CAPITAL STRUCTURE AND FIRM VALUE

Theory of Capital Structure

• Capital structure is the proportions of debt
instruments and preferred and common stock on a
company’s balance sheet.

• The capital structure of a firm can affect its total

valuation and its cost of capital.

• To assess this effect, we make some simplifying

assumptions
 Assumptions
• To examine the relationship between capital structure and cost of
capital, the following simplifying assumptions are commonly made:
• There are no corporate or personal income taxes and no bankruptcy
costs.
• The debt-equity ratio of a firm is changed by issuing debt to repurchase
stock or by issue of stock to payoff debt. There are no transaction costs

• The firm has 100 percent dividend payout policy.

• The expected values of the subjective probability distributions of

expected future operating income are the same for all investors in
the market.

• No growth in operating earnings of the firm. Operating earnings for all

future periods are the same as present operating earnings
 Focus of Analysis
• Given the assumptions, we are concerned with the following three
rates: I Annual int erest ch arg es
rD  
D Market value of debt
P Equity earnings
rE  
E Market value of Equity
O Operating income
rA  
V Market value of the firm

• Where V=D+E
• rD is the yield on the company’s debt, assuming this debt to be perpetual.
• rE is the required rate of return for investors in a company whose earnings
are not expected to grow and whose dividend payout ratio is 100%.
• rA is the overall capitalization rate
 for
D the firm. It
 is the
E WACC
 and may be
rA  rD   r
D E
E 
expressed as:  D E 
 Theory of Capital Structure
• There are different approaches that explain
what happens to rD, rE and rA when the degree
of leverage, as denoted by the ratio D/E varies.

• According to the net income approach, rD and

rE remain unchanged when D/E varies. The
constancy of rD and rE with respect to D/E
means that rA declines as D/E increases
 Net Income Approach
• The net income approach says that the average cost of funds declines as the leverage
ratio increases. This happens because the cost of debt and cost of equity remain
unchanged with increase in the debt-equity (D/E) ratio. Therefore, a firm can increase
value by increasing the proportion of debt.

• The net income approach is graphically shown in the following figure.

Rates
of return

rE

rA
rD

D/E
 Example-NI Approach
A company has an EBIT of Rs.2,00,000 and a 10% debt of Rs.8,00,000. The
cost of equity is 12.5%. Calculate the value of the company using the net
income approach. Does the value of the company change if it increases the debt
to Rs.10,00,000?

Value of the company when the debt is Rs.8,00,000

Value of equity =(Rs.2,00,000-Rs.80,000)/0.125 =Rs.9,60,000

Value of debt=Rs.8,00,000
Value of the company = Rs.17,60,000
Overall cost of capital = Rs.2,00,000/Rs.17,60,000= 11.36%

Value of the company when the debt is Rs.10,00,000

Value of equity =(Rs.2,00,000-Rs.1,00,000)/0.125 =Rs.8,00,000

Value of debt=Rs.10,00,000
Value of the company = Rs.18,00,000
Overall cost of capital = Rs.2,00,000/Rs.18,00,000= 11.11%
 Net Operating Income Approach
• According to the net operating income approach, market value and the
share price of a firm are not affected by its capital structure.

• This is because the overall cost of capital and the cost of debt remain
constant for all degrees of leverage.

• The main premise of this approach is that the market capitalizes the firm
as a whole at a discount rate which is independent of the firm’s debt-
equity ratio.

• As a result, the division between debt and equity is irrelevant.

• An increase in the use of debt funds which are apparently cheaper is offset
by an increase in the equity capitalization rate.

• This happens because equity investors seek higher compensation as they

are exposed to greater risk arising from increase in the degree of leverage.
 Net Operating Income Approach
• According to this approach the overall capitalization rate (rA)
and the cost of debt (rD) remain constant for all degrees of
leverage. Hence the cost of equity increases linearly with
leverage as follows:
• rE = rA + (rA – rD) (D/E)
rE

Rates of
return
• rA

• rD

• D/E
 Example-NOI Approach
A company with an EBIT of Rs.4,00,000 has an overall capitalization rate of 10 percent. Its
total requirement of funds is Rs.20,00,000. Determine the cost of equity of the company if it
employs 8% debt to the extent of 20%, 35% and 50% of its total fund requirement in its
capital structure.

