Capital & financial structure of the firm.

The capital structure of the firm refers to the long term sources of finance of the company while the financial
structure of the firm refers to the entire financing part of the statement of financial position i.e. the composition of
long term sources of finance and short term sources of finance already employed by the company. Therefore, the
capital structure is a portion of the financial structure. This can be represented diagrammatically as shown below
Balance Sheet Extract

Capital & liabilities

Ordinary share capital xxx
Retained earnings xxx
Reserves xxx
Capital structure
Preference shares xxx
Debentures xxx
xxx Financial Structure

Current liabilities
Payables xxx
Bank overdraft xxx
Accruals xxx
xxx

Factors to consider when making capital structure decisions

The following factors will influence the capital and financial structure decision of the firm
1. The cost of capital
Other factors constant the lower the cost of capital for each capital component the higher the proportion in the
capital structure
2. Availability of valuable assets
A firm with assets that can be used as collateral is likely to raise debt as compared with a small firm that does
not have assets which is forced to use equity capital to undertake new projects.
3. The purpose of finance/capital
E.g. a firm will borrow long term or permanent capital to finance acquisition of non-current asset while short
term loan will be borrowed to finance working capital needs.
4. Corporate tax rates
The higher the corporate tax rate the higher should be the debt capital so that the firm can enjoy higher tax
shield
5. Reserve capacity
If the firm currently has a low level of gearing it has a higher borrowing capacity and can increase its short
term or long term borrowing
6. Industrial norms or practices
A firm is financed like other firm in the same industry e.g. firms in agricultural sectors are known to have low
level of debt capital /gearing due to their high business risk i.e. fluctuation in operating profits/EBIT
7. Size of the firm and its growth stage
The bigger the firm and its scale of operation and the higher the needs for its growth then the more debt capital
it will require in its financial structure to finance the growth. Since retained earnings will not be adequate to
finance all investment opportunities
 8. Restrictive bond covenant
The providers of debt capital may include in debt agreement that the borrowing firm should not borrow additional
debt capital until the existing loans repaid to a certain extent or fully. Such firms should have a relatively high
quality capital /low financial risk (gearing).

The theories of capital structure

The theories of capital structure are mainly concerned with the following:
a. If the amount of debt in the capital structure affect the value of the firm
b. Whether the amount of debt capital in the company’s capital structure affects the cost of capital of the firm
i.e. whether it affect the WACC of the firm
c. If the amount of debt capital in the company’s capital structure affects cost of capital & value of the firm,
then which is the optimum capital structure.
There are basically 3 theories of capital structure
a. Net income approach (NI)
b. Net operating income approach (NOI)
c. The traditional view (theory) of the capital structure
GENERAL ASSUMPTIONS
i) That the capital structure of the firm, has only 2 sources of finance i.e. equity and debt, preference shares
are excluded as a source of finance in the company
ii) That all companies adopt the same dividend policy of 100% dividend payout ratio hence retained earnings
will be equal to zero and the EPS = DPS
iii) That the capital markets are perfect
iv) The return on capital employed will remain constant and the company will retain its original capital
structure hence EBIT for companies of the same size and in the same industry will be equal and will remain
constant for the foreseeable future
N/B besides these general assumptions, there are specific assumptions which are peculiar to each theory

a. The traditional view/theory of capital structure

According to this theory, the capital structure is relevant.
This theory states that:
i. The cost of debt will always be lower than the cost of equity (Ke > Kd)
ii. The increased use of debt capital has no effect on the cost of debt up to a given relevant range and beyond
this range, the cost of debt will increase with gearing
iii. Within the relevant range, the increased use of debt leads to an increase in the cost of equity but the
increase is insignificant. However, beyond the relevant range, there is a gradual increase in the cost of equity with
the increase in the amount of debt.
iv. Based on the above arguments the theory represented the optimal capital structure as shown below

