Capital Structure

Theory and Policy

It is better if the company raises the fund required for
financing the new project by issue of debentures in place
of equity shares. This will push up the EPS as well as
Market Price per Share.

MP= EPS X P/E Ratio

Points of Indifference:
The EBIT level at which EPS remains the same
irrespective of the D?E mix(Break even of EBIT for
alternative Financial Plans).

(X-I1) (1-T)-PD = (X-I2) (I-T)

S1 S2
2
It helps in ascertaining the level of Operating Profit beyond
which the debt alternative is beneficial because of its
favourable effects on EPS.
*If expected EBIT is likely to be going high - Debt financing
*If expected EBIT is likely to be going low - Equity Financing

Financial Break Even Point

The level of EBIT at which a firm will be in a position to
satisfy all fixed Financial Charges i. e. Interest & Pref.
Dividend
I+ PD/(1-T)

So, the profit available for Equity Shareholders would be

ZERO at this point, and therefore EPS would also be
ZERO. Any increase beyond this point will result in
increase in EPS more than the proportionate to increase in
EBIT. 3
Optimum Capital Structure(To maintain Financial Stability)

(Market Value per Equity Share is Maximum)

Optimum Capital structure is expressed by the proportion of
D/E securities which maximise the value of a company’s share
in stock market.
Maximisation in the value of firm

EZRA SOLOMON: “ Optimum Leverage can be defined as that

mix of debt & equity which will maximise the market value of a
company.
Advantages:
 It minimises the company’s Cost of Capital which in turns
increases its ability to find new wealth creating investment
opportunities(Rate of Investment)
By increasing the firm’s opportunity to engage in future
wealth creating investments(Wealth)
4
Considerations:

4.Take advantage of favourable financial leverage

while raising funds

2. Income tax leverage

3. Avoid perceived high risk capital structure

(Human Sentiments)

5
 Capital Structure Theories

In order to achieve the goal of identifying an Optimum D/E

mix, it is necessary to be conversant with basic theories
underlying the capital structure of corporate enterprise.
Existence of Optimum Capital Structure is not accepted by
all. There exist extreme views:

View point I:- The financing or D/E mix has a major impact
on Shareholders wealth

View point II:- The decision about financial structure is

irrelevant as regards maximisation of Shareholders wealth
6
 Capital structure theories:
 Net income (NI) approach.
 Net operating income (NOI) approach.
 Modigiliani-Miller hypothesis with and
without corporate tax.
 Traditional Approach

7
Assumptions:

3.Only two types of capital(D & E) – No Pref. Shares

4.No Corporate Tax(Removed later)
5.100% earning is distributed as Dividend- No R.E.
6.Investment Decisions are constant- No change in
assets
7.Total financing remains the same- No change in
Capital volume
8.EBIT are not expected to grow
9.Business risk is constant- not dependant on capital
structure or, financing risk
10.All investors have the same probability distribution of
the future expected EBIT for a given firm
11.Firm is having a perpetual life.

8
 Net Income (NI) Approach
 Suggested by Durand David

 Supports View point I

 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. 9
Higher debt in capital structure will result in decline in the
overall/ weighted average cost of capital i.e. increase in the
value of firm, & consequently increase in EPS

Assumptions:
4.No Corporate Tax
5.Cost of Debt is less than cost of Equity
6.Debt doesn’t change the risk perception of the investors

V= S+B; S = NI/ Ke

V= Value of firm
S= Market value of Equity
B= Market value of Debt
NI= Earning available for Equity Shareholders
Ke= Equity Capitalisation rate 10
 Cost

ke, ko ke

ko
kd kd

Debt

11
Net Operating Income (NOI) Approach
 Opposite of NI 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.

12
Market Value of a firm is not affected by Capital Structure
changes.
Market Value of the firm is ascertained by Capitalising the
net operating income at the overall cost of capital, which is
considered to be constant.

EBIT
V =
K

(Value of equity would be the residual value)

S= V- B

13
Assumption:
2.K is constant for all degrees of D/E mix
3.Market capitalises the value of the firm as a whole
4.Use of debt increases the risk of equity shareholders. This
results in increase in equity capitalisation rate
5.No corporate tax

V is constant irrespective of leverage mix Market price

will also not change No existence of optimum capital

structure
Tax Leverage (Maximum possible debt content)
Ke = (EBIT-I) / (V-B) ; K= Kd (B/V) + Ke(S/V)

Increase in debt proportion Ke would also increase

Market Price remain unchanged 14
Cost
ke

ko

kd

Debt

15
 Modigiliani-Miller Approach

Similar to NOI Approach

Value of the firm is independent to its capital structure i.e.
Independence of total valuation and the cost of capital of
the firm from its capital structure
NOI is purely conceptual, Doesn’t provide operational
justification
Supports NOI and provides behavioural justifications

Prepositions:
2.K & V are constant for all level of D/E mix. Total market
value of the firm is given by capitalising the expected net
operating income by the rate appropriate for that risk class.