Value of the firm (V) = EBIT/rA = Rs.4,00,000/0.10 = Rs.40,00,000

Percentage of debt B(Rs.) S=V-B(Rs.) re

20 4,00,000 36,00,000 10+(10-8)*4/36 =10.22

35 7,00,000 33,00,000 10+(10-8)*7/33 =10.42
50 10,00,000 30,00,000 10+(10-8)*10/30=10.67
 Traditional Approach
• The main propositions of the traditional approach are:
• 1. The cost of debt capital remains more or less constant up to a certain
degree of leverage but rises thereafter at an increasing rate.

• 2. The cost of equity capital remains more or less constant or rises only
gradually up to a certain degree of leverage and rises sharply thereafter.

• 3. The overall cost of capital, as a consequence of the behavior of cost of

debt and of cost of equity, decreases up to a point; remains more or less
unchanged for moderate increases in leverage thereafter; and rises
beyond a certain point.

• The optimal capital structure is given by the point where the overall cost
of capital is the minimum
 Traditional Approach
rE
Rates of
return

rA

rD

D/E
 Example-Traditional Approach
A company has a present EBIT of Rs. 3 lakh. Its current requirement of funds of Rs.20 lakh
is financed entirely through equity. The cost of equity is 16%. However, it is now considering
two alternatives of employing 30% and 50% of debt funding. In the case of 30 % debt
funding, cost of debt is expected to be 10% and cost of equity is expected to be 17%. If a debt
funding of 50% is used, cost of debt is expected to be 12% and cost of equity is expected to
be 20%. Calculate the value of the firm under the three alternatives.

Debt Percentage
0 30 50
EBIT Rs.300,000 300,000 300,000
Interest 0 60,000 120,000
---------------- ------------- -------------
Earnings available to equity shareholders 300,000 240,000 180,000
Cost of equity (%) 16 17 20
Value of Equity (S) 18,75,000 14,11,765 900,000
Value of Debt (B) - 600,000 1,000,000
----------------- ------------- ---------------
-
Value of the firm(V=S+B) 18,75,000 20,11,765 19,00,000

Overall cost of capital (EBIT/V) 16% 14.91% 15.79%

The optimal capital structure is that where the company uses 30% debt.
 Modigliani & Miller (MM) Position
• MM position is similar to NOI approach and also provides behavioral

justification for the NOI approach.

• Perfect Capital Market with no asymmetric information, transaction and

bankruptcy costs

• Investors are rational and choose a combination of risk and return that is

most advantageous to them. Managers act in the interest of shareholders

• Investors hold homogenous expectations about future operating earnings

• Firms can be divided into homogenous risk classes on the basis of their

business risks.

• Absence of Taxation
 MM Proposition I
• The value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure.
• V = D + E = O/r
• where V = market value of the firm
• D = market value of debt
• E = market value of equity
• O = expected operating income
• r = discount rate applicable to the risk class to which
the firm belongs
 MM Proposition I
• Proposition 1 of MM is based on the premise that investors are
able to substitute personal leverage for corporate leverage.

• They can borrow at the same rate as the company and can
thereby replicate any capital structure the firm might
undertake.

• Therefore, two firms that differ in capital structure only must

have the same value. If not, arbitrage will take place to bring
equality in their value.
•
 Example-MM Proposition I
Firm L and U are alike. L has 10% Rs.5 lakh debt and an EBIT of Rs.1,00,000. Cost of
equity is higher for L (16%) and lower for U (12.5%).

