CAPITAL STRUCTURE

Gagan Deep Sharma (Dr)

USMS, GGSIPU, New Delhi
CAPITAL STRUCTURE
A mix of debt, preferred stock, and common stock with which the firm plans to
finance its investments.
Objective is to have such a mix of debt, preferred stock, and common equity which
will maximize shareholder wealth or maximize market price per share
WACC depends on the mix of different securities in the capital structure. A change in
the mix of different securities in the capital structure will cause a change in the
WACC. Thus, there will be a mix of different securities in the capital structure at
which WACC will be the least.
An optimal capital structure means a mix of different securities which will maximize
the stock price share or minimize WACC.
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LEVERAGE AND CAPITAL STRUCTURE
Leverage means use of fixed cost source of funds. Generally, it refers to use of debt in
the capital structure of the firm
How much leverage should be there in a firm? Why is this question important? Two
reasons:
a higher debt ratio can enhance the rate of return on equity capital during good economic
times
a higher debt ratio also increases the riskiness of the firms earnings stream
Capital structure decision involves a trade off between risk and return to maximize
market price per share
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CAPITAL STRUCTURE

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CAPITAL STRUCTURE

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CAPITAL STRUCTURE

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CAPITAL STRUCTURE

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CAPITAL STRUCTURE

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CAPITAL STRUCTURE
Results
Range of ROEs
%
Leveraged 20 - 5
Un-leveraged 15 7.5
What effect will this have on expected/required equity returns?
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THEORETICAL POSITIONS
Net Operating Approach (the makes no difference camp)
Traditional Approach (the yes it does camp)
Modigliani and Miller (the we can prove it does not matter camp)
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NET OPERATING APPROACH

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NET OPERATING APPROACH

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Market value
of debt ($65M)
Market value
of equity ($35M)
Total firm market
value ($100M)
TOTAL VALUE PRINCIPLE:
MODIGLIANI AND MILLER
Market value
of debt ($35M)
Market value
of equity ($65M)
Total firm market
value ($100M)
Total market value is not altered by the capital structure (the total size
of the pies are the same).
M&M assume an absence of taxes and market imperfections.
Investors can substitute personal for corporate financial leverage.
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ARBITRAGE AND TOTAL MARKET
VALUE OF THE FIRM
Arbitrage -- Finding two assets that are essentially the same and
buying the cheaper and selling the more expensive.
Two firms that are alike in every respect
EXCEPT capital structure MUST have the same
market value.
Otherwise, arbitrage is possible.
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ARBITRAGE EXAMPLE
Consider two firms that are identical in
every respect EXCEPT:
Company NL -- no financial leverage
Company L -- $30,000 of 12% debt
Market value of debt for Company L equals its par
value
Required return on equity
- Company NL is 15%
- Company L is 16%
NOI for each firm is $10,000
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Earnings available to common shareholders = E = O I
= Rs 10,000 - 0
= Rs 10,000
Market value of equity = E / k
e
= Rs 10,000 / .15
= Rs 66,667
Total market value = Rs 66,667 + 0
= Rs 66,667
Overall capitalization rate = 15%
Debt-to-equity ratio = 0
ARBITRAGE EXAMPLE: COMPANY NL
Valuation of Company NL
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ARBITRAGE EXAMPLE: COMPANY L
Earnings available to common shareholders = E = O I
= Rs10,000 Rs 3,600
= Rs6,400
Market value of equity = E / k
e
= Rs 6,400 / .16
= Rs40,000
Total market value = Rs 40,000 + Rs 30,000
= Rs 70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
Valuation of Company L
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COMPLETING AN ARBITRAGE TRANSACTION
Assume that you own 1% of the stock of Company L
(equity value = Rs 400)
You should:
1. Sell the stock in Company L for Rs 400
2. Borrow Rs 300 at 12% interest (equals 1% of debt for Company L)
3. Buy 1% of the stock in Company NL for Rs 666.67. This leaves you
with Rs 33.33 for other investments (Rs 400 + Rs 300 Rs 666.67)
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Original return on investment in Company L
Rs 400 x 16% = Rs 64
Return on investment after the transaction
Rs 666.67 x 16% = Rs 100 return on Company NL
Rs 300 x 12% = Rs 36 interest paid
Rs 64 net return (Rs 100 Rs 36) AND Rs 33.33 left over
This reduces the required net investment to Rs 366.67 to earn Rs 64
COMPLETING AN ARBITRAGE TRANSACTION
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SUMMARY OF THE ARBITRAGE TRANSACTION
The investor uses personal rather than corporate financial
leverage.
The equity share price in Company NL rises based on
increased share demand.
The equity share price in Company L falls based on selling
pressures.
Arbitrage continues until total firm values are identical for
companies NL and L.
Therefore, all capital structures are equally as acceptable.
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EFFECTS OF CORPORATE TAXES
Consider two identical firms EXCEPT:
Company ND -- no debt, 16% required return
Company D -- $5,000 of 12% debt
Corporate tax rate is 40% for each company
NOI for each firm is $10,000
The judicious use of financial leverage (i.e.,
debt) provides a favorable impact on a
companys total valuation
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Earnings available to common shareholders = E = O- I
= Rs 2,000 Rs 0
= Rs 2,000
Tax Rate (T) = 40%
Income available to common shareholders = EACS (1 - T)
= Rs 2,000 (1 - .4)
= Rs 1,200
Total income available to all security holders = EAT + I
= Rs 1,200 + 0
= Rs 1,200
CORPORATE TAX EXAMPLE: COMPANY ND
Valuation of Company ND (having no debt)
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Earnings available to common shareholders = E = O- I
= Rs 2,000 Rs 600
= Rs 1,400
Tax Rate (T) = 40%
Income available to common shareholders = EACS (1 - T)
= Rs 1,400 (1 - .4)
= Rs 840
Total income available to all security holders = EAT + I
= Rs 840 + Rs 600
= Rs 1,440*
CORPORATE TAX EXAMPLE: COMPANY D
Valuation of Company D (having some debt)
* Rs 240 annual tax-shield benefit of debt (i.e., Rs 1,440 Rs 1,200)
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TAX-SHIELD BENEFITS
Tax Shield -- A tax-deductible expense. The expense
protects (shields) an equivalent amount of revenue from
being taxed by reducing taxable income.
Present value of tax-shield
benefits of debt
=
(r) (B) (t
c
)
r
= (B) (t
c
)
* Alternatively, $240 annual tax shield / .12 = Rs 2,000, where Rs 240 = Rs 600 Interest expense x .40 tax rate
=
(Rs 5,000) (.4) = Rs 2,000*
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VALUE OF THE LEVERED FIRM
Value of unlevered firm = Rs 1,200 / .16
(Company ND) = Rs 7,500*
Value of levered firm = Rs 7,500 + Rs 2,000
(Company D) = Rs 9,500
Value of Value of Present value of
levered = firm if + tax-shield benefits
firm unlevered of debt
* Assuming zero growth and 100% dividend payout
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SUMMARY OF CORPORATE TAX EFFECTS
The greater the amount of debt, the greater the tax-shield
benefits and the greater the value of the firm
The greater the financial leverage, the lower the cost of
capital of the firm.
The adjusted M&M proposition suggests an optimal strategy
is to take on the maximum amount of financial leverage.
This implies a capital structure of almost 100% debt! Yet, this
is not consistent with actual behavior.
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gagan.is.sharma@gmail.com
THANKS FOR YOUR TIME
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