16
2. Ke = Capitalisation of pure equity stream plus a
premium for the financial risk
3. The cutoff rate for investment purpose is completely
independent of the way in which investment is financed

Assumptions:
2.Capital market is perfect
(i) Investors are free to bye and sell
(ii) Well informed market
(iii) Firm & investors can borrow on the same
terms
(iv) Rational behaviour of investors
(v) No transaction cost
8.Homogeneous risk class
9.All investors have the same expectations of the firm’s
EBIT
10.No R.E.
11.No Corporate Tax(removed later) 17
In brief, MM hypothesis based on the idea that no matter
how the capital structure is been divided among D & E and
other claims, there is a conservation of investment value.
Because the total investment depends upon its underlying
profitability and risk.
Arbitrage Process( An operational justification of MM Approach

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. 18
Cost

ko

Debt
MM's Proposition I

19
* Arbitrage restores equilibrium in value of securities
Consequence: Market price of the securities of the two
firms(exactly similar in all respect except in their capital
structure) can't for a long time remain different in different
markets.
Example:

Two firm A & B are identical in all respect except that the firm
A has 10% Rs. 50,000 debentures. Both the firm have the same
EBIT amounting to Rs. 10,000. The equity capitalisation rate of
the firm A is 16% while that firm B is 12.5%.
You are required to calculate the total market value of each of
the firms and explain with an example the working of the
arbitrage process
20
 Particulars Firm A Firm B
EBIT 10,000 10,000
Less: Interest 5,000 NIL
Earning available for equity share holders 5,000 10,000
Equity capitalization rate(Ke) 16% 12.5%
Total market value of equity(s)
Firm A : (5,000X100)/16 31,250
Firm B : 10,000X100)/12.5 80,000
Total market value of debt(B) 50,000 NIL
Total value of Firm(V)
81,250 80,000
Overall cost of capital(K): EBIT/V
Firm A : (10,000X100)/81,250 12.3%
Firm B: (10,000X100)/80,000 12.5%
D/E Ratio: (B/S)-
Firm A: 50,000/81,250 0.6
21
Working of the Arbitrage Process:
The example shows that firm A ‘s market value is higher
than the firm B due to the debt financing. According to
MM hypothesis this situation is not going to continue for a
longer time due to arbitrage process. The investors in firm
B can earn a higher return on their investment with a
lower financial risk. Hence, the investors in firm A will
start selling their shares and they buy shares in firm B.
This process continue till firm A’s shares decline in price
and firm B’s shares increase in price enough to make the
total value of two firms identical.

Note: The investors sell the shares of overvalued firm,

borrow additional fund( Personal leverage/Home made) on
personal account and invest in the undervalued firm in
order to obtain the same return on a smaller investment
outlay
22
Example:

Mr. X holds 10% shares of firm A. His share in the earning would
amount to rs.500(i.e. 10% of 5000.Mr. X will sale his holding in
firm A and invest money in firm B. Financial risk in firm b is less
than firm A, so to have the same degree of financial risk Mr. X
will borrow home made loan i.e. Rs. 5000(10% of 50000) at 10%
interest. The proportionate holding of Mr. X in firm B is now
amounting to Rs. 8000(10% of 80000) .What will be the position
of Mr. X in these varied situations.

23
A. Mr. X position in firm A with 10% equity holding:
(i) Investment outlays Rs. 3125(i.e. 10% of 31250)
(ii) Dividend income 10% of Rs. 5000 Rs. 500
Return on own fund = (500X100)/3125 16%

B. Mr. X position in firm B with 10% equity holding:

(i)Investment Outlay(Own fund Rs. 3000+Borrowed fund Rs. 5000) 8000
(ii)Dividend Income
Total income 10% of Rs 10000 1000
less: Interest payable on borrowed fund 500 500
Return on owned fund = (500X100) /3000 16.67%

C. Mr. X position in firm B, if he invests the total available funds:

(ii)Total investment outlay:
(owned fund Rs. 3125+borrowed fund Rs. 5000) 8125
(ii) Total Income( 1000X8125)/ 80000 1016
Less: Interset 500 516
Return on owned fund = (516X100)/3125 16.51

*Point of equilibrium
24
 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.
25
 MM Hypothesis with Corporate Tax
After-tax earnings of Unlevered Firm:
T
X  X (1  T )
Value of Unlevered Firm:
X (1  T )
Vu 
ku
After-tax earnings of Levered Firm:
T
X  ( X  k d D )(1  T )  k d D
 X (1  T )  Tk d D
Value of Levered Firm:
X (1  T ) T k d D
Vl  
ku kd
 Vu  TD

