Bharat Singh Thapa

UNIT 2 Lecturer
CAPITAL STRUCTURE Central Department of Management
Tribhuvan University
UNIT OUTLINE
 Introduction to Capital Structure Theory
 Capital Structure Theory
 Incentive Issues and Agency Costs
 Financial Signaling
 Pecking Order Theory of Capital Structure
THE BALANCE-SHEET MODEL OF THE FIRM

Current Liabilities

Current Assets
Long-Term Debt
How can the firm
raise the money
Fixed Assets for the required
1 Tangible
investments?
Shareholders’
2 Intangible Equity

1-3
1. INTRODUCTION TO CAPITAL STRUCTURE
THEORY

Financial structure
The composition of all sources of funds of a firm
Shows all types of liabilities and equity capital
Capital structure
The composition of long-term funds
Shows the long-term liabilities and equity
CAPITAL STRUCTURE

Current Liabilities

Current Assets
Long-Term Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity

1-5
INTRODUCTION ...

The issue of capital structure: the effect of financing mix

on the total value of a firm
School of thoughts
Relevant school of thought
Irrelevant school of thought
INTRODUCTION ...

Assumptions
The world without taxes (both corporate and personal taxes)
No bankruptcy costs
Debt and equity are interchangeable source of funds
Perfect capital markets
No retention of earnings (100 percent dividend payout ratio)
INTRODUCTION ...

Definition of the terms used

Cost of debt
Required return on equity
Overall capitalization rate
INTRODUCTION ...

Cost of debt: cost of using and raising long term debt capital and it is defined as
I Annual interest expenses
kd = B = Market value of debt (2.1)

Where
kd = cost of debt
I = annual interest
B = market value of debt
INTRODUCTION ...

Required return on equity: minimum rate of return on equity

capital and it is defined as
E Earnings to common stockholders
ke = S = Market value of equity (2.2)

Where
E = earnings to common stockholders
S = market value of equity
INTRODUCTION ...

Overall capitalization rate: the discount rate (weighted average cost of capital)
at which net operating income is discounted and defined as follows:

NOI Net operating income

ko = V = Total Market value of the firm (2.3)

Where
NOI = net operating income
V = total market value of the firm
Here
V =B+S
INTRODUCTION ...

Restatement of Equation 2.3

 B S
ko = kd B + S + ke B + S (2.4)
   

B/(B+S) = weight of debt

S/(B+S) = weight of equity
INTRODUCTION ...
Example 2.1
Market value of debt (B) = Rs 1,000,000
Yield on debt (kd) = 5%
Market value of stock (S) = Rs 4,000,000
Required rate of return for investors (ke) = 7.5%
The overall capitalization rate is given by:

 B  S 
ko = k d B + S + k e B + S
   
 Rs 1000000   Rs 4000000 
= 5%   + 7.5%  
Rs 1000000 + Rs 4000000 Rs 1000000 + Rs 4000000
= 5% (0.2) + 7.5% (0.8) = 7%
2. CAPITAL STRUCTURE THEORY:
APPROACHES

Approaches to Capital Structure Theory

KEY QUESTIONS
Relevant approach
1. Can the firm affect its total valuation & its required
 Net income approach return by changing its financing mix?
 Traditional approach 2. What happens to the total valuation of the firm and to
its cost of capital when the ratio of debt to equity, or
Irrelevant approach degree of leverage is varied?

 Net operating income approach

 MM theory
CAPITAL STRUCTURE ...

Net Income Approach

There exists optimal capital structure.
As leverage increases, ‘ko’ declines & ‘V’ increases. MPS
also increases.
 Thus, firm’s capital structure affects the market value of
the firm and overall cost of capital.
NET INCOME APPROACH

Financial risk: increase in debt does not lead to increase in

financial risk perceptions of investors
Cost of equity: remains constant with increase in debt
Cost of debt: remains constant with increase in debt and
lower than cost of equity
Overall cost of capital: debt lowers the overall cost of capital
Value of firm: debt increases the value of the firm.
 NET INCOME APPROACH

Cost of capital, %
ke

ko
ki

Leverage
PRACTICE
Given:
B=$1000, NOI=$1000, i=15%, ke=20%, V=?, ko=?
If ‘B’ increases from $1000 to $3000, V=? Ko=?

