fm - chapter 15

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CHAPTER 15 CAPITAL STRUCTURE THEORY AND POLICY Q.1. Explain the assumptions and implications of the NI approach and the NOI approach. Illustrate your answer with hypothetical examples. A.1. Under the Net Income (NI) approach, the cost of debt and cost of equity are assumed to be independent to the capital structure. The weighted average cost of capital declines and the total value of the firm rises with increased use of leverage. Under the net operating income (NOI) approach, the cost of equity is assumed to increase linearly with leverage. The weighted average cost of capital remains constant and total value of firm also remains constant as leverage is changed. Example: Assume that EBIT (i.e., Net Operating Income) is Rs 1,00,000. The amount of debt employed by firm Rs 7,00,000; the cost of debt 6%; and the rate of return expected by equity shareholders 10%. k o = 8%. NI Approach : Rs NOI 1,00,000 Less: Interest costs 42,000 ---------- Net income available to shareholders 58,000 ---------- Market value of equity(S) 5,80,000 (58,000/0.10) Market Value of Debt (D) 7,00,000 ---------- Total value of firm (S+D) 12,80,000 ---------- NOI Approach: Rs NOI 1,00,000 Market value of firm 12,50,000 (1,00,000/0.08) Market value of Debt (D) 7,00,000 Market value of Share (S) 5,50,000 Now, assume that value of debt increases to Rs 9,00,000 NI approach : Rs NOI 1,00,000 Less: Interest cost 54,000 (9,00,000 x 6%) ---------

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Page 1: FM - Chapter 15

CHAPTER 15

CAPITAL STRUCTURE THEORY AND POLICY

Q.1. Explain the assumptions and implications of the NI approach and the NOI

approach. Illustrate your answer with hypothetical examples.

A.1. Under the Net Income (NI) approach, the cost of debt and cost of equity are

assumed to be independent to the capital structure. The weighted average cost of

capital declines and the total value of the firm rises with increased use of

leverage.

Under the net operating income (NOI) approach, the cost of equity is

assumed to increase linearly with leverage. The weighted average cost of capital

remains constant and total value of firm also remains constant as leverage is

changed.

Example: Assume that EBIT (i.e., Net Operating Income) is Rs 1,00,000.

The amount of debt employed by firm Rs 7,00,000; the cost of debt 6%; and the

rate of return expected by equity shareholders 10%. ko = 8%.

NI Approach:

Rs

NOI 1,00,000

Less: Interest costs 42,000

----------

Net income available to shareholders 58,000

----------

Market value of equity(S) 5,80,000 (58,000/0.10)

Market Value of Debt (D) 7,00,000

----------

Total value of firm (S+D) 12,80,000

----------

NOI Approach:

Rs

NOI 1,00,000

Market value of firm 12,50,000 (1,00,000/0.08)

Market value of Debt (D) 7,00,000

Market value of Share (S) 5,50,000

Now, assume that value of debt increases to Rs 9,00,000

NI approach:

Rs

NOI 1,00,000

Less: Interest cost 54,000 (9,00,000 x 6%)

---------

Page 2: FM - Chapter 15

Equity Earnings 46,000

Market value of shares (S) 4,60,000 (46,000/0.10)

Market value of debt (D) 9,00,000

---------

Total value of firm 13,60,000

----------

NOI approach:

Rs

NOI 1,00,000

Market value of firm 12,50,000

Market value of debt (D) 9,00,000

Market value of share (S) 3,50,000

From the above, it is clear that as per NI approach the value of firm

increases as the use of debt increases, i.e., from Rs 12,50,000 to Rs 13,60,000. As

per NOI approach, the value of firm remains constant.

Q.2. Describe the traditional view on the optimum capital structure. Compare and

contrast this view with the NOI approach and the NI approach.

A.2. According to traditional approach, the cost of capital declines and the value of the

firm increases with leverage up to a prudent debt level and after reaching the

optimum level, leverage cause the cost of capital to increase and the value of the

firm to decline. The optimum capital structure occurs when the cost of capital is at

its minimum or the value of firm is at maximum.

The NI approach indicates that the total value of firm rises with increased

use of leverage, and weighted average cost of capital declines.

The NOI approach assumes that the total value of firm remains constant as

leverage is changed, because the cost of equity increases linearly with leverage

and sets off the benefits of debt capital.

The NI approach is valid, if financing decisions have an important effect

on the value of firm. NOI approach is valid, if the financing decisions is not of

great concern, but overall cost of capital depends on business risk. Traditional

approach is based on the NI approach.