26
Miller’s Approach WITH Corporate and
Personal Taxes
 To establish an optimum capital structure both corporate
and personal taxes paid on operating income should be
minimised. The personal tax rate is difficult to determine
because of the differing tax status of investors, and that
capital gains are only taxed when shares are sold.
 Merton miller proposed that the original MM proposition I
holds in a world with both corporate and personal taxes
because he assumes the personal tax rate on equity income
is zero. Companies will issue debt up to a point at which
the tax bracket of the marginal bondholder just equals the
corporate tax rate. At this point, there will be no net tax
advantage to companies from issuing additional debt.
 It is now widely accepted that the effect of personal taxes
is to lower the estimate of the interest tax shield.
27
 Traditional Approach
 The traditional approach argues that moderate degree

of debt can lower the firm’s overall cost of capital and

thereby, increase the firm value. The initial increase in
the cost of equity is more than offset by the lower cost
of debt. But as debt increases, shareholders perceive
higher risk and the cost of equity rises until a point is
reached at which the advantage of lower cost of debt is
more than offset by more expensive equity.
28
Cost

ke

ko

kd

Debt

29
Financial Distress
 Financial distress arises when a firm is not able to
meet its obligations to debt-holders.
 For a given level of debt, financial distress occurs
because of the business (operating) risk . with higher
business risk, the probability of financial distress
becomes greater. Determinants of business risk are:
 Operating leverage (fixed and variable costs)
 Cyclical variations
 Intensity of competition
 Price fluctuations
 Firm size and diversification
 Stages in the industry life cycle

30
Consequences of Financial Distress
 Bankruptcy costs
Specific bankruptcy costs include legal and
administrative costs along with the sale of assets at
“distress” prices to meet creditor claims. Lenders
build into their required interest rate the expected
costs of bankruptcy which reduces the market value of
equity by a corresponding amount.
 Indirect costs
 Investing in risky projects.

 Reluctance to undertake profitable projects.

 Premature liquidation.

 Short-term orientation.

31
Debt Policy and Shareholders Conflicts
 Shareholder—manager conflicts
 Managers have a tendency to consume some of the firm’s

resources in the form of various perquisites.

 Managers have a tendency to become unduly risk averse

and shirk their responsibilities as they have no equity

interest or when their equity interest falls. They may be
passing up profitable opportunities.
 Shareholder—bondholder conflicts
 Shareholder value is created either by increasing the

value of the firm or by reducing the the value of its

bonds. Increasing the risk of the firm or issuing
substantial new debt are ways to redistribute wealth from
bondholders to shareholders. Shareholders do not like
excessive debt.
32
 Monitoring
 Outside investors will discount the prices they are
willing to pay for the firm’s securities realising that
managers may not operate in their best interests.
 Firms agree for monitoring and restrictive covenants
to assure the suppliers of capital that they will not
operate contrary to their interests.
 Agency Costs
 Agency costs are the costs of the monitoring and
control mechanisms.
 Agency costs of debt include the recognition of the
possibility of wealth expropriation by shareholders.
 Agency costs of equity include the incentive that
management has to expand the firm beyond the
point at which shareholder wealth is maximised.

33
 Optimum Capital Structure:
Trade-off Theory
 The optimum capital structure is a function of:
 Agency costs associated with debt
 The costs of financial distress
 Interest tax shield

 The value of a levered firm is:

Value of unlevered firm

+ PV of tax shield

– PV of financial distress
34
Features of an Appropriate Capital
Structure
 Return

 Risk

 Flexibility

 Capacity

 Control

35
 Approaches to Establish
Appropriate Capital Structure
 EBIT—EPS approach for analyzing the
impact of debt on EPS.

 Valuation approach for determining the

impact of debt on the shareholders’ value.

 Cash flow approach for analyzing the firm’s

ability to service debt.

36
Cash Flow Approach to Target Capital
Structure
 Cash adequacy and solvency
 In determining a firm’s target capital structure, a key
issue is the firm’s ability to service its debt. The focus of
this analysis is also on the risk of cash insolvency—the
probability of running out of the cash—given a
particular amount of debt in the capital structure. This
analysis is based on a thorough cash flow analysis and
not on rules of thumb based on various coverage ratios.
 Components of cash flow analysis
 Operating cash flows
 Non-operating cash flows
 Financial cash flows

37
 Reserve financial capacity
 Reduction in operating and financial flexibility is costly to
firms competing in charging product and factor markets.
Thus firms need to maintain reserve financial resources in
the form of unused debt capacity, large quantities of liquid
assets, excess lines of credit, access to a broad range of
fund sources.
 Focus of cash flow analysis
 Focus on liquidity and solvency
 Identifies discretionary cash flows
 Lists reserve financial flows
 Goes beyond financial statement analysis
 Relates debt policy to the firm value

38
 Cash Flow Analysis Versus EBIT–EPS
Analysis
 The cash flow analysis has the following advantages over
EBIT–EPS analysis:
 It focuses on the liquidity and solvency of the firm over a
long-period of time, even encompassing adverse
circumstances. Thus, it evaluates the firm’s ability to meet
fixed obligations.
 It goes beyond the analysis of profit and loss statement and
also considers changes in the balance sheet items.
 It identifies discretionary cash flows. The firm can thus
prepare an action plan to face adverse situations.
 It provides a list of potential financial flows which can be
utilized under emergency.
 It is a long-term dynamic analysis and does not remain
confined to a single period analysis.
39
Practical Considerations in Determining
Capital Structure
 Control
 Widely-held Companies
 Closely-held Companies
 Flexibility
 Loan Covenants
 Early Repay ability
 Reserve Capacity
 Marketability
 Market Conditions
 Flotation Costs
 Capacity of Raising Funds
 Agency Costs
40