CAPITAL STRUCTURE

Capital Structure
The optimum capital structure may be defined as the capital structure or combination of debt and equity that leads to the maximum value of the firm.

Major capital structure theories

1)Net Income Approach 2)Net Operating Income Approach 3)Modigliani-Miller(MM)approach 4)Traditional Approach

Assumptions
1)There are only two source of funds 2)There are no corporate taxes 3)The dividend-payout ratio is 100 4)The total assets remain constant 5)Firms total financing remain constant.

Assumptions
6)Risk perception of the investor remains constant 7)The operating profit(EBIT)are not expeted to grow 8)Perpectual life of the firm 9)Return on Investment remains constant 10)Investors profits remains constant

Definitions and symbols

S=total market value of equity B=total market value of debt I=total interest payments V=total market value of the firm(V=S+B) NI=net income available to equity holders

Definitions and symbols

Cost of debt(kd)=I/B Value of debt(B)=I/Kd Cost of equity capital (Ke)=D1/S Value of equity(S)=D1/Ke Value of firm(V)=B+S Weighted average cost of debt(Wd)=B/V Weighted average cost of equity(We)=S/V Ko=Wd.Kd+We.Ke Ko=B/V*Kd+S/V*Ke

Net operating Income Approach

Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

Propositions/Assumptions of NOI Approach

1)Overall cost of capital/capitalisation Rate is constant 2)Residual Value of equity S=V-B 3)Changes in cost of equity capital 4)Cost of Debt Explicit cost Implicit cost 5)Optimum capital structure

Net Income approach

According to the Net Income approach, suggested by the Durand, the Cpital structure decision is relevant to the valuation of the firm.In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm.

Assumptions
The IN approach to valuation is based on three assumptions: 1)There are no taxes 2)The cost of debt is less than the cost of equity 3)That the use of debt does not change the risk perception of investors. Thus, with the cost of debt and cot of equity being constant, the increased use of debt, will magnify the shareholders earnings and, thereby, the market value of the ordinary shares.

Modigliani-Miller approach
The Modigliani-miller Thesis relating to the relationship between the capital structure,cost of capital and valuation is akin to the NOI Approach.The MM proposition supports the; NOI approach relating to the independence of the cost of capital of the degree of leverage at any level of debt-equity ratio.The significance of their theory hypothesis lies in the fact that it provides behavioural justification for constant overall cost of capital, and ,therefore,total value of the firm.

Basic Propositions
There are three basic propositions of the MM Approach: 1) overall cost of capital(Ko) and the value of the firm(V) are independent of its capital structure 2) Ke=Ko of pure equity firm plus a premium for financial risk that is,Ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt. 3)The Cut-off rate for investment purposes is independent of capital structure.

Assumptions
1)Perfect capital market Investors are free to buy/sell securities Investors can borrow without restrictions on the same terms and conditions as firms can There are no transaction costs Information is perfect Investors are rational and behave accordingly

Assumptions
2)Investors have the same expectations of firms EBIT 3)Business risk is equal among all firms with similar operating environment 4)The dividend payout ratio is 100% 5)There are no taxes.this assumption is removed later.

Proposition-1
The total value of a firm must be constant irrespective of the degree of leverage. Similarly, the cost of capital as well as the market price of shares must be the same regardless of the financing-mix. Operational justification: Arbitrage process Equilibrium is restored in the market price of a security in different markets.

Proposition-1
Operational justification: Two firm which are exactly similar in all respects except leverage The total value of the homogeneous firms which differ only in respect of leverage cannot be different because of the operation of arbitrage. Home trade leverage/personal leverage

Arbitrage process
Switching from levered firm to unlevered firm Switching from unlevered firm to levered firm

Corporate taxes and MM approach

MM agree that the value of the firm will increase and cost of capital will decline with leverage, if corporate taxes exists: Interest on debt is tax deductable Actual cost of borrowing is comparatively low The levered firm would have greater market value than an unlevered firm.

Corporate taxes and MM approach

MM state that the value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate. Vt=Vu+Bt Vt=value of levered firm Vu=value of unlevered firm B=value of debt T=Tax rate

Limitations of MM Approach
The risk perception of personal and corporate leverage are different Higher risk exposure, the investors would find the personal leverage inconvenient Constraint on the perfect substitutability of personal and corporate leverage is cost Institutional restrictions stand in the way of a smooth operation of the arbitrage process.

Limitations of MM Approach
The arbitrage process may not actually work because of double leverage {An investor would have leverage both in personal portfolio as well as in the firms portfolio} Transaction costs would affect the arbitrage process

Limitations of MM Approach
Personal leverage and corporate leverage are, therefore not perfect substitutes.This implies that the arbitrage process will be hampered and will not be effective. If corporate taxes are taken into account the MM approach will fail to explain the relationship between financing decision and value of the firm.

TRADITIONAL APPROACH
The Traditional approach is midway between the NI and NOI approaches.It parttakes of some features of both these approach. It resembles the NI approach in arguing that cost of capital and total value of the firm are not independent of the capital structure. But it does not subscribe to the view(of NI approach) that value of a firm will necessarily increase for all degrees of leverage.

TRADITIONAL APPROACH
In one respect it shares a feature with the NOI approach that beyond a certain degree of leverage, the overall cost increases leading to a decrease in the total value of the firm. But it differs from the NOI approach in that it does not argue that the weighted average cost of capital is constant for all degree of leverage.

TRADITIONAL APPROACH
If however, the amount of debt is increased further, two things are likely to happen: 1)owing to increased financial risk,Ke will record a substantial rise 2)The firm would become very risky to the creditors who also would like to be compensated by a higher return such that Ki will rise.

TRADITIONAL APPROACH
The crux of the traditional view relating to leverage and valuation is that through judicious use of debt-equity proportions, a firm can increase its total value and thereby reduce its overall cost of capital. The advantages arising out of the use of debt is so large that, even after allowing for higher Ke, the benefit of the use of the cheaper source fo funds is still available.

TRADITIONAL APPROACH
There are, of course, variations to the traditional approach. According to one of these, the equity capitalisation rate(Ke)rises only after a certain degree of leverage and not before,so that the use of debt does not necessarily increase the Ke.this happens only after a certain degree of leverage.The implication is that a firm can reduce its cost of capital significantly with the initial use of leverage.

TRADITIONAL APPROACH
Another variant of the traditional approach suggests that there is no one single capital structure,but,there is a range of capital structures in which the cost of capital(Ko) is the minimum and the value of the firm is the maximum.In this range,changes in leverage have very little effect on the value of the firm.