Ke

WACC
Cost
of Kd
capi
tal
Optimal capital structure

Gearing

The increased use of debt within the relevant range will lead to an increase in the value of the firm. However,
beyond the relevant range, the increased use of debt capital will lead to an increase in WACC leading to a
reduction in the value of the firm. Therefore according to this theory, there exist an optimal capital structure where
the value of the firm is maximized and the WACC is minimized.

b. Net income approach (NI)

The fundamental assumption of this theory is that the financial risk (gearing) doesn’t affect the individual cost of
capital for sources of finance i.e. the cost of equity (Ke) and cost of debt (Kd) will remain constant at all levels of
gearing. However, the theory agrees that the cost of debt (Kd) will always be less than the Ke, this is because of the
interest tax shield benefit and the fact that the debenture holders are almost assured of their fixed annual interest
charges irrespective of the company’s performance
Although the financial risk has no effect on the individual cost of capital, it will affect favorably the companies
WACC i.e. the WACC decreases as gearing increases. The WACC of the firm is an average measure of the
company’s general risk level hence the lower the WACC, the more attractive the company is, the capital structure
of the firm is relevant because it affects both the value of the firm and the WACC for the company.

Illustration
An investor is evaluating three firms A, B and C whose capital structures are as follows.
A B C
Equity 100M 80M 60M
7.5% debt 0 20M 40M
100M 100M 100M
The required rate of return for the three firms is 10% and the cost of equity is 10%.

Required:
a) Determine the value of each firm.
b) Explain the difference in the value of the firms.
Solution
a) Value of the firms.

A B C
EBIT @ 10% 10,000 10,000 10,000
Less interest @7.5% 0 (1,500) (3,000) (interest to debt providers)
Earning before tax 10,000 8,500 7,000
Less tax 0 0 0
Earnings to O. S. holders 10,000 8,500 7,000
Value of the firms
Firms A B C
Equity value (10m/0.1) 100.000 (8.5/0.1) 85,000 (7m/0.1) 70,000
Debt value - (1.5m/0.075) 20,000 (3m/0.075) 40,000
Value of the firm 100,000 105,000 110,000

a) Difference in value of the firm explained

As debt is increased in the capital structure the value of the firm also increases this is because of lower finance
cost paid to the providers of debt capital as compared to the finance available to the providers of equity capital.
Interest saving on debt capital = 10% - 7.5% = 2.5%.
The finance cost per annum increases the earnings to the providers of equity capital, when the annual finance cost
is discounted at the firms cost of equity the present value explains the difference in value between a geared firm
and a similar ungeared firm.

Firms A B C
Finance cost saving p.a 0 (2.5%x20M) 500,000 (2.5%x40M) 1,000,000
P.V of annual finance cost saving (0.5m/0.1) = 5M (1m/0.1) 10M
Difference in value 0 (105m-100m) 5M (110m-100m) 10M
 10% Ke

C
os
t WACC
of
ca 7.5% Kd

Gearing

c. Net operating income approach (NOI)

According to this theory the capital structure of the firm is irrelevant. This is because the amount of debt in the
company’s capital structure doesn’t affect the value of the firm and WACC for the firm. This theory operates
under the following assumptions.

Specific assumptions for NOI theory

i. The cost of equity is affected by both financial risk and business risk meaning Ke increases with debt.
ii. The cost of debt is affected by business risk alone meaning it does not increase with debt.
iii. In the initial stages taxation was assumed to be equal to zero
The cost of equity for a geared firm (Keg) is explained from the cost of equity for ungeared firm (Keu) using a
graph under NOI as follows:

Keg

Keu - Kd

Keu =WACC

Keu - Kd

Kd

Keu – cost of equity for ungeared firm

Keg – Cost of equity for a geared/levered firm
Kd – cost of debt
WACC – weighted average cost of capital = KeWe + KdWd

