capital struture

8/8/2019 Capital Struture

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Capital Structure

Meaning of Capital StructureTheories of Capital Structure


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Meaning and Definition of Capital Structure

Estimation of capital requirement is necessary, but theformation of a capital structure is important

According to Gerestenbeg, Capital structure of a companyrefers to the composition or make-up of its capitalization

and it includes all long-term capital resources viz., loans,reserves, shares and bonds

Capital structure refers to the kinds of securities and theproportionate amounts that make up capitalization.

For raising long-term finances, a company can issue three

types of securities viz.,E

quity shares, Preference sharesand Debentures.

A decision about the proportion among these type ofsecurities refers to the capital structure of the enterprise


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Capitalization, Capital Structure and

Financial Structure

The terms capitalization, capital structure andfinancial structure do not mean the same

Capitalization is a quantitative aspect of the

financial planning of an enterprise. It refers to thetotal amount of securities issued by a company

Financial structure means the entire liabilities sideof the balance sheet. It refers to all the financialresources marshaled by the firm, short as well as

long-term, and all forms of debt as well as. Thus,financial structure generally, is composed of aspecified percentage of short-term debt, long-termdebt and shareholders funds.


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Capital structure and Firms value

The choice of a firms capital is marketing problem. A firmdecides how the cash flows is used to meet the obligationstoward debt capital and a residual that belongs to equityshareholders

Since the objective of financial management is to maximizethe shareholders wealth, the key issue is: What isrelationship between capital structure and firms value?Alternatively, what is the relationship between capitalstructure and cost of capital?

If capital structure decision can affect a firms value, then itwould like to have a capital structure, which maximizes themarket value. However, there exist conflicting theories onthe relationship between capital structure and the value ofa firm.


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Theories of Capital Structure

Different kinds of theories have been propoundedby different authors to explain the relationshipbetween capital structure, cost of capital and value

of the firm. The important theories are:1. Relevance of capital structure: The Net Income

approach (NI)

2. Irrelevance of capital structure: The Net

Operating Income approach (NOI)3. Traditional view/position

4. Modigliani and Miller position (MM)


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The Net Income Approach

The NI approach is recommended by Durand

According to NIA, the capital structure decision is relevantto the valuation of the firm.

In other words, a change in the financial leverage will lead

to a corresponding changes in the overall cost of capital aswell as the total value of the firm

That is, if the degree of financial leverage as measured byratio of debt to the equity is increased the WACC willdecline, while the value of the firm as well as the market

price of equity shares will increase. Conversely, a decreasein the financial leverage will cause an increase in theoverall cost of capital and a decline in both the value of thefirm as well as the market price of the equity shares


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Assumption of NIA

There are no taxes

The cost of debt is less than the equitycapitalization rate or cost of equity

The use of debt does not change the riskaspect of the investors

A firm that finance its assets by equity

and debt is called levered firmA firm that finances its assets entirely by

equity is called unlevered firm


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The Net Operating Income Approach

The Net Operating Income position has beenadvocated by David Durand

But this NOI approach is quite contrary to the NI

approach According to the NOI, whatever be the pattern of

the capital structure the overall cost of capitalremains one and the same as the total value of the

firm remains constant. The only change that canbe noticed from one type of capital structure toanother type is change in the cost of equity andthere by value of equity


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The Net Operating Income Approach The critical premise of this approach is that the market

capitalizes the firm as a whole at a discount rate which isindependent of the firms debt-equity ratio. As such thedivision between debt-equity is irrelevant

According to this approach the market value of a firmdepends on its net operating income and business risk. Thechange in the financial leverage employed by a firm cannot

change these underlying factors. It merely changes thedistribution of income and risk between debt and equity,without affecting the total income and risk which influencethe market value of the firm.

In other words, whatever be the pattern of capitalstructure we maintain the overall cost of capital remains

one and the same and as such the total value of the firmremains constant. The only change that can be noticedfrom one type of capital structure to another type is changein the cost of equity and there by the value of equity

This approach also assumes there are no taxes


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Traditional Position/Approach

The traditional view has emerged as a compromiseto the extreme position taken by the NI and NOIapproach

According to this view, a judicious mix of debt andequity capital can increase the value of the firm byreducing the WACC up to certain level of debt. TheWACC decreases only within the reasonable limitof financial leverage and reaching a minimum

level, it starts increasing with financial leverage Hence, a firms optimum capital structure that

occurs when WACC is minimum, and there bymaximizing the value of the firm.


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Why does WACC decline?

Low cost debt is replaced for expensive equity capital

This financial leverage results in risk to shareholders,

will in turn cause the cost of equity to increase

However, the increase in the cost of equity is offset bythe lower cost of debt

But further when leverage increases the WACC also

starts to increase as the advantage of cheaper debts

are taken off

This can be illustrated by an example


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Suppose a firm is expecting a perpetual net

operating income of Rs. 1,50,000 on assets of Rs.

15,00,000 which are entirely financed by equity.

The firms equity capitalization rate is 10%.

It is considering substituting equity capital by

issuing perpetual debentures of Rs. 3,00,000 at 6%interest rate. The cost of equity is expected to

increase to 10.56%.