Market value of U = Rs.1,00,000/0.125 =Rs.8,00,000

Market value of L = Rs.(1,00,000-50,000)/0.16 +Rs.5,00,000
=Rs.3,12,500+Rs.5,00,000 =Rs.8,12,500

X who holds 10% in L receives an income of Rs.5,000 (16% of Rs.31,250) on an investment

of Rs.31,250 (10% of Rs.3,12,500 being the market value of firm L’s stock.) X sells the
shares in L for Rs.31,250 (Rs.3,12,500*0.10), borrows Rs.48,750 and invests the total
amount of Rs.80,000 to buy 10% in U.

He gets a return of Rs.10,000 (10% of Rs.1,00,000) from U. Out of this money he pays
Rs.4,875 as interest on the loan and is left with Rs.5,125 (Rs.10,000-Rs.4,875).

X has been able to earn a higher return of Rs.125 (Rs.5,125-Rs.5,000) from U on an equal
investment of Rs.31,250. As many other investors also sell shares in L and buy shares in U,
their market values will become equal.
 MM Proposition II

• The expected return on equity is equal to the expected rate of

return on assets, plus a premium.

• The premium is equal to the debt-equity ratio times the

difference between the expected return on assets and the

expected return on debt

• rE = rA + (rA – rD) (D/E)

 Risk-Return Trade-Off
• As leverage increases, equity shareholders require a higher
return because equity beta increases.

• E = A + D/E (A - D)

• where E = equity beta

• A = asset beta

• D/E = debt-equity ratio

• D = debt beta
 Criticism of MM Theory
• Firms and investors pay taxes

• Bankruptcy costs can be high

• Agency costs exist

• Managers tend to prefer a certain sequence of financing

• Informational asymmetry exists

• Personal and corporate leverage are not perfect substitutes

 Corporate Taxes
• When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
• In general
• O ( 1 - tC)
• V = ------------- + tC D
• r
• where V = value of the firm
• O = operating income
• tC = corporate tax rate
• r = capitalization rate applicable to the unlevered firm
• D = market value of debt
• It means:
• Value of levered firm = Value of unlevered firm + Gain from leverage
• VL = VU + tC D
 Example-MM Proposition I with Corporate Taxes
Two firms A and B are similar in all respects except that firm B has a debt capital of Rs.4
million bearing 12 percent interest. Both the firms have an operating income of Rs.1 million
and are subject to tax at the rate of 30 percent. The combined income of debt holders and
shareholders is higher in the case of firm B as shown below:

A B
Operating income 10,00,000 10,00,000
Interest on debt 0 4,80,000
Profit before taxes 10,00,000 5,20,000
Taxes 3,00,000 1,56,000
Profit after tax (Income available to shareholders) 7,00,000 3,64,000
Combined income of debt holders and shareholders 7,00,000 8,44,000

The combined income of debt holders and shareholders of firm B is higher by Rs.1,44,000.
This amount represents the tax shield on interest (Rs.4,80,000*30%) enjoyed by firm B.

If the debt employed by a firm is perpetual in nature, the present value of tax shield associated
with interest payment can be obtained by applying the formula for perpetuity.

tc rD D
Present value of tax shield =  tc D
rD
where tc is the corporate tax rate, D is the market value of debt and rD is the interest rate on
debt.
The present value of tax shield available to firm B is Rs.12,00,000 (30% of Rs.40,00,000).
This represents an increase in the market value due to financial leverage.

In general, in a world with corporate taxes but no bankruptcy costs, the firm value is an
increasing function of leverage. The value of an unlevered firm (Vu) in the presence of
corporate taxes is given by:

EBIT (1  tc )
Vu 
rA
The value of a levered firm is equal to the value of an unlevered firm plus gain from leverage.

VL  Vu  tc D

This is MM proposition I in the presence of corporate taxes and the implication of this
proposition is that greater the leverage, the greater will be the value of a firm. The optimal
strategy of a firm should, therefore, be to maximize the degree of leverage in the capital
structure
 Example-MM Proposition II with Corporate taxes
The cost of capital of an unlevered company with an operating income of Rs.4,00,000 is 10
percent. The company, thereafter, raises a debt of Rs.4,00,000 bearing an interest rate of 8
percent. The applicable corporate tax rate is 35 percent. Calculate the value of the firm as an
unlevered firm and as a levered firm. Also calculate the cost of equity of the firm under
leverage.