Q.3. Explain the position of MM on the issue of an optimum capital structure, ignoring

the corporate income taxes. Use an illustration to show how home-made leverage

by an individual investor can replicate the same risk and return as provided by the

levered firm.

A.3. The Modigliani-Miller hypothesis is identical with the NOI approach. MM

approach indicates that a firm’s market value and the cost of capital remain

invariant to the capital structure changes, i.e., any combination of debt and equity

is as good as any other. MM hypothesis indicates that securities are traded in

perfect capital market situation, and firms can be grouped into homogeneous risk

classes. Further, it is also assumed that no corporate income taxes exist, and firms

distribute all net earnings to the shareholders.

Page 3: FM - Chapter 15

If two identical firms, except for the degree of leverage, have different

market values, arbitrage will take place to enable investors to engage in personal

or home-made leverage as against the corporate leverage, to restore equilibrium in

the market.

Example: Assume that two firms, i.e., unleveraged firm U and leveraged

firm L – have identical expected NOI of Rs 10,000. The value of leveraged firm is

Rs 1,10,000 – the value of equity shares being Rs 60,000 and the value of debt is

Rs 50,000, and the value of unleveraged firm is Rs 1,00,000. Firm L has

borrowed at the expected rate of return of 6%. Assume that an investor, Mr X,

holds 10% of shares of leveraged firm. How does the arbitrage benefit him?

Mr X’s value of investment in firm L = Rs 6,000 (60,000 x 10%)

Mr X’s return from firm L

= 10% of (EBIT – INT)

= 10% (10,000 – 3,000)

= Rs 700

Now, Mr X will sell his shares of firm L for Rs 6,000 and will borrow Rs

5,000 (Rs 50,000 × 10%) at 6% interest rate on his personal account. He will

invest Rs 11,000 to purchase shares of firm U (Rs 110,000 × 10%).

Mr. X’s return from firm U

= 10% x 11,000 = 1100

Less: Interest on personal borrowing

= 6% x 5,000 = 300

-----

Rs 800

-----

This strategy pays to Mr X more return at same investment. As a result of

this switching, i.e., arbitrage process, the market value of leveraged firm’s share

will decrease and that of unleveraged firm will increase. So, equilibrium takes

place when values of both firms, i.e., U and L are identical.

Q.4. Assuming the existence of the corporate income taxes, describe the MM

proposition on the issue of optimum capital structure.

A.4. When the corporate taxes are assumed, firms can increase earnings of investors

through borrowing which results in interest tax shield. Under the assumption of

infinite stream of constant tax shield, the value of interest tax shield (PVINTS) is

equal to tax rate multiplied by debt (TD).

TDk

)Dk(TPVINTS

d

d==

where T is the corporate tax rate, kd is the cost of debt and D is the amount

of debt. Thus the market value of levered firm is equal to market value of un-

levered firm plus the present value of interest tax shield.

Q.5. ‘The MM thesis is based on unrealistic assumptions.’ Evaluate the reality of the

assumptions made by MM.

A.5. The MM thesis is based on the assumption of perfect capital market in which

arbitrage is expected to work. The assumption that firms and individuals can

Page 4: FM - Chapter 15

borrow and lend at the same rate of interest may not hold in practice. In reality,

firms are able to borrow at lower rates of interest than individuals. The existence

of limited liability of firms in contrast with unlimited liability of individuals

makes it incorrect to assume that ‘personal leverage’ is a perfect substitute of

‘corporate leverage’. The existence of transaction costs also interferes with the

working of arbitrage. The existence of number of institutional investors would

make it unfeasible to substitute personal leverage for corporate leverage. The

existence of corporate income tax provide the interest tax shield benefits to firm,

which results in lower cost of borrowed funds than the contractual rate of interest.

Q.6. How does the cost of equity behave with leverage under the traditional view and

the MM position?

A.6. According to the traditional view, the rate at which shareholders’ capitalize their

net income, i.e., the cost of equity, ke remains constant up to certain level of debt,

(i.e., a certain degree of leverage). Later on, further increase in the leverage

increases the cost of equity due to the added risk (i.e., financial) and offsets the

advantage of low cost of debt, after the acceptable limit of leverage.

On the other hand, according to MM view, the cost of equity increases

with debt; ke, is equal to the constant average cost of capital, ko, plus a premium

for the financial risk, which is equal to debt–equity ratio times the spread between

the constant average cost of capital and the cost of debt, (ko – kd) D/E. The ke is a

linear function of leverage, measured by the market value of debt to equity, D/E.