According to this theory, the value of the firm will be equal to EBIT
WACC

The theory states that the shareholders in a geared firm are exposed to higher financial risks than their counterparts
in the ungeared firm, therefore they will demand a higher return than their counterparts in the ungeared firm hence
the Ke (cost of equity) will increase as gearing increases, since the shareholders in a geared firm are compensated
for the financial risk, they will perceive the company as if it was not geared
 For this reason, the WACC for the geared firm will be equal to the cost of equity for a similar ungeared firm
(Keu). Since the risk level of the firm is measured by its WACC, then a geared firm in which the shareholders are
adequately compensated for the financial risk will have no difference in terms of overall risk if compared with
similar ungeared firm.
Illustration
A firm is considering three financing options as follows:
Options A B C
Equity 100m 70m 40m
Debt capital @ 7.5% - 30m 60m
100m 100m 100m
The required rate return on all investments is 15%,

Required:
Determine the cost of capital and the WACC at all levels of gearing.

Solution
Income statement
Options A B C
EBIT @ 15% 15,000 15,000 15,000
Less interest @ 7.5% 0 (2,250) (4,500)
EBT 15,000 12,750 10,500
Less tax 0 0 0
Earnings attributable to
O.S. Holders 15,000 12,750 10,500
Cost of equity (Ke) 15/100m = 15% (12.75/70m) = 18.2% (10.5/40m) = 26.25%
WACC=KeWe+KdWd 15% 15% 15%

Option A: 15x100/100 + 7.5x0/100 = 15%

Option B: 18.2x70/100 + 7.5x30/100 = 15%
Option C: 26.25x40/100 + 7.5x60/100 = 15%

Keg
26.25%.

Keu-Kd
18.2%

15% Keu = WACC

Co
st Keu-Kd
of 7.5% Kd
ca
X
Gearing
pit
al
The NOI theory has been expounded by Milton Miller and Franco Modigliani in their proposition usually known
as the MM propositions:

1. MM 1st proposition – The value of a firm:

Miller and Modigliani in their first proposition they dealt with the value of the firm, they argued that there are no
two firms which can attract different values simply because one is geared whole the other one is ungeared,. They
said that in case this happens, the investors shall practice an Arbitrage process.
 The Arbitrage process is a process where investors sell their ownership in the overvalued firm and purchase the
shares (ownership) in the undervalued firm. It operates under the following assumptions:
i. That there are perfect capital markets
ii. That both corporate firms and individuals can borrow any amount of money at the same cost of capital
iii. That corporate borrowing has the same financial effect on the investor as individual borrowing i.e. the separate
legal entity is ignored.
Under these assumptions, the Arbitrage process will operate as follows:
a. The investor will sell his ownership in the overvalued firm and realize the amount
b. The investor will then borrow on personal account an amount of money equal to the percentage of his
ownership x debt in the overvalued firm.
c. The investor will make a comparison of the proposed income from the new undervalued firm and his current
income from the overvalued firm
d. The investor will make a decision on whether to invest or not i.e. he will invest where his pay is maximized.
Illustration
Consider the following 2 identical firms with the following characteristics
A B
shs shs
EBIT 100,000 100,000
Interest - 5%×300,000 (15,000)
Earnings to O.S.H 100,000 85,000
KE 10% 11%
Required:

a) Determine the values of each firm.

b) Explain the arbitrage process and compare the returns of an investor who holds 20% in firm B assuming
i. All the available funds are invested in firm A
ii. If he maintains 20% ownership in firm A
Solution
a) Value of the firms
Firms A B
Value of equity 100,000 =1,000,000 85,000 = 772,727
0.1 0.11
15,000
Value of debt 0 /0.05 300,000
1,000,000 1,072,727
The two firms being in the same industry should be of the same value but firm B has a higher value hence it is said
to be overvalued by the forces of demand and supply in the market.
b) Arbitrage process
Step 1
Since firm B is overvalued, the investor shall sell his ownership in the overvalued firm to realize 20%×772,727 =
154,545.4
Step 2
Borrow an amount equal to the % of his ownership × debt in the overvalued firm
= 20%×300,000 = 60,000
Therefore, the amount available for investment = 154,545+60,000 = 214,545.4
Step 3
Invest in the undervalued firm i.e. firm A
a. If he decides to invest the whole amount
% of ownership = 214,545.4 ×100 = 21.45% from 20%
1,000,000
b. If he decides to maintain his percentage ownership, then the amount to spend will be:
20% ×1,000,000 =sh 200,000
Therefore, balance 214,545.4 - 200,000 = 14,545.4
 A B
If he invest the whole amount If he maintain 20%
21.45% 20% 20%
Amount invested 214,545.00 200,000.00 154,545.00
Equity profit
21.45%x100,000 20%x100,000 20%x85000
share
= 21,450.00 =20,000.00 = 17,000.00
Less: interest
(3,000.00) (3,000.00) -
(5%x60,000)
Net income 18,450.00 17,000.00 17,000.00
NB if for some reasons, the value of the ungeared firm is greater than the value of the geared firm, then the
Arbitrage process will operate in the opposite direction.

