Chapter Four

Capital Structure
 Capital Structure
Capital structure can be defined as the mix of
owned capital (equity, reserves & surplus) and
borrowed capital (debentures, loans from
banks, financial institutions)
Maximization of shareholders’ wealth is
prime objective of a financial manager. The
same may be achieved if an optimal capital
structure is designed for the company.
 Capital Structure Theories
• 1) Net Income Approach (NI)
• 2) Net Operating Income (EBIT)
• 3) Modigliani – Miller Model (MM)
• 4) Traditional Approach
• 5) Pecking Order Model
• 6) Trade-off theory
 1) Net Income Approach (NI)
 Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.
 The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in debt
does not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke)
 1) Net Income Approach (NI)
 Asper NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus,as per NI approach, a firm will have maximum value at
a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
 1) Net Income Approach (NI)

As the proportion of
Cost
debt (Kd) in capital
structure increases,
ke, ko ke
the WACC (Ko)
kd
ko
kd reduces.

Debt
 2) Net Operating Income (EBIT)
 Net Operating Income (NOI) approach is the
exact opposite of the Net Income (NI) approach.
 As per NOI approach, value of a firm is not
dependent upon its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the
business risk.
o The cost of debt (Kd) is constant.
 2) Net Operating Income (EBIT)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the
capital structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity
capitalization rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (Kd )
Hence, the finance mix is irrelevant and does not affect the
value of the firm.
2) Net Operating Income (EBIT)
 Cost of capital (Ko)
Cost is constant.
ke
 As the proportion of
ko
debt increases, (Ke)
kd increases.
 No effect on total
Debt
cost of capital
(WACC)
 3) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioral justification in favor
of the NOI approach (personal leverage)
 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, & switch
between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
 3) Modigliani – Miller Model (MM)
MM Model proposition –
o Value of a firm is independent of the capital structure.
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms are
different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities between
identical firms (from levered firms to un-levered firms) and
receive the same returns from both firms.
 4) Traditional Approach
 The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
 Traditional approach (‘intermediate approach’) is a
compromise between these two extreme approaches.
 Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
 As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
 4) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in
borrowings (since Kd < Ke). As a result, the WACC
reduces gradually.
2) At the end of this phenomenon, reduction in WACC
ceases and it tends to stabilize. Further increase in
borrowings will not affect WACC and the value of firm
will also stagnate.
3) Increase in debt beyond this point increases
shareholders’ risk (financial risk) and hence Ke
increases. Kd also rises due to higher debt, WACC
 4) Traditional Approach
 Cost of capital (Ko) Cost

is reduces initially. ke

 At a point, it settles ko

 But after this point,

(Ko) increases, due kd

to increase in the
Debt
cost of equity. (Ke)
 5) Trade-off Theory
• MM & NI theory ignores bankruptcy
(financial distress) costs, which increase as
more leverage is used.
• At low leverage levels, tax benefits outweigh
bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax
benefits.
• An optimal capital structure exists that
balances these costs and benefits.
 Capital Structure and Tax
Interest payments on debt obligations are
deductible for tax purposes, whereas dividends
paid to shareholders are not deductible. This
bias affects a firm’s capital structure decision
We refer to the benefit from interest
deductibility as the interest tax shield, since
the interest expense shields income from
taxation.
 The tax shield from interest deductibility is:
Tax shield = (Tax rate)(Interest expense)
 Capital Structure and Financial Distress

 A firm that has difficulty making payments to its

creditors is said to be in financial distress.
 Extreme financial distress may very well lead to
bankruptcy.
 Costs of Financial Distress
Managers may start making decision keeping
short-term rather than long-term interest of the
company.
Employee may warry about their future and their
efficiency and productivity declines.
 Capital Structure and Financial Distress
 Customers may shy away from its products
because they may perceive the firm unable to
provide maintenance, replacement parts, and
warranties.
 Investors may either not willing to supply
capital to the firm or they make fund available
at high cost and rigid terms and conditions.
 Suppliers may be unwilling to extend trade
credit or may extend trade credit only at
unfavorable terms.
Tax Shield vs. Cost of Financial Distress

Tax Shield
Value of Firm, V

VL
VU

0 Debt

Distress Costs
19
 6) Pecking Order Model
• This theory is based on the view that companies will not seek
to minimize their WACC. Instead they will seek additional
finance in an order of preference, or 'pecking order'.
• Pecking order theory states that firms will prefer retained
earnings to any other source of finance, and then will choose
debt, and last of all equity. The order of preference will be:
– Retained earnings
– Straight debt (bank loans or bonds)
– Convertible debt
– Preference shares
– Issue new equity shares
 Planning a capital structure
• According to finance theory, firms possess an optimal
target capital structure that will minimize its weighted
average cost of capital and maximize value of the firm.
• Unfortunately, theory can not yet provide financial mangers
with a specific methodology to help them determine what
their firm’s optimal capital structure might be.
Planning a capital structure is a highly psychological,
complex and qualitative process.
It involves balancing the shareholders’ expectations (risk
& returns) and capital requirements of the firm.
 Planning a capital structure
 Take advantage of tax benefits by issuing more debt,
especially if the firm has:
 High tax rate

 Stable sales

 Less operating leverage

 Maturing company
 Planning a capital structure
 Avoid financial distress costs by maintaining excess
borrowing capacity, if the firm has:
 Volatile sales

 High operating leverage

 Many potential investment opportunities (growing

firm)
 Special purpose assets (instead of general purpose

assets that make good collateral)

 Practical Considerations
in Capital Structure
 There are many practical considerations
regarding capital structure in addition to the
impacts of financial risk, business risk, the tax-
deductibility of interest and financial distress.
 Industry Standards
 It is natural to compare a firm’s capital
structure to other firms in the same industry.
 Business risk is a significant factor impacting
a firm’s capital structure and business risk is
heavily influenced by industry.
 Practical Considerations
in Capital Structure
 Creditor Requirements
 Firms need to abide by restrictive covenants

agreed upon. These may include restrictions

on the amount of future debt.
 Firms typically desire to appear financially

strong to potential creditors in order to

maintain borrowing capacity and low interest
rates. Using less debt in capital structure
helps to maintain this appearance.
 Practical Considerations
in Capital Structure
 Maintaining Excess Borrowing Capacity
 Successful firms typically maintain excess
borrowing capacity. This provides financial
flexibility to react to investment opportunities.
 The maintenance of excess borrowing capacity

causes firms to use less debt in their capital

structure than otherwise.
 Corporate Control
 Controlling owners may desire to issue debt
instead of common stock since debt does not
grant ownership rights.
 Practical Considerations
in Capital Structure
 Profitability and the Need for Funds

– If a firm generates high profits and

reinvests a large proportion back into
the firm, then it has a continuous
source of internal funding. This will
reduce the use of debt in the firm’s
capital structure.
 Capital Restructuring
 Capital restructuring involves changing
the amount of leverage a firm has without
changing the firm’s assets
 Increase leverage by issuing debt and
repurchasing outstanding shares.
 Decrease leverage by issuing new shares
and retiring outstanding debt.