Q.7. Consider two firms, L and U, that are identical except that L is levered where as U

is unlevered. Let Vl and Vu stand respectively, for the market value of L and U. In

a perfect market, would one expect Vu to be less or greater than or equal to Vl?

Explain.

A.7. In a perfect market, Vu will be equal to Vl. If Vu is less than Vj then arbitrage

process (as suggested by MM) will take place and value of both firms will

become equal. The arbitrage process is explained above in answer A.3.

Q.8. ‘When the corporate income taxes are assumed to exist, Modigliani-Miller and the

traditional theorists agree that capital structure does affect value, so the basic

point of dispute disappears.’ Do you agree? Why or why not?

A.8. Two theories are based on different premises. Taxes or no taxes, traditional theory

is based on the assumption that leverage has three-stage effect on value of the

firm (or the firm’s cost of capital). First, there is a favourable effect on value.

Second, there is no effect. Third, as the use of leverage goes beyond certain level

(undefined level), there is unfavourable effect. The MM theory, on the other hand,

is based on the assumption that there is a linear relationship between leverage and

financial risk. Since the advantage of leverage taken off by the financial risk,

there is no effect on value. When corporate taxes are considered, there is a net

advantage of leverage because of the interest tax shield.

Q.9. Explain the effect of capital structure on the value of the firm when both corporate

and personal income taxes are considered?

Page 5: FM - Chapter 15

A.9. Investors are required to pay personal taxes on the income earned by them.

Hence, from investor’s view point, taxes will include both corporate and personal

taxes. So, firms have to aim at minimizing the total taxes while deciding about

capital structure.

The advantage of interest tax shield is offset by the personal taxes paid by

debt holders on interest income. Income on account of interest is tax-exempt at

corporate level while dividend income is not. Interest income is taxed at personal

level while dividend income may largely escape personal taxes. Thus, companies

can induce tax paying investors to buy debt securities if they are offered high rate

of interest. But after a stage it will not be possible to attract investors in the high

tax brackets. This point establishes the optimum debt ratio in the economy.

Thus, the value of leveraged firm will be equal to value of unleveraged

firm plus present value of interest tax shield benefits. The present value of interest

tax shield (PVINTS) is:

D)Tpb1(

)Tpe1)(T11PVINTS

−−−=

where T is corporate tax rate; Tpe is personal tax rate on equity income;

Tpb is personal tax rate on dividend income; and D is the amount of debt.

Vl = Vu + PVINTS

where Vl value of leveraged firm and Vu is value of unleveraged firm.

Q.10. What is financial distress? How does it affect the value of firm?

A.10. The offsetting advantage of debt is grouped under the term financial distress.

Financial distress occurs when the firm finds it difficult to honour the obligations

of creditors, which may lead to insolvency also. The financial distress also

introduces inflexibility of raising funds by firm when needed. The financial

distress reduces the value of the firm, on account of insolvency costs like legal

costs, arranging the funds at higher cost of capital, etc. Hence:

Value of leveraged firm = Value of unleveraged firm

+ PV of tax shield benefit

– PV of financial distress.

The costs of financial distress increases as more and more debt is introduced in

the capital structure of the firm.

Q.11. Define the capital structure. What are the elements of a capital structure? What

do you mean by an appropriate capital structure? What are the features of an

appropriate capital structure?

A.11. Capital structure refers to the mix of long term sources of funds, such as

debentures, long-term debt, preference share capital and equity share capital

including reserves and surpluses.

The appropriate capital structure maximizes the long term market price per

share, also keeping in view the financial requirements of a company.

A sound or appropriate capital structure should have the following

features:

Page 6: FM - Chapter 15

1. It should generate maximum returns to the shareholders.

2. There should not be the use of excessive debt to maintain long-term

solvency.

3. The capital structure should be flexible, to provide funds to finance its

profitable activities in future.

4. The capital structure should involve minimum risk of loss of control of the

company.

Q.12. Briefly explain the factors that influence the planning of the capital structure in

practice.

A.12. In addition to the concerns about EPS, value of firm and cash flow; the other

important considerations are as follows:

• The desire to continue control over the company: For example, closely

held companies do not make issues of new shares, while widely-held

companies may make issue of new equity shares.

• The firm’s willingness to venture into new profitable activities as and

when needed, then they may like to have present target debt ratio at lower

end.

• Restrictive covenants in loan agreements already executed.

• Readiness of the investors to purchase a security in a given period of time

and to demand reasonable return.

• Also, study of the market conditions, and internal conditions of a company

from the view point of marketability of securities, etc.