MM’S Second proposition of incorporating taxes

In their initial investigation MM maintained that the capital structure is irrelevant and therefore, agreed on the Net
operating income Approach
MM in their 2nd proposition are concerned with the determination of the formulae for calculating the cost of equity
in a geared firm given a cost of equity in a similar ungeared firm. This is explained graphically as follows.
Y

Keg

Cost of (Keu-Kd)D/E
capital
Keu =WACC

(Keu-Kd)

Kd

0% Gearing X

Where Keg – cost of equity in a geared firm

Keu – Cost of equity in ungeared firm
Kd – Cost of debt
MM summarized the formula as shown below
Keg = Keu + (Keu – Kd) D in absence of taxation
E
Keg = Keu + (Keu – Kd) D (1-t) in presence of taxation
E
The finance cost saving i.e. (Keu – Kd) is used to compensate the equity shareholders for the financial risk of the
firm. The company’s overall risk level to the investor is as it was before gearing hence a WACC which is equal to
the cost of equity for a similar ungeared firm.
Later on when MM incorporated taxes, they concluded that the effects of the interest tax shield benefit of using
cheaper debt finance makes a geared firm to be more attractive than an ungeared firm, therefore, in the presence of
taxation, the equity shareholders in a geared firm will enjoy the interest tax shield benefits besides the cheaper debt
benefits which are used to compensate them for the financial risk. Consequently, in the presence of taxation the
equity shareholders will now perceive a geared firm to be less risky and will be higher value than the value of a
similar ungeared firm i.e. Vg>Vu
MM concluded that in order to prevent the investors from practicing the Arbitrage process, the excess value of a
geared firm above a similar ungeared firm should always be restricted to the P.V of the interest tax shield benefit
(P.V.I.T.S), given by:
P.V.I.T. = Annual interest tax shield = interest rate (Kd) ×debt × tax rate
Cost of Debt (Kd) cost of debt (Kd)

P.V.I.T.S = Kd × debt × tax rate = Debt × tax rate

Kd
Therefore according to MM the value of geared firm = value of ungeared firm + present value interest tax shield
Vg = Vu + PVITS
Illustration
Consider the following two firms with the following characteristics
A B
EBIT (shs) 100,000 100,000
5% debt (shs) 600,000 -
Ke 10.5% 10%
Tax rate 40% 40%
Required:
1. Determine the total market values of the two firms
2. Now assume that an investor owns 20% of firm A. determine how such an investor will practice the
Arbitrage process
Solution:
a) Value of the firm
Firms A B
EBIT 100,000 100,000
Less: interest 5%×600.000 (30,000) -
EBT 70,000 100,000
LESS: Tax @40% 28,000 40,000
EAT 42,000 60,000