19.05% 17.39%
 NET INCOME ...
Example 2.2: Suppose a firm has Rs 10,000 in net operating income (NOI). The firm has
Rs 20,000 in 10 percent debt (B), and its equity capitalization rate (ke) is 20 percent.
Given these information, what is the value of firm’s equity? What is the value of the
firm? What is its overall cost of capital?
Net operating income (NOI) – Interest (I)
Value of equity (S) = Equity capitalization rate (ke)
Rs 10000 – Rs 20‚000 × 0.10
= 0.20 = Rs 40,000
The firm has Rs 20,000 in debt so that total value of the firm is given by:
Value of the firm (V) = Value of debt (B) + Value of equity (S)
= Rs 20,000 + Rs 40,000 = Rs 60,000
The overall cost of capital of the firm at this level is given by:
B S
ko = kd B + S + keB + S
   
Rs 20‚000 Rs 40‚000
= 0.10   + 0.20 Rs 60‚000
Rs 60‚000  
= 0.0333 + 0.1333 = 0.1666 or 16.66%
TRADITIONAL APPROACH
 It supports NI approach and states that there exists optimal capital structure.
 The firm initially can lower its cost of capital and raise its total value through
leverage.
 Although investors raise the equity capitalization rate, the increase in ke does not
offset entirely the benefit of using cheaper debt funds.
 Benefit of using cheaper funds is more than equity capitalization rate, and hence
overall cost of capital declines.
Required equity rate increases at increasing rate after certain level of debt in a firm and
the use of cheaper debt does not offset the rising required equity rate and overall cost of
capital starts to rise.
Total value of a firm is maximized where overall cost of capital reaches to the lowest
point and this level of debt is the optimal capital structure.
 Optimal capital structure is given by the lowest point in ko curve.
 Cost of capital is not independent of capital structure.
Cost of capital,% ke

ko

ki

X
Leverage
NET OPERATING INCOME (NOI) APPROACH

 Overall cost of capital (ko): independent of capital structure

 Value of the firm (V): independent of capital structure and constant
regardless of the ratio of debt to equity
 Total value of the firm: capitalized amount of net operating income by its
overall capitalization rate and remains constant regardless of debt to equity
ratio
 Value of equity: total value of the firm minus market value of debt

V= B+S
NET OPERATING ...

Cost of debt: constant at any level of debt capital used

Cost of equity and overall cost of capital: increasing use of
debt capital results into an increase in cost of equity and the
increased equity cost is exactly offset by the use of low-cost
debt capital, and overall cost of capital also remains
unchanged.
 NET OPERATING INCOME APPROACH

Cost of capital, %
ke

ko

ki
Leverage
PRACTICE
There exists no optimal capital structure.
It assumes that ‘ko’ & ‘V’ remain constant as leverage increases. MPS also
remains constant.
As leverage increases, ke increases.
NOI=$1000, ko=20%, B=$1000, i=15% S=?, ke=?
If B increases to $3000, ke=?

21.25% 27.50%
 Items Before After debt incr.
to $3,000
O Net operating earnings $1,000 $1,000
ko Overall capitalization rate 0.2 0.2
V Total value of the firm $5,000 $5,000
B Market value of debt 1,000 3,000
S Market value of stock 4,000 2,000
E $850
Ke = ------------ = ------------ 21.25 27.50
S 4,000 percent percent
NET OPERATING ...
Example 2.3
A firm has Rs 20,000 in debt capital (B) bearing a 10 percent interest,
Rs 10,000 in net operating income (NOI) and the overall capitalization
rate (ko) of the firm is 20 percent. Calculate the market value of the
firm, market value of equity and the cost of equity.
Net operating income (NOI)
Total value of the firm (V) = Overall capitalization rate (k )
o

Rs 10‚000
= 0.20 = Rs 50,000

The market value of equity is obtained by deducting the market value

of debt from total value of the firm as follows:
Market value of equity (S) = V - B = Rs 30,000
The cost of equity capital is obtained as follows:
Earnings to common stockholders (E) Rs 8‚000
ke = Market value of equity(S) = = 26.67%
Rs 30‚000
ONE MORE PRACTICE
The MM Company has net operating earnings of Rs 20,000 and Rs 30,000 of debt with a 10
percent interest charge. Assume the absence of taxes
a. Using the net income approach and an equity capitalization rate of 12 percent, compute
the total value of the firm and the implied overall capitalization rate.
b. Using the net operating income approach and an overall capitalization rate of 11 percent,
compute the total market value, the stock market value, and the implied equity
capitalization rate for the MM.
a. S = Rs 141,667; V = Rs 171,667 and Ko = 11.65%
b. V = Rs 181,818; S= Rs 151,818 and Ke = 11.2 %
MODIGLIANI-MILLER THEORY

MM (1958) support NOI approach & suggest that there is no optimal
capital structure.
A firm's market value and the cost of capital remain invariant to the
capital structure changes in the absence of taxes.
 “No matter how you divide up the capital structure of a firm among
the debt, equity and other claims, there is a conservation of
investment value which depends on profitability and risk.”

