CAPITAL

STRUCTURE

RT
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)

•Every organization tries to achieve optimal capital

structure to maximize shareholders wealth and
manage capital requirements of the firm.
Value of a Firm – directly co-related with the
maximization of shareholders’ wealth
Value of a firm depends upon earnings of a firm 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.
Capital Structure Theories

Net Income Approach (NI)

Net Operating Income (NOI)

Traditional Approach

Modigliani – Miller Model (MM)

Net Income Approach (NI)
▪ NetIncome 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.
Net Income Approach (NI)

▪ Asper 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.
Net Income Approach (NI)
As the proportion of
debt (Kd) in capital
structure increases,
the WACC (Ko)
reduces.
EXAMPLE:
Net Income Approach (NI)
Solution
Net Operating Income (NOI)
▪ As per NOI approach, value of a firm is not dependent upon
its capital structure.
▪ Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital i.e.
the WACC only.
o The cost of debt (Kd) is constant.
o The cost of equity (Ke)is not constant.
o Corporate income taxes do not exist.
Net Operating Income (NOI)

▪ NOI propositions
• The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
• Increasein 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 )
• Inother words, the finance mix is irrelevant and does not affect
the value of the firm.
Net Operating Income (NOI)
▪ Cost of capital (Ko)
is constant.
▪ As the proportion of
debt increases, (Ke)
increases.
▪ No effect on total
cost of capital (WACC)
EXAMPLE:
Net Operating Income (NOI)
Solution
Traditional Approach
▪ The NI approach and NOI approach hold extreme views on the
relationship between capital structure, cost of capital and the value of a
firm.
▪ Traditional
approach (‘intermediate approach’) is a compromise between
these two extreme approaches.
▪ Traditionalapproach confirms the existence of an optimal capital
structure; where WACC is minimum and value of the firm is maximum.
▪ As
per this approach, a best possible mix of debt and equity will
maximize the value of the firm.
Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings (since Kd < Ke). As a
result, the WACC reduces gradually. This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize.
Further increase in borrowings will not affect WACC and the value of firm will also
stagnate.
3) Increase in debt beyond this point increases shareholders’ risk (financial risk) and
hence Ke increases. Kd also rises due to higher debt, WACC increases & value of
firm decreases.
Traditional Approach

▪ Cost of capital (Ko)

is reduces initially.
▪ At a point, it settles
▪ But after this point,
(Ko) increases, due
to increase in the
cost of equity. (Ke)
EXAMPLE:
Traditional Approach
Solution
Modigliani & Miller theory
• Modiglianiand Miller (1958) supports the NOI approach,
i.e. the capital structure (debt-equity mix) has no effect
on value of a firm.
MM (1958) Assumptions
o Capital markets are perfect and investors are free to buy,
sell, & switch between securities.
o Investors can borrow without restrictions at par with the
firms
o Investors are rational & informed of risk-return of all
securities
o No corporate income tax, and no transaction costs
o 100 % dividend payout ratio, i.e. no profits retention

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M&M Proposition I
• Firms cannot change the total value of their securities by
splitting cash flows into two different streams
• Firm value is determined by real assets
• Capital structure is irrelevant
MM Theory: Zero Taxes

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800

CF to shareholder $3,000 $1,800

CF to debt holder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical.
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MM Results: Zero Taxes
•MM prove:
• If
total CF to investors of Firm U and Firm L are equal,
then the total values of Firm U and Firm L must be
equal:
• VL = V U

•Therefore, capital structure is irrelevant

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M&M Proposition II
•Bonds are almost risk-free at low debt levels
• rD is independent of leverage
• rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
•As firms borrow more, the risk of default rises
• rD starts to increase
• rE increases more slowly (because the holders of risky
debt bear some of the firm’s business risk)
M&M
r Proposition II
rE

r
A

rD
D
Risk free debt Risky debt E
MM (1963): Corporate Taxes
• Relaxed assumption of no corporate taxes
• Interest may be deducted, reducing taxes paid by levered firms
• More CF goes to investors, less to taxes when leverage is used
• Debt “shields” some of the firm’s CF from taxes