Value of equity 42,000 = 400,000 60,000= 600,000

10.5% 10%
Value of debt 30,000 = 600,000 -
Value of the firms 0.05 1,000,000 600,000
According to MM, the value of the geared firm = value of ungeared + P.V of interest tax shield
Therefore, VA = VB +PVITS
PVITS = debt × tax rate = 600,000 × 40% = 240,000
VA = 600,000+240,000 = 840,000
The value of firm A is ksh 1,000,000 meaning that firm A is overvalued and the Arbitrage process will take place
to restore the value of firm A to equilibrium.
b) Arbitrage process.
a. Sell his ownership in overvalued firm A and realize the amount
20%×400,000 = sh. 80,000

b. Borrow an amount equal to 20% on debt in overvalued firm

20%×600,000 = sh 120,000
Therefore, the total amount available for investment will be
120,000+80,000 = 200,000
Invest in the undervalued firm B
 If he invests the whole amount
% ownership = 200,000 ×100 = 33.3% from 20%
600,000

 If he decides to maintain his ownership at 20%.

Amount spent = 20%×600,000 = 120,000
Balance 200,000 -120,000 = 80,000
Comparison of the returns:
A B
Return on Equity 10.5% × 80,000 8,400 10%×120,000 = 12,000
Less: interest expense - 5%×120,000 (1-0.4) = (3,600)
8,400 8,400
Incorporating personal taxes
When personal taxes are incorporated, the net earnings will increase and will be obtained by the formula
Net Earnings = Combined Earnings (1- personal taxes)
= Combined Earnings (1-Pt)
While the additional benefits in the form of interest tax savings will be obtained as interest tax benefit (1-personal
taxes)

Illustration
Consider the following two identical firm A & B with the following characteristics
A B
EBIT (shs) 1,000,000 1,000,000
5% Debt (shs) 2M -
Equity (shs) 8M 10M
Ke 10% 10%
Tax rate 30% 30%
Required:
Determine the total earnings to the providers of capital in each firm

A B
EBIT 1,000,000 1,000,000
Less. Interest 5%×2M(100,000) -
EBIT 900,000 1,000,000
Less: tax 30% (270,000) (300,000)
EAT 630,000 700,000

Combined earning A B
Earnings to debt holders 100,000 0
Earnings to equity providers 630,000 700,000
Combined earnings 730,000 700,000
The difference between the total benefits to the providers of funds in the two firms is ksh.30,000 which is as a
result of interest tax saving = tax rate x Interest = 100,000 ×30% = 30,000

Personal taxes
Assume that there is a personal tax rate of 40%.determine the combined Net Earnings to the providers of funds to
the two firms.
A B
Combined net earnings 730,000 700,000
Less: personal tax 40% 292,000 280,000
Net Income 438,000 420,000
The difference between the two firms is ksh.18,000 which is normally given as interest tax benefit/shield x (1-
personal taxes) = 30,000 x (1- 0.4) = 18,000

Incorporating bankruptcy costs and agency costs (BC & AC)

When MM incorporated bankruptcy costs and agency costs in their model, they argued that the value of the geared
firm will start decreasing as gearing increases beyond the optimal capital structure
Bankruptcy costs are end costs, incurred by the firm as a result of financial distress e.g.
i. The sale of the company’s assets so as to improve the financial position of the company.
ii. Avoiding to undertake investments in profitable projects which are considered to be risky.
iii.Changing the company’s dividend policy so as to meet the company’s financial distress needs.
iv.If the company is finally put under receivership, the bankruptcy cost will include the management and legal
expenses.
The agency costs are those costs incurred by the firm as a result of the conditions set by the debt holders in order to
protect their interest in the company. They include conditions such as:
i. No investments in particular arears which are considered to be risky
ii. No payment of dividends unless the company’s earnings exceed given agreed level
iii.No additional debt capital should be raised by the company unless the current gearing level is reduced to a
given figure.
When MM incorporated, the agency and bankruptcy costs in their model, they concluded that.
Vg = Vu + PVITS – (P V of BC & AC)
Vg - value of a geared firm
Vu - Value of ungeared firm
PVIT - present value of interest tax shield (debt x tax)
P V of BC & AC – Present value of bankruptcy cost and agency cost

Vg without BC and AC
Y

Effect of BC and AC

Vg with BC & AC
Optimal capital structure
VU
X