Capital structure theories

The proportion of debt, preference and

equity shares on a firm’s balance sheet.
 Assumptions and Definitions
To understand relationship between financial leverage n cost of capital:

 Only two source of financing: Debt and Equity

 The total assets are given and do not change.
 The net operating income is not expected to change overtime.
 There is no corporate tax (removed later).
 The firm has a policy of paying its total earnings as dividend.
 Investors have identical subjective probability distributions of net
operating income for each company.
 Without incurring transaction costs, a firm can change its capital
structure.
 Business risk is constant over time and independent of its capital
structure and financial risk.
Definitions
S = Market value of equity, B = Market value of debt
V = Total market value of the firm (V=S+B)
NI = Net income available to the shareholders
I = Interest payments, P0 = Current market price of shares
D1 = Net dividend, E1 = Earnings per share

Cost of Debt (ki) = I/B, => B = I/ki

Cost of Equity (ke) = g+ (D1/P0), g = expected growth rate

G=br, where r is rate of return on equity and b is the retention

rate. Since b=0, therefore, g= br= 0
Formula:

 P0 = E1/Ke (per share basis)

 S = (EBIT-I)/Ke (Total basis)
 Cost of capital Ko = (B/V)Ki + (S/V)Ke
 Ko = EBIT/V or V = EBIT/Ko
 V = B+S = I/Ki + (EBIT-I)/Ke

 Ke = Ko + (Ko – Ki)B/S
 Theories

 Net income (NI) approach.

 Net operating income (NOI) approach.

 Traditional approach
 MM hypothesis with and without corporate tax.

 Miller’s hypothesis with corporate and personal taxes.

 Trade-off theory: costs and benefits of leverage.

5
Net Income approach by “David Durand”

 Capital structure is RELEVANT in determining the value of

the firm.
 Assumptions:
 The ‘Ki’ is cheaper than the ‘Ke’.
 Income tax has been ignored.
 The ‘Ki’ and ‘Ke’ remain constant.
 Use of debt does not change the risk perception of the investors.

 With a judicious mixture of debt and equity, a firm can

evolve an optimal capital structure at which the value of the
firm is highest and the overall cost of capital is lowest.
 Net Income (NI) Approach

 Cost of debt (ki) & cost of equity

Cost (ke) = constant.

 As a result, the overall cost of

capital declines and the firm
ke, ko ke value increases with more debt.

ko
ki ki  This approach has no basis in
reality; the optimum capital
structure would be 100 per cent
Debt debt financing under NI
Degree of leverage
approach.

7
Computation of the Total Value of the Firm

Total Value of the Firm (V) = S + B

Where,
S = Market value of Shares = EBIT-I = E = NI
Ke Ke Ke
B = Market value of Debt = Face Value
E = Earnings available for equity shareholders
Ke = Cost of Equity capital or Equity capitalization rate.
K0 = EBIT/V = Ki (B/V) + Ke (S/V)

Ke = K0 + (K0 – Ki).B/S
Net Operating Income approach by Durand

 Capital structure is IRRELEVANT in determining the

value of the firm.
 Any change in the leverage will not lead to any change
in the value of the firm. The market value of shares as
well as overall cost of capital is independent of the
degree of leverage.
 The advantage associated with the use of cheaper source
of financing i.e., debt is exactly neutralized by the
increase in cost of equity.
Net Operating Income (NOI) Approach

 The value of the firm and the

weighted average cost of capital
are independent of the firm’s
Cost
capital structure.
ke

 In the absence of taxes, an

individual holding all the debt
ko
and equity securities will receive
ki the same cash flows regardless
of the capital structure.

Debt
 The value of the company is the
same.

10
Traditional Theory by Ezra Solomon:

• According to this theory, a firm can reduce the overall

cost of capital or increase the total value of the firm by
increasing the debt proportion in its capital structure to
a certain limit.

• Because debt is a cheap source of raising funds as

compared to equity capital, it would be beneficial at
first but after a certain point increasing leverage would
result in increase in cost of capital.
Effects of Changes in Capital Structure on ‘Ko’
& ‘V’

 First Stage: The use of debt in capital

structure increases the ‘V’ and decreases
the ‘Ko’.

 Second Stage: During this Stage, there is a

range in which the ‘V’ will be maximum and
the ‘Ko’ will be minimum.

 Third Stage: The ‘V’ will decrease and the

‘Ko’ will increase.
 Traditional Approach

 The traditional approach argues

Cost that moderate degree of debt can
lower the firm’s overall cost of
ke capital and thereby, increase the
firm value.

ko
 The initial increase in the cost of
equity is more than offset by the
lower cost of debt.
ki
 But as debt increases, shareholders
perceive higher risk and the cost of
Debt equity rises until a point is reached
at which the advantage of lower
cost of debt is more than offset by
more expensive equity.
13
Modigliani Miller (MM) Approach

 Capital structure is IRRELEVANT in determining the

value of the firm.
 The K0 and V are independent of its capital structure
and are constant for all degrees of leverage.

 The total value is given by capitalizing the expected

stream of operating earnings at a discount rate
appropriate for its risk class
 Ke = K0 + (K0 – Ki) B/S
Assumptions:

 Dividend pay out ratio is 100%

 There are no taxes

 Perfect capital market

 All investors have the same expectations of
EBIT

 Business risk is equal among all firms

within similar operating environment
Limitations:

 Risk perception
 Convenience

 Cost
 Institutional restrictions

 Double leverage
 Transaction cost
MM Approach with taxes

 MM agree that the value of the firm will

increase and cost of capital will decline with
leverage, if corporate taxes are introduced.
 The value of levered firm would exceed that of
unlevered firm by an amount equal to the
levered firm’s debt multiplied by the tax rate.
 Vl = Vu + Bt, where, Vl & Vu are
value of levered n unlevered firm, B is the total
borrowings of the levered firm and t is the tax
rate.