Value of unlevered firm V u = EBIT(1-T)/ko = Rs.4,00,000(1-0.35)/0.1 = Rs.26,00,000

Value of tax shield on interest cost = 0.35*4,00,000 =Rs.1,40,000

Value of firm under leverage = Rs.26,00,000 +Rs.1,40,000 =Rs.27,40,000

Value of levered equity = Rs.27,40,000-Rs.4,00,000 = Rs.23,40,000

Cost of levered equity:

ke  ko  (ko  ki )(1  tc )  B / S
= 0.10 +(0.10-0.08)(1-0.35)*4/23.4 =0.1022 or 10.22%

The value of levered equity can be verified using the cost of levered equity in the equation
( EBIT  ki  B )(1  tc )
S 
ke

(4, 00, 000  32, 000)(1  0.35)

=  Rs.23, 40, 000 (approximately)
0.1022
 Corporate and Personal Taxes
• When personal taxes are considered along with corporate taxes, the tax
advantage of a rupee of debt is:
• (1 – tc) (1 – tpe)
• 1 – ----------------------
• (1 – tpd)
• where tc = corporate tax rate
• tpd = personal tax rate on debt income
• tpe = personal tax rate on equity income
• Example : Suppose tc = 50 percent, tpe = 5 percent, and tpd = 30 per cent.
The tax advantage of every rupee of debt is:
• (1 – 0.5) (1 – 0.05)
• 1– ---------------------------- = 0.32 rupee
• (1 – 0.3)
 Example-Corporate and Personal Taxes
• The corporate tax rate is 35 percent, personal tax on equity
income is 5 percent and personal tax on debt income is 30
percent. The tax benefit per rupee of debt will be Re.0.118 as
shown below.

• Present value of tax shield on interest per rupee of debt =

 (1  0.35)(1  0.05) 
1    0.118
 (1  0.30) 
 Tradeoff Theory
• According to the tradeoff theory, the optimal debt-equity ratio
of a firm depends on the tradeoff between the tax advantage
of debt on one hand and the financial distress and agency
costs on the other hand.

• The higher the debt, the higher is the probability of financial

distress.

• There are direct and indirect costs associated with financial

distress.
 Costs of Financial Distress
• A high level of debt may lead to financial distress that entails
certain costs:
• Direct Costs
• Delay in liquidation may diminish asset value
• Distress sale fetches lower price
• Legal and administrative costs are high
• Indirect Costs
• Managers become myopic
• Stakeholders dilute their commitment
 Agency Costs
• There is an agency relationship between the shareholders and
creditors of firms that have substantial amounts of debt. Hence
lenders impose restrictive covenants and monitor the behaviour
of the firm.

• The loss in efficiency on account of restrictions on operational

freedom plus the cost of monitoring (which are almost invariably
passed on to shareholders) represent agency costs associated
with debt.
 Trade Off Model
Value of the firm considering
Value
• of the tax advantage of debt
the firm

• Financial distress costs and

• agency costs
• Value of the firm considering
• the tax advantage and financial
• distress and agency costs

•
• Value of the unlevered firm

• D/E
 Tradeoff Theory
• As per the tradeoff theory, every firm has an optimal debt
equity ratio that maximizes its value.

• The optimal debt-equity ratio of a profitable firm that has

stable and tangible assets will be higher than the optimal
debt-equity ratio of an unprofitable firm with risky, intangible
assets.

• When assets are tangible and stable, financial distress costs

and agency costs tend to be lower
 Tradeoff Theory
• The tradeoff theory successfully explains many industry differences in capital
structure.

• For example, airline, power and oil refining companies use more debt as their
assets are tangible and safe.

• Software and high-tech growth companies, on the other hand, borrow less
because their assets are intangible and somewhat risky.

• The tradeoff theory, however, fails to explain why some profitable companies
(e.g. pharmaceutical companies) depend so little on debt and pay large
amounts by way of income tax which they can possibly save by use of debt.

