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CAPITAL STRUCTURE
THEORY
Chapter
CAPITAL STRUCTURE
Excel BooksExcel BooksFINANCIAL MANAGEMENT, Dr. Sudhindra Bhat
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CAPITAL STRUCTURE
THEORY
Capital Structure Defined
The term capital structure is used to represent the proportionate relationship
between debt and equity.
The various means of financing represent the financial structure of an enterprise.
The left-hand side of the balance sheet (liabilities plus equity) represents the
financial structure of a company. Traditionally, short-term borrowings are excluded
from the list of methods of financing the firm’s capital expenditure.
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CAPITAL STRUCTURE
THEORY
Questions while Making the Financing Decision
How should the investment project be financed?
How does financing affect the shareholders’ risk, return and value?
Does there exist an optimum financing mix in terms of the maximum value to the
firm’s shareholders?
What factors in practice should a company consider in designing its financing
policy?
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CAPITAL STRUCTURE
THEORY
Features of An Appropriate Capital Structure
capital structure is that capital structure at that level of debt – equity proportion
where the market value per share is maximum and the cost of capital is minimum.
Appropriate capital structure should have the following features
Profitability
Solvency
Flexibility
Control
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CAPITAL STRUCTURE
THEORY
Determinants of Capital Structure Seasonal Variations
Tax benefit of Debt
Flexibility
Control
Industry Leverage Ratios
Agency Costs
Industry Life Cycle
Degree of Competition
Company Characteristics
Requirements of Investors
Timing of Public Issue
Legal Requirements
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CAPITAL STRUCTURE
THEORY
Definitions used in Capital Structure…• E = Total Market Value of Equity.
• D = Total Market Value of Debt.• V = Total Market Value of the Firm.• I = Annual Interest payment.• NI = Net Income.• NOI = Net Operating Income.• Ee = Earning Available to Equity Shareholder.
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CAPITAL STRUCTURE
THEORY
Patterns / Forms of Capital Structure
Following are the forms of capital structure:
Complete equity share capital;
Different proportions of equity and preference share capital;
Different proportions of equity and debenture (debt) capital and
Different proportions of equity, preference and debenture (debt) capital.
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CAPITAL STRUCTURE
THEORY
Assumption of Capital Structure Theories
There are only two sources of funds i.e.: debt and equity.
The total assets of the company are given and do not change. [Investment decision is
assumed to be constant].
The total financing remains constant. [Total capital is same, but proportion of debt and
equity may be changed].
Operating profits (EBIT) are not expected to grow.
All the investors are assumed to have the same expectation about the future profits.
Business risk is constant over time and assumed to be independent of its capital
structure and financial risk.
Corporate tax does not exit.
The company has infinite life.
Dividend payout ratio = 100%.
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CAPITAL STRUCTURE
THEORY
A Conceptual Look --Relevant Rates of Return
kkdd = the yield on the company’s debt = the yield on the company’s debt
Annual interest on debt
Market value of debt
I
D==kkdd
Assumptions:• Interest paid each and every year• Bond life is infinite• Results in the valuation of a perpetual bond• No taxes (Note: allows us to focus on just capital structure issues.)
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CAPITAL STRUCTURE
THEORY
E
S
A Conceptual Look --Relevant Rates of Return
==
kkee = the expected return on the company’s equity = the expected return on the company’s equityEarnings available to Earnings available to common shareholderscommon shareholders
Market value of common Market value of common stock outstandingstock outstanding
kkee
Assumptions:• Earnings are not expected to grow• 100% dividend payout• Results in the valuation of a perpetuity• Appropriate in this case for illustrating the theory of the firm
E
S
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CAPITAL STRUCTURE
THEORY
O
V
A Conceptual Look --Relevant Rates of Return
=
Ko = an overall capitalization rate for the firmKo = an overall capitalization rate for the firm
Earnings to all capital supplierTotal Market value of the firmKoKo
Assumptions:• V = B + S = total market value of the firm• Earnings to all capital supplier or EBIT=Interest plus earnings available
to common shareholders
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CAPITAL STRUCTURE
THEORY
Debt-equity Mix and the Value of the Firm
Capital structure theories:
Traditional approach and Net income (NI) approach.
