CAPITAL STRUCTURE

OUTLINE
• Introduction and Rationale
• Capital Structure Components: Advantages
and Dis advantages.
• Capital Structure Theories.
• Determinants of Capital Structure
• Applications.
 INTRODUCTION
• Capital Structure is a mixture of funds a firm
uses to finance business operations.
• Capital structure decision is one of the main
decisions in financial management; others
being dividend policy and investment
decisions. In effect, it is a financing decision.
• The main components of capital structure are;
equity and debt.
 INTRO (CONT.)
• The amount of debt a firm uses to finance its assets is
called a leverage. Thus, a firm with leverage is called a
levered firm while the one without a leverage (an all-
equity firm) is an unlevered firm. The value of levered
firm is greater than the value of unlevered firm i.e.
• VL = VUL + TD where, VL is the value of levered firm, VUL
is the value of unlevered firm, T is tax rate and D is debt.
• The capital structure choice matters especially when the
firm wants to minimize the cost of capital and maximize
the value of the firm.
 Components of Capital Structure
(i) DEBT
Advantages
• Interest is tax deductible (lowers the effective
cost of debt).
• Debt-holders have a fixed rate of return.
 Components of Capital Structure
Disadvantages
(i) Debt holders do not have voting rights.
(ii) Higher debt ratios may lead to;
• greater risk and
• higher required interest rates (to compensate
for the additional risk)
 Components of Capital Structure
(ii) EQUITY
Advantages
• Ownership rights
• Voting rights
• Resources raised through equity can be cash,
property or services.
Disadvantages
• Loss of money in case the company fails to perform
or during liquidation.
 CAPITAL STRUCTURE PUZZLE
• The question on: How firms choose capital
structure remains a centrepiece of discussion
among financial economists.
• In 1984, Stewart Myers labelled it as a puzzle (
i.e. capital structure puzzle) and that it is
tougher than the dividend puzzle.
• The dividend puzzle was on whether or not
dividend payment increases firm′s value.
 CAPITAL STRUCTURE PUZZLE
• Does the choice of source of capital matter on the value
of the firm?
• This question has led to many capital structure theories
pioneered by American Financial Economists and
Nobel Prize Winners; Franco Modigliani and Merton
Miller.
• They pioneered the Modigliani-Miller Theorem which
proposed the Irrelevance of Debt-Equity Structure.
• The Capital Structure Puzzle is still unresolved.
• More contributions or empirical evidence are needed.
 SCHOOLS OF THOUGHT ON CAPITAL
STRUCTURE
• There are two schools of thought on Capital
Structure
• First, the value of the firm is independent of
the capital structure (i.e. Capital Structure has
no influence on the value of the firm) and
• Second; the value of the firm is dependent of
Capital Structure (i.e. Capital structure affects
the value of the firm).
 CAPITAL STRUCTURE THEORIES

(i) Modigliani and Miller I (MMI, 1958). MMI

proposes that, the overall value of the firm is
independent of its capital structure. This theory
is also referred to as a Capital Structure
Irrelevance Theory or MM- No Tax Model.
According to MM1, the value of the firm is
dependent on future investment opportunities NOT
Financing arrangements.
C
V  1

i.e. WACC
 MM1 PROPOSITIONS
Proposition 1
The total market value of any firm is independent of its
capital structure. C
V  1

WACC

Where; v = the value of the firm,

C1 = Cash flows to be received one year ahead,
WACC = the Weighted Average Cost of Capital and it is
constant because the cost of equity capital rises to exactly
offset the effect of cheaper debt and thus shareholders value
is neither enhanced nor destroyed by altering gearing level.
 MM1 PROPOSITIONS
Proposition 2
The expected rate of return on equity increases
proportionately with the gearing ratio.
Proposition 3
The cut-off rate of return for new projects is
equal to the Weighted Average Cost of Capital-
which is constant regardless of gearing.
 MM1 PROPOSITIONS
MM 1 theory of capital of structure implies that,
there is no optimal capital structure.
 CAPITAL STRUCTURE THEORIES

Assumptions
(i) No taxation
(ii) Capital markets are perfect
(iii) No financial distress and Liquidation costs
(iv) Firms can be classified into distinct risk
classes
(v) Individuals can cheaply borrow at the same
rate as giant corporations
 CAPITAL STRUCTURE THEORIES

(ii) MM II (1963) : This theory asserts that, the

overall value of the firm is dependent on its
capital structure. This is also referred to as
Capital Structure Relevance Theory or MM with
Taxes Model.
With this theory;
• The cost of capital (WACC) decreases as
gearing increases.
 CAPITAL STRUCTURE THEORIES

• The cost of equity capital increases because

shareholders are likely to demand higher level
of return as a result of increase in debt in the
financial structure.
• This theory implies that, there is an optimal
capital structure.
 CAPITAL STRUCTURE THEORIES