• There is an alternative theory, the pecking order theory of financing, that

explains why profitable firms use little debt
 Pecking Order of Financing
• Firms prefer to raise capital in a sequential order: first
spontaneous credit, then retained earnings, then other debt,
and finally new common stock.

• The reasons for this pecking order are:

• no floatation costs are incurred to raise capital as spontaneous
credit or retained earnings
• costs are relatively low for issuing new debt.
• floatation costs for new stock issues are quite high.
• existence of asymmetric information /signaling effects make it
undesirable to issue new common stock.
• Given the pecking order of financing, there is no well- defined
target debt-equity ratio.
 Signaling Theory
• Noting the inconsistency between trade-off theory and the
pecking order of financing, Myers proposed a new theory,
called the signaling, or asymmetric information, theory of
capital structure.

• A critical premise of the trade-off theory is that all

parties have the same information and homogeneous
expectations. Myers argued that there is asymmetric
information and divergent expectations which explains the

pecking order of financing observed in practice.

 Signaling Theory
• Symmetric information is the situation where investors and
managers have identical information about firms’ prospects.

• Asymmetric information is the situation where managers have

different (better) information than investors about firms’ prospects.

• Asymmetric information has an important effect on the optimal

capital structure.

• It is expected that a firm with very favorable prospects to avoid

selling stock and instead raise any required new capital by using
new debt even if this moved its debt ratio beyond the target level.

• A firm with unfavorable prospects would want to finance with stock,

which would mean bringing in new investors to share the losses
 Signaling Theory
• The conclusion from the signaling theory is that firms with
extremely bright prospects prefer not to finance through new
stock offerings, whereas firms with poor prospects do like to
finance with outside equity.

• The announcement of a stock offering is generally taken as a

signal that the firm’s prospects as seen by its management are
not bright.

• This, in turn, suggests that when a firm announces a new

stock offering, more often than not, the price of its stock will
decline.

• Empirical studies have shown that this situation does exist.

 Signaling Theory
• The implications of the signaling theory for capital structure
decisions are:
• Issuing stock emits a negative signal and thus tends to
depress the stock price.
• So even if the company’s prospects are bright, a firm should,
in normal times, maintain a reserve borrowing capacity that
can be used in the event that some especially good
investment opportunity comes along.
• This means that firms should, in normal times, use more
equity and less debt than is suggested by the tax
benefit/bankruptcy cost trade-off model.
 Summing Up
• Several positions have been taken on the relationship between capital
structure and firm value (or cost of capital)
• According to the net income approach the average cost of capital declines
as the leverage ratio increases
• According to the net operating income approach, the cost of capital does
not vary with capital structure
• According to the traditional approach, the cost of capital decreases up to a
point, remains more or less unchanged for moderate increases in leverage
thereafter, and rises beyond that at an increasing rate
• Modigliani and Miller (MM) restated and amplified the net operating
income approach in terms of two basic propositions: (a) the value of a firm
is independent of its capital structure. (b) The expected return on equity is
equal to the expected return on assets, plus a premium. The premium is
equal to the debt-equity ratio times the difference between the expected
return on assets and the expected return on debt
 Summing Up
• The beta of a firm’s equity may be expressed as:
E = A + D/E (A – D)
• The imperfections in the real world cast their shadow over the leverage
irrelevance theorem of MM
• The value of a firm, when corporate taxation is considered, is :
V = [O (1 – tc)]/r + tcD
• When personal taxes are considered, along with corporate taxes, the gain in the

value per rupee of debt is equal to :

• [1 – (1 – tc) (1 – tpe) / (1 – tpd)]
• Considering the tax effect and financial distress and agency costs, the value of a

levered firm is:

Value of the unlevered firm + Tax advantage of debt - Financial distress and
agency cost
• In the real world, firms seem to follow a pecking order of financing which goes
as follows; internal finance, debt finance, and external equity.
• Myers explains this with the help of the signaling theory