Net operating income (NOI) approach
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal taxes.
Trade-off theory: costs and benefits of leverage.
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CAPITAL STRUCTURE
THEORY
Net Income Approach…• A change in the proportion in capital structure will lead to a corresponding change in
Ko and V.• Assumptions:
(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(iii) Use of debt in capital structure does not change the risk
perception of investors.
(iv) Cost of debt and cost of equity remains constant;
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CAPITAL STRUCTURE
THEORY
Net Income (NI) Approach According to NI approach both the
cost of debt and the cost of equity are
independent of the capital structure;
they remain constant regardless of
how much debt the firm uses. As a
result, the overall cost of capital
declines and the firm value increases
with debt.
This approach has no basis in reality;
the optimum capital structure would be
100 per cent debt financing under NI
approach.
ke
kokd
Debt
Cost
kd
ke, ko
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CAPITAL STRUCTURE
THEORY
Formula used for NI Approach…• Net Income [NI] = EBIT – Debenture Interest.
• Market Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D]
• Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke]
• Market value of Debt [D] = Interest [I] / Cost of Debt [Kd]
• Cost of Capital [Ko or R] = EBIT / V * 100 or EBIT/ (E+D) * 100
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CAPITAL STRUCTURE
THEORY
Net Operating Income Approach…• There is no relation between capital structure and Ko and V.
• Assumptions: Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. The market capitalizes the total value of the firm as a whole and no importance
is given for split of value of firm between debt and equity; The market value of equity is residue [i.e., Total value of the firm minus market
value of debt) The use of debt funds increases the received risk of equity investors, there by
ke increases The debt advantage is set off exactly by increase in cost of equity. Cost of debt (Ki) remains constant There are no corporate taxes.
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CAPITAL STRUCTURE
THEORY
Net Operating Income (NOI) Approach According to NOI approach the value
of the firm and the weighted average
cost of capital are independent of the
firm’s capital structure.
In the absence of taxes, an individual
holding all the debt and equity
securities will receive the same cash
flows regardless of the capital
structure and therefore, value of the
company is the same.
ke
ko
kd
Debt
Cost
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CAPITAL STRUCTURE
THEORY
Formula used for NOI Approach…• Value of the Firm [V] = EBIT / Ko• Market Value of Equity [E] = V – D• Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT – I /
V - D
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CAPITAL STRUCTURE
THEORY
MM Approach Without Tax: Proposition I
MM’s Proposition I states that the firm’s value is independent of its capital
structure. With personal leverage, shareholders can receive exactly the same
return, with the same risk, from a levered firm and an unlevered firm. Thus, they
will sell shares of the over-priced firm and buy shares of the under-priced firm until
the two values equate. This is called arbitrage.
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CAPITAL STRUCTURE
THEORY
MM’s Proposition II
The cost of equity for a levered firm equals the constant overall cost of capital
plus a risk premium that equals the spread between the overall cost of capital
and the cost of debt multiplied by the firm’s debt-equity ratio. For financial
leverage to be irrelevant, the overall cost of capital must remain constant,
regardless of the amount of debt employed. This implies that the cost of equity
must rise as financial risk increases.
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CAPITAL STRUCTURE
THEORY
MM Hypothesis With Corporate Tax
Under current laws in most countries, debt has an important advantage over
equity: interest payments on debt are tax deductible, whereas dividend
payments and retained earnings are not. Investors in a levered firm receive in
the aggregate the unlevered cash flow plus an amount equal to the tax
deduction on interest. Capitalising the first component of cash flow at the all-
equity rate and the second at the cost of debt shows that the value of the
levered firm is equal to the value of the unlevered firm plus the interest tax shield
which is tax rate times the debt (if the shield is fully usable).
It is assumed that the firm will borrow the same amount of debt in perpetuity and
will always be able to use the tax shield. Also, it ignores bankruptcy and agency
costs.
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CAPITAL STRUCTURE
THEORY
Features of an Appropriate Capital Structure
Profitability
Solvency
Return
Risk
Flexibility
Capacity
Control
Conservatism