Paper topic: The cost of capital, corporate finance and theory of

investment
MM'S PROPOSITION: ASSUMPTIONS

1.Capital markets are perfect.

Information is costless & readily available.
No transaction costs.
All securities are infinitely divisible.
Investors are rational & behave accordingly.
2.Expected operating earnings for all future periods are the same as present
operating earnings.
3.All firms within a class have the same degree of business risk.
4.The absence of corporate and personal income taxes. (These assumptions
are removed later).
 MM'S PROPOSITION ...

Proposition I
The market value of any firm is independent of its capital
structure and is given by capitalizing its expected return at the
overall capitalization rate appropriate to its risk class.
PROPOSITION I ...

A firm cannot change the total value of its outstanding

shares by changing the proportions of its capital structure
No better or worse capital structure from the perspective of
firm’s shareholders
Total value of a firm depends on its underlying profitability
and risk
Two firms alike in every respect except their capital
structure must command the same total value due to
arbitrage process
Arbitrage process – buying cheap and selling high restores
equilibrium
MM'S PROPOSITION ...

Proposition II

The expected yield of a share of stock is equal to the appropriate

capitalization rate for a pure equity stream in the class plus a
premium related to financial risk.
 Premium is equal to the debt-to-equity ratio times the spread
between pure equity capitalization rate and debt capitalization
rate.
MM'S PROPOSITION II …

Expected return on equity: positively related

to leverage
Risk to common stockholders: increases
with leverage
Cost of levered equity: the cost of unlevered
equity plus risk premium for the use of debt
MM'S PROPOSITION ...

Cost of Levered Equity

ke(L) = ke(U) + [ke(U) –kd](B/S) (2.5)
Where
ke(L) = cost of levered equity
ke(U) = cost of unlevered equity
kd = cost of debt
B/S = the debt equity ratio
Consider the two firms, A & B, identical in every
respects except their capital structures. B has
$30,000 of 12 percent bonds. Total value =?
Co. A Co. B
O NOI $10,000 $10,000
F Interest (12%,$30,000) 0 3,600
E Earnings avail. to common stockholders
10,000 6,400
ke Equity cap. rate 0.15 0.16
S Market value of stock 66,667 40,000
B Market value of debt 0 30,000
V Total value of firm 66,667 70,000
Ko Implied overall cap rate 15% 14.3%
B/S Debt-equity ratio 0 75%
MM maintain that this situation cannot last long.
Arbitrage will occur very soon, which will drive the values of
two firms together.
Company B cannot command a higher total value simply
because it has a financing mix different from company A’s.
Investors in Company B would move to Company A because
they get the same return with less capital outlay.
The arbitrage process will be ceased when the values of the
two firms would be identical.

Arbitrage steps:
If you are a rational investor who owns 1 percent of the stock
of Company B, the levered firm, worth $400, you should:
1. Sell the stock in Company B for $400.
2. Borrow $300 at 12 percent interest. This personal debt is
equal to 1 percent of the debt of Company B -
proportional ownership.
3. Buy 1 percent of the shares of Company A for $666.67.
Return?
Return in Company B: 16% of $400 = $64.
Return in Company A: 15% of $666.67 = $100
Less interest:12% of $300 = 36
Net return 64
Cash outlay?
Outlay in Company B:1% of $40,000 $400
Outlay in Company A:1% of $66,667.67 $666.67
Less Personal debt 300.00
Net outlay 366.67
 TAXES AND CAPITAL STRUCTURE

Release of the assumption of no tax world

No tax advantage for unlevered firm
Value of unlevered firm (VU):
EBIT (1 – Tc)
VU = k (2.6)
e(U)

Where
EBIT = earning before interest and tax
Tc = corporate tax
Ke (U) = cost of unlevered equity
TAXES AND CAPITAL STRUCTURE …
Tax saving on debt financing
Value of levered firm (VL) is increased by the amount of PV of tax
shield and it is given by
PV of tax shield = BTC (2.7)
Where
B = debt
Tc = corporate tax rate
TAXES AND CAPITAL STRUCTURE …

Value of a levered firm (VL)

The sum of value of unlevered firm and present value of
tax shield
VL =VU + BTc (2.8)
Uncertainty of tax shield
Release of assumption of certainty of tax shield
Value of tax shield is lost due to the uncertainty of tax
shield and lost value is deducted from the PV of tax shield
TAXES AND CAPITAL STRUCTURE …

Value of a levered firm (VL) under uncertainty of tax

shield:
VL =VU + BTc - V (2.10)
Where
V = value lost due to the uncertainty of tax
shield
Uncertainty of tax shield reduces the value of levered
firm.
TAXES AND CAPITAL STRUCTURE …

