Capital Structure

Theories
 Coverage –

• Capital Structure concept

• Capital Structure planning
• Concept of Value of a Firm
• Significance of Cost of Capital (WACC)
• Capital Structure theories –
 Net Income
 Modigliani-Miller
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.
It involves balancing the shareholders’ expectations
(risk & returns) and capital requirements of the firm.
 Advantages of debt capital

· It is cheaper than equity because

· i) The administrative costs and issuing costs are
normally lower – underwriting is usually not required.
· ii) Debt interest is allowable against profits for tax
purposes
· iii) The pre-tax rate of interest is invariably lower than
ke the return required by shareholders because
lenders have prior charge claims.
·
 Disadvantages of Debt

· However it introduces the default risk – inability to

service loan may lead to liquidation.

Is there a correct level of Debt?

How much should a firm borrow?
Planning the Capital Structure
Important Considerations –
 Return: ability to generate maximum returns to the shareholders, i.e.
maximize EPS ( as measured by EBIT per share) and market price per
share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than
equity due to tax shield on interest.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of control, hence debt preferred to new equity
shares.
 Flexible: altering capital structure without much costs & delays, to
raise funds whenever required.
 Capacity: ability to generate profits to pay interest and principal.
Value of a Firm – directly co-related with
the maximization of shareholders’ wealth.
 Value of a firm depends upon earnings of a firm (EBIT) and its cost of
capital (i.e. WACC).
 Earnings are a function of investment decisions, operating efficiencies, &
WACC is a function of its capital structure.
 Value of firm is derived by capitalizing the earnings by its cost of capital
(WACC). Value of Firm = Earnings / WACC
 Thus, value of a firm varies due to changes in the earnings of a company or
its cost of capital, or both.
 Capital structure cannot affect the total earnings of a firm (EBIT), but it can
affect the residual shareholders’ earnings.
 THEORIES OF CAPITAL
STRUCTURE(OPTIMAL D/E MIX)
· These theories attempt to find a combination of debt
and equity that maximises the overall market value.
Capital Structure Theories
GENERAL ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no change in total
assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
Capital Structure Theories –
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) [i.e. Kd < Ke ]
o Corporate income taxes do not exist.
Capital Structure Theories –
Net Income Approach (NI)
 As per 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.
Capital Structure Theories –
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
Capital Structure Theories –
A) Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm $ 200,000. Ke = 10% Kd = 6%
Debt capital $ 500,000 Debt = $700,000 Debt = $ 200,000
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000

Ke 10% 10% 10%

Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)

Value of D ebt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%

(EBIT / Value) * 100
MM Proposition I without Taxes:
Capital Structure Irrelevance theory
 Proposition I without Taxes:
Capital Structure Irrelevance
MM Proposition I
The market value of a company is not affected by the capital structure of
the company.

· Based on the assumptions that there are no taxes, costs of financial

distress, or agency costs, so investors would value firms with the same
cash flows as the same, regardless of how the firms are financed.
· Reasoning: There is no benefit to borrowing at the firm level because
there is no interest deductibility. Firms would be indifferent to the source
of capital and investors could use financial leverage if they wish.

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 Proposition II without Taxes:
Higher Financial Leverage
MM Proposition II:
The cost of equity is a linear function of the company’s debt/equity ratio.

· Because creditors have a claim to income and assets that has

preference over equity, the cost of debt will be less than the cost of
equity.
· As the company uses more debt in its capital structure, the cost of
equity increases because ofKthe
=kseniority of debt:
+(k -k (D/E)
e 0 0 d

ko
where r0 is the cost of equity if there is no debt financing.
· The WACC is constant because as more of the cheaper source of
capital is used (that is, debt), the cost of equity increases. 16
Proposition II without Taxes:
Higher Financial Leverage
 Cost of capital (Ko)
Cost is constant.
ke
 As the proportion
of debt increases,
ko

kd
(Ke) increases.
 No effect on total
Debt
cost of capital
(WACC)
Capital Structure irrelevance theory
Proposition 2
 MM 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 )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.
MM Proposition II without Taxes:
Higher Financial Leverage
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = $ 200,000. WACC (Ko) = 10% Kd = 6%
Debt = $ 300,000, $ 400,000, $500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200 000 200 000 200 000
WACC (Ko) 10% 10% 10%

Value of the firm 2 000 000 2 000 000 2 000 000

Value of Debt @ 6 % 300 000 400 000 500 000
Value of Equity (bal. fig) 1 700 000 1 600 000 1 500 000

Interest @ 6 % 18 000 24 000 30 000

EBT (EBIT - interest) 182 000 176 000 170 000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%

 Introducing Taxes into the MM Theory

When taxes are introduced (specifically, the tax deductibility of interest by the
firm), the value of the firm is enhanced by the tax shield provided by this
interest deduction. The tax shield:
– Lowers the cost of debt.
– Lowers the WACC as more debt is used.
– Increases the value of the firm by tD (that is, marginal tax rate times
debt)
Without Taxes With Taxes
Value of the Firm VL = V U VL = VU + tD

WACC

Cost of Equity Ke=k0+(k0-kd) (D/E) Ke=k0+(k0-kd)(1-t) (D/E)

Bottom line: The optimal capital structure is 99.99% debt 20

 Introducing costs of
financial distress
· Costs of financial distress are costs associated with a company that is
having difficulty meeting its obligations.
· Costs of financial distress include the following:
– Opportunity cost of not making optimal decisions
– Inability to negotiate long-term supply contracts.
– Loss of customers.
· The expected cost of financial distress increases as the relative use of
debt financing increases.
– This expected cost reduces the value of the firm, offsetting, in part, the
benefit from interest deductibility.
– The expected cost of distress affects the cost of debt and equity.