Q.13. Explain the features and limitations of three approaches of determining a firm’s

capital structure: (a) EBIT-EPS approach, (b) valuation approach, and (c) cash

flow approach.

A.13. The EBIT-EPS approach analyses the impact of debt on EPS. The use of fixed

cost sources of finance, such as debt and preference share capital to finance the

assets of the company, is known as financial leverage. If the assets financed with

the use of debt yield a return greater than the cost of debt, the earnings per share

also increases without an increase in the owners’ interest. The firm with high level

of the EBIT can make profitable use of the high degree of leverage to increase

return on the shareholders’ equity. The EBIT-EPS analysis does not reflect the

debt-servicing ability of the firm. This approach does not consider operating and

business risk also.

In the valuation approach, the capital structure is evaluated in terms of its

effect on the value of the firm. According to MM theory, capital structure will

have favourable effect on the value of the firm only because of the interest tax

shield. This advantage reduces because of personal taxes and financial distress

caused by leverage.

In the cash flow approach, a firm is considered prudently financed if it is

able to service its fixed charges, i.e., pay interest and principal, under any

reasonably predictable adverse conditions. At the time of planning the capital

structure, the ratio of net cash inflows of fixed charges (debt-servicing ratio)

Page 7: FM - Chapter 15

should be examined carefully. It focuses on the liquidity and solvency of the firm

over a long-period of time.

Q.14. ‘….the analysis of debt to equity ratios alone can be deceiving, and an analysis of

the magnitude and stability of cash flow relative to fixed changes is extremely

important in determining the appropriate capital structure.’ Give your opinion.

A.14. The cash flow analysis indicates firm’s ability to service debt obligations even

under the adverse conditions, by examining the debt-servicing ratio. It indicates

the number of times the fixed financial obligations are covered by the net cash

inflows generated by the company. The greater the coverage, the greater is the

amount of debt a company can use. The impact of debt–equity ratio should be

evaluated in terms of value, rather than EPS. It is possible for a high-growth

profitable company to suffer from cash shortage if its liquidity management is

poor. Hence, the debt capacity should be thought in terms of cash flows rather

than debt ratios.

Q.15. What are the implications of growth opportunities for the financial leverage?

A.15. To exploit growth opportunities, a firm needs funds. Hence, firms with growth

opportunities will tend to borrow more debt in addition to utilizing internal funds.

Q.16. What is meant by financial flexibility? Is a flexible capital structure costly?

A.16. Flexible capital structure means firm’s ability to adapt its capital structure to the

needs of the changing conditions. The company should be able to raise funds,

without undue delay and cost, whenever needed, to finance the profitable

investments. The financial plan of the company should be flexible enough to

change the composition of capital structure as warranted by operating needs. It is

costly on account of restrictions imposed by loan covenants, pre-maturity

repayment charges in case of retirement of loan or early redemption of

debentures, flotation costs, etc.

Q.17. What is the importance of marketability and flotation costs in the capital structure

decision of a company?

A.17. The internal conditions of a company dictate the marketability of securities in

addition to readiness of investors to purchase a security in a given period of time

and to demand reasonable return. Due to changing market sentiments, the

company has to decide whether to raise funds with an equity issue or debt issue.

Flotation cost is not a very important factor influencing the capital

structure of a company. Flotation costs occur only when the funds are externally

raised. Generally, the flotation cost of debt is less than cost of equity issue. The

flotation costs can be an important consideration in deciding the size of a security

issue. Generally, the flotation costs as a percentage of funds raised will decline

with larger amount of funds.

Q.18. How do the considerations of control and size affect the capital structure decision

of the firm?

Page 8: FM - Chapter 15

A.18. Capital structure decision is governed by desire of management to continue

control over the company. The ordinary (equity) shareholders elect the directors

of the company. This may result into dilution of control by present management

or owner. In the case of a widely-held company, the shares of such company are

widely scattered, and by issues of new shares, there is a risk of dilution of control.

The risk of loss of control can be reduced by distribution of shares widely and in

small lots.

A closely-held small company would like to maintain control. Because of

fear of sharing control and being interfered by others, the closely held company

would like to raise debt capital instead of equity issue. To avoid the risk of loss of

control, small companies may slow down their rate of growth or issue preference

share capital or raise debt capital. A very excessive debt capital can also cause

serious liquidity problem, and render the company sick, which means complete

loss of control.

The size of company may influence its capacity and availability of funds

from different sources. A small company finds it difficult to raise long term debt

or long term loan at acceptable rate of interest and convenient terms. If small

companies are able to approach capital markets, the cost of issuing shares is

generally more than larger companies.