Example 2.4
Income of unlevered firm available to stockholders = Rs 31,500
Required rate of return on equity of unlevered firm (ke(U)=15%
Debt of levered firm (B) = Rs 100,000
Interest rate = 10%
Calculate the value of unlevered firm and levered firm if corporate tax is 30 percent.
 EXAMPLE 2.4 …

The value of levered firm is given by:

EBIT (1 – Tc) Rs 31‚500
VU = VU = k = 0.15 = Rs 210,000
e(U)

Therefore value of the levered firm L:

VL = VU + BTc = Rs 210,000 + Rs 100,000 × 0.3
= Rs 240,000
TRY YOURSELF 2.2

MM Corporation has earnings before interest and taxes of Rs 3

million and a 40 percent tax rate. Its required rate of return on equity
in the absence of borrowing is 18 percent. In the absence of personal
taxes, what is the value of the company in an MM world (1) with no
leverage? (2) with Rs 4 million debt?

Value of unlevered firm = Rs 10 million

Value of firm with Rs 4 million debt = Rs 11.6 million
TAXES AND CAPITAL STRUCTURE …

Corporate plus Personal Tax

Taxable income for individual investors: dividend,
capital gain and interest
Tax rates: different on capital gain and dividend and
interest
Effect of personal taxes: personal tax paid by investors
may reduce or eliminate the tax advantage on debt
financing (tax shield) and reduce the present value of tax
shield
TAXES AND CAPITAL STRUCTURE …

PV of tax shield is given by:

 (1 – Tc) (1 –Tps)
Present value of tax shield = B 1 – (2.11)
 (1 –Tpd) 
Where
Tps = tax rate applicable to stock income of shareholders
Tpd = tax rate applicable to debt income of debt holders
Other symbols as defined before
TAXES AND CAPITAL STRUCTURE …

Cancel out (1-Tps) and (1- Tpd) and this reduces Equation 2.11 to
Equation 2.7 when Tps and Tpd become equal
V (PV of Tax shield) increases if Tps =Tpd
V increases and value of the firm is more than in the presence of
only corporate tax if Tps> Tpd
V decreases and the firm cannot keep the tax advantage on
corporate debt financing if Tps< Tpd
EFFECTS OF BANKRUPTCY COSTS

Benefits of debt financing: value of tax shield

Disadvantage: fixed burden and financial distress resulting to
bankruptcy
Bankruptcy costs: direct and indirect
Effect of Bankruptcy costs: reduction in the value of the tax
shield
VL is given by
VL = VU + BTc – PV of bankruptcy costs
BANKRUPTCY COSTS...
OTHER IMPERFECTIONS

Corporate and home made leverage: perfect substitutions of

each other, but in reality they are not perfect substitute
Institutional restriction on investment behavior
3. INCENTIVE ISSUE AND AGENCY COSTS

Incentive Issues among Debt holders and Shareholders:

Agency relationship
Principal: Debt holders
Agent: Shareholders
INCENTIVE ISSUES ...

Position of principal
Debt holders lose their value in the case of loss and get
nothing more than interest and principal amount in case of
profit.
Position of agent
Shareholders lose only their investment if the firm sustain loss
and they are liable only up to the par value of the shares.
They receive the earning if the firm gain from the risky
investment at the expense of debt holders.
Analysis in the framework of option pricing model
 INCENTIVE ISSUES ...

Under investment issue

Incentive problem:
Restrictive condition
Rejection of projects with positive NPV
Analysis in the framework of option pricing model
Solution to underinvestment problem: own both shares and
debt of the firm
3. INCENTIVE ISSUE ...

Agency Costs and Capital Structure

Shift of wealth from bondholders to shareholders through
capital structure decision
Agency costs: monitoring costs, legal costs, loss from
inefficient operation
Optimum capital structure: where there is trade-off
between interest rate charged and monitoring costs
3. INCENTIVE ISSUE ...

Incentive to Manage Efficiently

Condition of agency conflict
 Management may invests in the project that yields less
than the expected return
 Management does unnecessary expenses
Solution to agency problem: incentive to management
Obligation of debt makes the management more
responsible and discipline
4. FINANCIAL SIGNALING

Information asymmetry
Insiders have more information than outsiders do
have.
Financial signaling
Issue of debt signals better than what stock price
reflects in the market and issue of stock signals the over
pricing of stock in the markets.
5. PECKING ORDER THEORY OF CAPITAL
STRUCTURE

No target capital structure

Order of financing
Internal equity financing
Debt financing
External equity financing
5. PECKING ORDER THEORY OF CAPITAL
STRUCTURE

Figure 2.5 Order of priority of financing