Bottom line: There is an optimal capital structure at which the value 21

of the
 Agency Costs

· Agency costs are the costs associated with the separation of owners
and management.
· Types of agency costs:
– Monitoring costs
– Bonding costs
– Residual loss
· The better the corporate governance, the lower the agency costs.
· Agency costs increase the cost of equity and reduce the value of the
firm.
· The higher the use of debt relative to equity, the greater the monitoring
of the firm and, therefore, the lower the cost of equity.

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Financial Distress

Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt

Debt/Total Assets
 Costs of Asymmetric Information

· Asymmetric information is the situation in which different parties have

different information.
– In a corporation, managers will have a better information set than
investors.
– The degree of asymmetric information varies among companies and
industries.
· The pecking order theory argues that the capital structure decision is
affected by management’s choice of a source of capital that gives
higher priority to sources that reveal the least amount of information.

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Pecking Order Theory
Asymmetric information exists and it is costly. Managers have more
information about the quality of the firm.

· Companies select financing according to the law of least effort.

(1) Internal financing (retained earnings), first.
(2) Bank debt (in different levels, easiest: bank debt) , second
(3) Equity, last resort.

Adverse selection issues: Equity has a lot, debt a little, retained

earnings none.
=> The choice of financing is a signal.
 Pecking Order Theory

The announcement of a stock issue drives down the stock price

because investors believe managers are more likely to issue when
shares are overpriced.

Therefore firms prefer internal finance since funds can be

raised without sending adverse signals.

If external finance is required, firms issue debt first and equity as a

last resort.

The most profitable firms borrow less not because they have lower
target debt ratios but because they don't need external finance.
 Pecking Order Theory

Some Implications:

 Internal equity may be better than external equity.

 Financial slack is valuable.
 If external capital is required, debt is better.
 The Optimal Capital Structure

Costs to
Financial
Taxes Distress Optimal Capital Structure?
No No No
Yes No Yes, 99.99% debt
Yes Yes Yes, benefits of interest deductibility are offset by
the expected costs of financial distress

We cannot determine the optimal capital structure for a given company, but we
know that it depends on the following:
• The business risk of the company.
• The tax situation of the company.
• The degree to which the company’s assets are tangible.
• The company’s corporate governance.
• The transparency of the financial information.

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 Deviating from Target

A company’s capital structure may be different from its target capital

structure because of the following:
– Market values of outstanding issues change constantly.
– Market conditions that are favorable to one type of security over
another.
– Market conditions in which it is inadvisable or too expensive to raise
capital.
– Investment banking fees that encourage larger, less frequent
security issuance.

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 Evaluating Capital Structure Policy

· Analysts consider a company’s capital structure

– Over time.
– Compared with competitors with similar business risk.
– Considering the company’s corporate governance.
· Analysts must also consider
– The industry in which the company operates.
– The regulatory environment.
– The extent to which the company has tangible assets.
– The degree of information asymmetry.
– The need for financial flexibility.

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 Leverage in an International Setting

· Country-specific factors affect a company’s choice of capital structure

and the maturity structure within the capital structure.
· Types of factors to consider:
– Institutional and legal environments
– Financial markets and banking sector
– Macroeconomic factors

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 4. Summary

· The goal of the capital structure decision is to determine the financial leverage
that maximizes the value of the company (or minimizes the weighted average
cost of capital).
· In the Modigliani and Miller theory developed without taxes, capital structure is
irrelevant and has no effect on company value.
· The deductibility of interest lowers the cost of debt and the cost of capital for the
company as a whole. Adding the tax shield provided by debt to the Modigliani
and Miller framework suggests that the optimal capital structure is all debt.
· In the Modigliani and Miller propositions with and without taxes, increasing a
company’s relative use of debt in the capital structure increases the risk for
equity providers and, hence, the cost of equity capital.
· When there are bankruptcy costs, a high debt ratio increases the risk of
bankruptcy.
· Using more debt in a company’s capital structure reduces the net agency costs
of equity. 32
 Summary (continued)

· The costs of asymmetric information increase as more equity is used versus debt,
suggesting the pecking order theory of leverage, in which new equity issuance is the
least preferred method of raising capital.
· According to the static trade-off theory of capital structure, in choosing a capital
structure, a company balances the value of the tax benefit from deductibility of
interest with the present value of the costs of financial distress. At the optimal target
capital structure, the incremental tax shield benefit is exactly offset by the
incremental costs of financial distress.
· A company may identify its target capital structure, but its capital structure at any
point in time may not be equal to its target for many reasons.
· Many companies have goals for maintaining a certain credit rating, and these goals
are influenced by the relative costs of debt financing among the different rating
classes.
· In evaluating a company’s capital structure, the financial analyst must look at the
capital structure of the company over time, the capital structure of competitors that
have similar
Copyright business
© 2013 risk, and company-specific factors that may affect agency
CFA Institute 33
 Summary (continued)

· Good corporate governance and accounting transparency should lower

the net agency costs of equity.
· When comparing capital structures of companies in different countries,
an analyst must consider a variety of characteristics that might differ
and affect both the typical capital structure and the debt maturity
structure.

Copyright © 2013 CFA Institute 34