changing the financial leverage will lead to a corresponding change in the cost of capital as well as the total value of the firm Assumption- 1.The cost of debt is less than the cost of equity. 2.There are no taxes. 3.The risk perception of investors is not changed by the use of debt. V=S+D V=Total market value of firm S=Market value of equity shares D=Market value of debt Overall cost of capital(ko)=EBIT/V
ke ko kd Debt Cost kd ke, ko Example A companys expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000 @ 10% debentures. The equity capitalization rate (ke) 12.5
Example Rs. Net Operating Income (EBIT) 50000 (Less) Interest on 20000 PBT ( no tax so) PAT (NI) 30000 K e 0.125 Value of equity (S) [ NI/Ke) 240000 Value of debt (D) 200000 Value of the firm [S+D] 440000 Overall cost of capital Ko = EBIT/V 11.36% Suppose, the company raise debt by 100000 i.e.., Rs.300000 Net Operating Income (EBIT) 50000 (Less) Interest on 30000 PBT ( no tax so) PAT (NI) 20000 Ke 0.125 Value of equity (S) [ NI/Ke) 160000 Value of debt (D) 300000 Value of the firm [S+D] 460000 Overall cost of capital Ko = EBIT/V 10.9% Thus the Ko is differ when Debt differ B) Net Operating Income (NOI) According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firms capital structure., Therefore value of the company is the same. Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Assumptions o The market capitalizes the value of the firm as a whole o The business risk is constant at every level of debt equity mix o The cost of debt (K d ) is constant. o Corporate income taxes do not exist. V=EBIT/Ko S=V-D S= market value of equity shares D= market value of debt V=total market value of a firm Ko=overall cost of capital
ke ko kd Debt Cost Example A companys expected annual net operating income (EBIT) is Rs.50000. The company has Rs.200000 @ 10% debentures. The equity capitalization rate (ke) 12.5%. Example Rs. Net Operating Income (EBIT) 50000 Overall cost of capital (Ko) 0.125 Value of the firm [ EBIT/ Ko ] 400000 Value of the debt (D) 200000 Value of the equity (S) = V-D 200000 Ke = Eps / Value of Equity shares Eps = EBIT I = 50000 20000 = 30000 30000/200000 = 0.15 Ko = K [B/V ]+ Ke [S/V] =0.10 [ 200000/400000]+ .15[200000/400000] = 0.125
D) Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm. Traditional approach (intermediate approach) is a compromise between these two extreme approaches. Traditional approach confirms the existence of an optimal capital structure; where Weghited average Cost of capital (WACC) is minimum and value is the firm is maximum. As per this approach, a best possible mix of debt and equity will maximize the value of the firm. Traditional Approach is midway between NI approach and NOI approach It is also known as Intermediate approach It argues that Ko will not change upto certain level of change in debt equity proportion. Example: Assume a firm has EBIT of Rs. 40000. the firm has 10 % debentures of Rs. 100000 and its current equity capitalisation rate is 16 %. Particulars Amount (Rs) EBIT 40000 Less : Interest (10% on Debt) 10000 EAT [NI] 30000 Equity Capitalisation rate 0.16 Total MV of Equity (S) [NI/Ke] 187500 Total MV of Debt (B) 100000 Total Value of the Firm [V=S+B] 287500 Ko [EBIT/V] 0.139 Therefore the Ko is approx 14%
Suppose debentures increase by Rs. 50000 i.e. Rs.150000 and Interest Is increase by 11% and Ke 17% Ensure whenever Debt increase interest will also increase
EBIT 40000 Less : Interest 16500 NI 23500 Ke 0.17 S = NI / Ke 138235 D= 150000 Then V = (S+D) 288235 Ko = [ EBIT / V ] 0.138 Therefore the Ko is approx 14% Thus we can understand that there is no relevant of the Ko with the proportion of S: D At the same time suppose if the firm issue additional debt Rs.100000 i.e. Rs.200000 then interest is 12.5% and Ke 20 % then Ko will differ from past capital structure
EBIT 40000 Less : interest 25000 NI 15000 Ke 0.20 Value of the Equity (S) [NI / Ke] 75000 Value of the Debt (D) 200000 Value of the firm V = [S+D] 275000 Ko = EBIT / V 0.145
C) Modigliani Miller Model (MM) Modigliani and Miller (1958) show that financing decisions dont matter in perfect capital markets. The Modigliani Miller Approach is relating to the relationship between the capital structure, Cost of capital. MM Approach maintains that the Weghited average Cost of capital (WACC) does not change, with a change in the proportion of debt to equity in the capital structure. M&M Proposition 1: Firms cannot change the total value of their securities by splitting cash flows into two different stream. Capital structure is irrelevant MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm. Assumptions o Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible. o Investors can borrow without restrictions at par with the firms. o Investors are rational & informed of risk-return of all securities o No corporate income tax, and no transaction costs. o 100 % dividend payout ratio, i.e. no profits retention. MM Model proposition o Value of a firm is independent of the capital structure. o Firms total market value=EBIT/Ke o Firms market value of equity(S)=V-D o Firms leverage cost of equity=Cost of equity o MM prove, under a very restrictive set of assumptions, that a firms value is unaffected by its financing mix: V L = V U
V u is the value of an unlevered firm = price of buying a firm composed only of equity, and V L is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.