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MM Result: Corporate Taxes
•MM show that the value of a levered firm = value of
an identical unlevered form + any “side effects.”
VL = VU + TD
•If
T=40%, then every dollar of debt adds 40 cents of
extra value to firm

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 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
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MM relationship between capital costs and
leverage when corporate taxes are considered

Cost of
Capital (%)
rs

WACC
rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
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Modern Capital Structure Theories

•Agency costs theory

•Trade-off theory
•Pecking order
Agency Theory
•Agency costs are the costs associated with the
fact that all large companies are managed by
non-owners
•Agency costs are the incremental costs arising
from conflicts of interest between agent and
owner
• Managers – shareholders – bondholders
•Smaller stake of managers rises the probability of
not giving their best efforts in running the Co.
•Shareholders are aware of this conflict
• They take action to minimize the loss
• Monitoring costs
• Bonding costs
• Residual costs

•Good governances translates into higher

shareholder value (better aligned objectives)
•Leveraged companies give less freedom to
managers either to take more debt or spend cash
Trade-off Theory
•An optimal capital structure exists (theoretically)
that balances costs and benefits.
•The probability of bankruptcy increases as more
leverage is used
•Company uses these tool to decide the optimal
level of debt
• At low leverage, tax benefits outweigh bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax benefits.

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Effect of Leverage on Value

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Financial Distress
•Lower or negative earnings put companies under
financial distress which leads to filing of
bankruptcy
•The probability of bankruptcy increases as the
degree of leverage increases
•The probability of bankruptcy depends on:
• Company’s business risk
• Company’s corporate governance structure
• Management of the company
Costs of financial distress
•Direct cost of financial distress
• Cash expenses associated with the bankruptcy process
• Legal and administrative fees

•Indirect cost of financial distress

• Forgone investment opportunity
• Impaired ability to conduct business
Pecking Order Theory
•Mayers and Majluf, suggests that managers choose
methods of financing that range from the least
visible (internal fund) to most visible (equity
offering) signal
•Firms use internally generated funds first (1):
• No flotation costs
• No negative signals
•If more funds are needed, firms then issue debt (2)
• Lower flotation costs than equity
• No negative signals

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• If more funds are still needed, firms then issue equity (3)
•Flotationcosts
•Negative signals
• Management needed capital beyond what comes
cheaply
• Managers often sell stock if stock is overvalued
(better information)
Factors determining
capital structure
Determinants of Capital Structure
•Asset structure
•Positive association between tangible assets and
leverage
•Financial distress
•Firms with volatile earnings are likely to be less
leveraged
•Size
•Large firms tend to be more diversified and
hence, less prone to financial distress. Therefore
large firms expected to be highly leveraged
•Age of firm
• Young firms are more prone to facing the problem of
asymmetric information, they are likely to avoid equity
market
•Growth
• Negative association between leverage and future growth
•Profitability
• Negative association between leverage and profitability
•Uniqueness
• Firmscharacterized by unique products are likely to be less
leveraged
 Windows of Opportunity

Managers try to “time the market” when

issuing securities.
Issue When And
Equity Market is “high” Stocks have “run up”
Debt Market is “low” Interest rates low

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Implications for Managers

•Take advantage of tax benefits by

issuing debt, especially if the firm
has:
•High tax rate
•Stable sales
•Less operating leverage

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Implications for Managers
•Avoid financial distress costs by maintaining excess
borrowing capacity, especially if the firm has:
• Volatile sales
• High operating leverage
• Special purpose assets (instead of general-purpose assets
that make good collateral)

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Implications for Managers
•If manager has asymmetric information regarding
firm’s future prospects, then:
• Avoidissuing equity if actual prospects are better than the
market perceives
•Consider impact of capital structure choices on
lenders’ and rating agencies’ attitudes

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•Thus, we can conclude that:
“planning a capital structure is a highly psychological,
complex and qualitative process”.
Thank you

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