The firm is also considering the alternative of

raising perpetual debentures of Rs. 6,00,000 at 7%interest rate and cost of equity will rise to 12.5%

calculate the firms value in each alternative


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Modigliani-Miller Position/Hypothesis

MM Position or MM Hypothesis was 1stformaltheory of capital structure proposed by FrancoModigliani and Merton Miller

The following are the assumptions of MMproposition I

1. Perfect Capital Market

2. Rational investors and managers

3. Homogeneous expectations4. Equivalent risk classes

5. Absence of corporate taxes


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MM Proposition I The value of a firm depends upon its expected netoperating income and the overall capitalization rate or the

opportunity cost of capital. Since the form of financing (debt or equity) can neither

change the firms net operating income nor its operatingrisk, the value of levered and unlevered firms ought be the

same Financing changes the way in which the net operating

income is distributed between equity holders and debt-holders. Firms, with identical net operating income andbusiness (operating) risk, but differing capital structure,should have same total value

MM proposition I is that, for firms in the same risk class,the total market value is independent of the debt-equitymix and is given by capitalizing the expected net operatingincome by the capitalization rate (i.e., the opportunity costof capital) appropriate to that risk class.


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Arbitrage Process/Argument

Arbitrage process is a process by which the investors oflevered firm L sell their equity and buy the equity inunlevered firm U with personal leverage, the marketvalue of firm L tends to decline and the market value of

firm U tends to rise This process continues until the market values of both

the firms become equal because only then the possibilityof earning a higher income, for a given level ofinvestment and leverage, by arbitraging is eliminated. Asa result, the cost of capital for both the firms becomesthe same

To see how arbitrage mechanism work, we can considerthe following illustration


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MM Proposition II

According to MM second proposition the expected return on equity is equal tothe expected rate of return on assets, plus a premium. The premium is equal tothe debt-equity ratio times the difference between the expected return onassets and the expected return on debt.

Financial leverage does not affect a firms net operating income but it doesaffect shareholders return (EPS and ROE). EPS and ROE increase with leverage

when the interest rate is less than the firms return on assets. Financialleverage also increases shareholders financial risk by amplifying thevariability ofEPS and ROE.

Thus, financial leverage causes two opposing effects: it increases theshareholders return but it also increases their financial risk. Shareholders willincrease the required rate of return on their investment to compensate for thefinancial risk. The higher financial risk, the higher the shareholders required

rate of return or the cost of equity. This is MM proposition II In simple words, MM proposition II states that the cost of equity, ke, will

increase enough to offset the advantage of cheaper cost of debt so that theopportunity cost of capital, kc, does not change. A levered firm has financialrisk while an unlevered firm is not exposed to financial risk


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Paul, the CEO of the company, believes that the shareholders wouldbenefit if the company employs debt and equity in equal proportions.So he proposes to issue Rs. 10 million of debentures carrying an

interest rate of 15% and use the proceeds to buy back 500,000 equityshares. The following additional information is available.

Existing capital structure:

Operating income: Rs 4,000,000

number of shares: 1,000,000

price per share: Rs 20

market value of shares: Rs 20,000,000Proposed capital structure:

operating income: Rs 4,000,000

number of shares: 500,000

price per share: Rs 20

market value of shares: Rs 10,000,000

market value of debt: Rs 10,000,000

interest at 15%: Rs 1,500,000


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Analysis at different operating incomeExisting Capital Structure

Basic data

Operating income: Rs. 4,000,000

Number of shares: 1,000,000

Price of share: Rs. 20Market value of shares: Rs. 20,000,000

Possible Outcome

Operating income: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000

Equity earnings: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000

EPS: Rs. 2 Rs. 4 Rs. 6

ROE: 10% 20% 30%

Proposed Capital Structure

Basic data

Operating income: Rs. 4,000,000

Number of shares: 500,000

Price of share: Rs. 20

Market value of shares: Rs. 10,000,000

Market value of debt: Rs. 10,000,000

Interest at 15%: Rs. 1,500,000

Possible Outcome

Operating income: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000

Interest: Rs. 1,500,000 Rs. 1,500,000 Rs. 1,500,000

Equity earnings: Rs. 500,000 Rs. 2,500,000 Rs. 4,500,000

EPS: Rs. 1 Rs. 5 Rs. 9

ROE: 5% 25% 45%


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The Risk-Return Tradeoff

MM proposition I says that financial leverage hasno effect on the wealth of shareholders and MMproposition II says that the rate of return expected

by shareholders increases with financial leverage Why are shareholders indifferent to increased

leverage when it enhances expected return?

The reason is that an increase in expected return is

accompanied by an increase in risk which in turnraises the shareholders required rate of return


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Effect of Leverage on Risk

Operating Income

Rs. 2,000,000 Rs. 4,000,000Existing debt-equity is 0:1

EPS Rs. 2 Rs. 4

ROE 10% 20%

Proposed debt-equity is 1:1

EPS Rs. 1 Rs. 5

ROE 5% 25%


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Criticisms ofMMTheory

Existence of corporate tax

Lending and borrowing rates discrepancy

Non-substitutability of personal andcorporate leverages

Transaction costs, agency costs exists

Informational asymmetry exists becausemanagers are better informed than

investors

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