• The benefits of using debt (tax shield) are

likely to be accrued up to the optimal capital
structure point beyond which WACC is likely
to increase.
• At optimal capital structure, WACC is
minimum and the value of the firm is
maximized.
 MMII- Assumptions
Assumptions
(i) There is taxation
(ii) Capital markets are imperfect
(iii) There are financial distress and Liquidation
costs
(iv) Firms can not be classified into distinct risk
classes
(v) Individuals can not borrow as cheaply as firms.
 (iii)Pecking Order Theory-POT
(Information Asymmetry Theory-IAT)
• This theory was put forward by Myers and Majluf
(1984).
• It supports MM1 theory by arguing that there is no
optimal capital structure.
• It asserts that, when considering financing decision,
firms should first look for Internally Generated
Funds (IGF) e.g. retained earnings before they can
look for Externally Generated Funds (EGF) e.g.
borrowings, preference shares and new issues of
equity.
 POT (IAT)-CONT.
• The pecking order should be as follows;
Retained Earnings (RE)- IGF(Internally generated
funds.
Borrowings- EGF
Preference shares-EGF
New issues of equity-EGF
Why pecking order?
• Equity issue is perceived as bad news by the market.
• Transaction and floatation costs
 (iv) Static Trade off Theory ( Tax- Based
Theory)
• This theory was suggested by Myers (1984).
• This theory supports MMII theory by arguing that
there is an optimal capital structure.
• According to this theory, the optimal capital structure
is obtained when the net advantage of debt financing
balances the leverage related costs such as bankruptcy
and financial distresses.
• The theory argues that capital structure is based on a
trade-off between tax savings and distress costs of
debt.
Agency Cost Theory of Capital Structure

• The pioneers of this theory are Jensen and

Meckling (1976) and was first put forward by Adam
Smith (1776) in his famous book, An Inquiry into
the Nature and Causes of the Wealth of the Nations.
• It states that the optimal capital structure is
determined by balancing the various sources of
funds (equity, debt or mixed) that allow the
reconciliation of conflicts of interests between
agents (managers) and principals (owners).
 Determinants of Capital Structure
Extant research points out the following as
factors or determinants of capital structure;
• Profitability- Higher profit level gives rise to a
higher debt capacity and accompanying tax
shields.
• Tangibility- Firms with higher level of
tangible assets are more likely to be in a
position to provide for collaterals.
 Determinants of Capital Structure
Extant research points out the following as
factors or determinants of capital structure;
• Profitability- Higher profit level gives rise to a
higher debt capacity and accompanying tax
shields.
• Tangibility- Firms with higher level of
tangible assets are more likely to be in a
position to provide for collaterals.
 Determinants of Capital Structure
• Firm size- Large firms have higher debt
capacity and hence greater financing needs than
small firms.
• Level of growth opportunities. Others are;
Tax environment, earnings volatility, industry,
asset structure, Legal environment, Economic
system, Technological capabilities, GDP
growth rates, inflation rates and the
development level of capital markets.
 Applications

• Used in determining the financing needs of the

firm.
• Helps managers to find the appropriate mix of
the sources of funds.
 Seminar Questions
1. What is capital structure?
2. Assuming taxes exist, why the value of
levered firm is always greater than the value
of unlevered firm?
3. Discuss advantages and disadvantages of
using equity and debt in the capital structure.
4. Discuss at least five determinants of capital
structure.
 Seminar Questions
5. Identify and discuss various sources of funds a firm may use to
finance its business operations.
6. The cost of Mamboleo Ltd, an all equity firm is 14%. What is
the WACC of the firm?
7. (a) Define the following terms as they are used in capital
structure;
(i) leverage
(ii) Gearing
(iii)Levered firm
(iv)Unlevered firm
(v) Optimal capital structure
 Seminar Questions
(b) Explain the relationship between the value of
levered firm and unlevered firm.
(c) Why do you think it is important for financial
managers to understand the capital structure and
value of the firm concepts?
8. The following are the estimations of the cost of
debt and equity for various financial gearing
levels for TBL Ltd. Determine the optimal capital
structure.
 Seminar Questions
Proportion of Debt Required Rate of Return
VD
Debt, k DAT Equity, kE
VE  VD

% %
0.80 9.0 35.0
0.70 7.5 28.0
0.60 6.8 21.0
0.50 6.4 17.0
0.40 6.1 14.5
0.30 6.0 13.5
0.20 6.0 13.2
0.10 6.0 13.1
0.00 - 13.0
 Seminar Questions
9. TMK plc has a capital structure which is 30
per cent debt and 70 per cent equity. The cost of
debt (i.e. borrowings) before taxes is 9 per cent
and for equity is 15 per cent. The firm's future
cash flows, after tax but before interest are
expected to be a perpetuity of £750,000. The tax
rate is 30 per cent. Calculate the WACC and the
value of the firm.
 Seminar Questions
10. (a) Discuss the following theories of capital
structure;
(i) MMI (without Taxation) Theory
(ii) MMII (with taxes) Theory
(iii) Pecking Order Theory
(iv) Static Trade off Theory
 Seminar Questions
(b) Given the following information about ABC
Ltd, what would the cost of capital be if it was
transformed from its current gearing to having
no debt, if Modigliani and Miller̓ s model with
no tax applied?
k E= 30% VD
VD  VE
k D
= 9%
V
V V
D
D
= 0.6
E