MM Theory:Corporate Taxes Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. MM show that: V L = V U + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm. Millers Theory:Corporate and Personal Taxes Personal taxes lessen the advantage of corporate debt: o Corporate taxes favor debt financing since corporations can deduct interest expenses. o Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate. V L = V U + [1 - (1 - T c )(1 - T s )]D ( 1- T d ) T c = corporate tax rate. T d = personal tax rate on debt income. T s = personal tax rate on stock income. T c = 40%, T d = 30%, and T s = 12%. V L = V U + [1 - (1 - 0.40)(1 - 0.12) ]D (1 0.30) = V U + (1 - 0.75)D = V U + 0.25D. Value rises with debt; each $1 increase in debt raises Ls value by $0.25 Effects of Bankruptcy Cost Another important imperfection affecting CS decision is the presence of bankruptcy cost. When a firm is unable to meet its obligations it results in financial distress that can lead to bankruptcy because a major contributor to financial distress is debt. The greater the level of debt, the larger the debt servicing burden associated with it, the higher the probability of financial distress. If there is a possibility of bankruptcy, and if administrative and other costs associated with bankruptcy are significant, the levered firm may be less attractive to investors than that of the unlevered one. As a result, the investors are likely to penalize the price of the stock as Leverage increases. Expected bankruptcy cost rise when Price declines, and the threat of this cost pushes less profitable firms toward lower Leverage targets. Similarly, expected bankruptcy cost is higher for firms with more volatile earnings, which should drive smaller, less-diversified firms toward fewer targets Leverage. Taxes have two offsetting effects on optimal Capital structure. The deductibility of corporate interest payments pushes firms toward more target Leverage, while the higher personal tax rate on debt,relative to equity, pushes them toward less Leverage. Baxter (1967)35 used the concept of bankruptcy costs to argue for the existence of an optimal capital structure. Expected bankruptcy cost depends on the cost of bankruptcy (eg., legal fees, loss of sales, employees and suppliers) and the probability of occurrence. Increased debt financing will increase the probability of bankruptcy and will in turn increase expected bankruptcy costs. The optimal debt ratio is reached when the marginal tax savings from debt financing is equal to the marginal loss from expected bankruptcy costs. Trade-off Theory The term trade-off theory is used by different authors to describe a family of related theories. Management running a firm evaluates the various costs and benefits of alternative Leverage plans and strives to bring a trade- off between them. Often it is assumed that an interior solution is obtained so that marginal costs and marginal benefits are balanced. Thus, trade-off theory, implies that companys Capital structure decision involves a trade-off between the tax benefits of debt financing and the costs of financial distress. When firms adjust their Capital structure, they tend to move toward a target debt ratio that is consistent with theories based on tradeoffs between the costs and benefits of debt. MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits. Signaling Theory MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would o Sell stock if stock is overvalued. o Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. The pioneering study of Donaldson (1961)41 examined how companies actually establish their Capital structure Firms prefer to rely on internal accruals, that is, on retained earnings and depreciation cash flow. Expected future investment opportunities and expected future cash flows influence target dividend payout ratios. Firms set the target payout ratios at such a level that capital expenditures, under normal circumstances are covered by internal accruals. Dividends tend to be sticky in the short run. Dividends are raised only when the firm is confident that the higher dividend can be maintained;dividends are not lowered unless things are very bad. If a firms internal accruals exceed its capital expenditure requirements, it will invest in marketable securities, retire debt, raise dividend, and resort to acquisitions or buyback its shares. If a firms internal accruals are less than its non- postponable capital expenditures, it will first draw down its marketable securities portfolio and then seek external finance. When it resorts to external finance, it will first issue debt, then convertible debt, and finally equity stock, thus, there is a pecking order of financing. Debt Financing and Agency Costs One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage: o Bonds free cash flow. o Forces discipline on managers to avoid perks and non-value adding acquisitions. o A second agency problem is the potential for underinvestment. o Debt increases risk of financial distress. o Therefore, managers may avoid risky projects even if they have positive NPV