Capital Structure

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) Maximization of shareholders wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company. Planning a capital structure is a highly psychological, complex and qualitative process. It involves balancing the shareholders expectations (risk & returns) and capital requirements of the firm.

Planning the Capital Structure Important Considerations

Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share. Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends. Risk: insolvency risk associated with high debt component.

Control: avoid dilution of management control, hence debt preferred to new equity shares.
Flexibility: altering capital structure without much costs & delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and principal.

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.

WACC
Weighted Average Cost of Capital Also called the hurdle rate

D = Market Value of Debt E = Market Value of Equity

V=D+E

Costs of Financing
Cost of Debt
YTM is a good estimate

Cost of Common Stock

Derived from current market data Beta
Cost has 2 factors
Business or Asset Risk

Financing or Leverage Risk (Leverage increases equity risk)

Example WACC
Equity Information
5,00,000 shares Rs 80 per share

Tax rate = 40% Debt Information

Rs10,00,000 Coupon rate = 10% YTM = 8% 20 years to maturity

Beta = 1.15
Market risk prem. = 9% Risk-free rate = 5%

Cost of equity?

kE = 0.05 + 1.15(0.09) = 0.1535 or 15.35% kD = 0.08 or 8%

Cost of debt?

Example WACC
Capital structure weights?
E = 5,00,000 shares (Rs 80/share) = Rs 4,00,00,000 D = Rs1,00,00,000 V=4+1= Rs 5,00,00,000 What is the WACC? WACC = kE (E/V) +kD (D/V) = 0.1535(4/5) + 0.08(1/5) = 0.1228+0.016 =0.1338 or 13.38%

Capital Structure Theories

ASSUMPTIONS

Firms use only two sources of funds equity & debt. No change in investment decisions of the firm, i.e. no change in total assets.

100 % dividend payout ratio, i.e. no retained earnings.

Business risk of firm is not affected by the financing mix. No corporate or personal taxation.

Investors expect future profitability of the firm.

Capital Structure Theories A) Net Income Approach (NI)

Cost

ke, ko

ke

kd

ko kd

As the proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces.

Debt

Capital Structure Theories B) Traditional Approach

Cost of capital (Ko) reduces initially.

Cost ke

At a point, it settles
But after this point, (Ko) increases, due to increase in the cost of equity. (Ke)
ko

kd

Debt

Capital Structure Theories C) Net Operating Income (NOI)

Cost ke

Cost of capital (Ko) is constant.

ko kd

As the proportion of debt increases, (Ke) increases.

No effect on total cost of capital (WACC)

Debt

Capital Structure Theories D) Modigliani Miller Model (MM)

MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm. Further, the MM model adds a behavioural justification in favour of the NOI approach (personal leverage) Assumptions
o

o o

o
o

Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible. Investors can borrow without restrictions at par with the firms. Investors are rational & informed of risk-return of all securities No corporate income tax, and no transaction costs. 100 % dividend payout ratio, i.e. no profits retention

Capital Structure Theories D) Modigliani Miller Model (MM)

MM Model proposition
o

Value of a firm is independent of the capital structure.

Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC).
Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT Expected WACC

Capital Structure Theories D) Modigliani Miller Model (MM)

MM Model proposition
o

As per MM, identical firms (except capital structure) will have the same level of earnings. As per MM approach, if market values of identical firms are different, arbitrage process will take place. In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.

Total Value Principle: Modigliani and Miller

Market value of debt (Rs35M) Market value of debt (Rs65M) Market value of equity (Rs35M) Total firm market value (Rs100M)

Market value of equity (Rs65M)

Total firm market value (Rs100M)

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.

M&M (Debt Policy Doesnt Matter)

Modigliani & Miller When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

M&M (Debt Policy Doesnt Matter)

Assumptions By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if:
Investors do not need choice, OR There are sufficient alternative securities

Capital structure does not affect cash flows e.g...

No taxes No bankruptcy costs No effect on management incentives

No Magic in Financial Leverage

MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio.

M&M Proposition II
Cost of equity is equal to the capitalisation rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalisation rate and cost of debt times the ratio of debt to equity Debt financing increases financial risk.
Cost of equity depends on business risk and financial risk.

Arbitrage and Total Market Value of the Firm

Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. Otherwise, arbitrage is possible. Arbitrage -- Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.

Arbitrage Example
Consider two firms that are identical in every respect EXCEPT:

Company NL -- no financial leverage Company L -- Rs30,000 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 Rs10,000

Arbitrage Example: Company NL

Valuation of Company NL
Earnings available to common shareholders Market value of equity =E =OI = Rs10,000 - Rs0 = Rs10,000 = E / ke = Rs10,000 / .15 = Rs66,667 = Rs66,667 + Rs0 = Rs66,667 = 15% =0

Total market value

Overall capitalization rate Debt-to-equity ratio

Arbitrage Example: Company L

Valuation of Company L
Earnings available to shareholders Market value of equity =E=OI = Rs10,000 - Rs3,600 = Rs6,400 = E / ke = Rs6,400 / .16 = Rs40,000 = Rs40,000 + Rs30,000 = Rs70,000 = 14.3% = .75

Total market value

Overall capitalization rate Debt-to-equity ratio

Completing an Arbitrage Transaction

Assume you own 1% of the stock of Company L (equity value = Rs400).
You should: 1. Sell the stock in Company L for Rs400. 2. Borrow Rs300 at 12% interest (equals 1% of debt for Company L).

3. Buy 1% of the stock in Company NL for Rs666.67. This leaves you with Rs33.33 for other investments (Rs400 + Rs300 - Rs666.67).

Completing an Arbitrage Transaction

Original return on investment in Company L Rs400 x 16% = Rs64 Return on investment after the transaction
Rs666.67

x 16% = Rs100 return on Company NL Rs300 x 12% = Rs36 interest paid Rs64 net return (Rs100 - Rs36) AND Rs33.33 left over. This reduces the required net investment to Rs366.67 to earn Rs64.

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.

Market Imperfections and Incentive Issues

Bankruptcy
Agency costs Debt and the incentive to manage efficiently Institutional restrictions Transaction costs

costs

Required Rate of Return on Equity with Bankruptcy

ke with bankruptcy costs

Required Rate of Return on Equity (ke)

ke with no leverage
ke without bankruptcy costs

Premium for financial risk Premium for business risk Risk-free rate

Rf

Financial Leverage (B / S)

Agency Costs
Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firms contractual agreements with creditors and shareholders.
Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions. Costs are borne by shareholders. Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.

Bankruptcy Costs, Agency Costs, and Taxes

Taxes, bankruptcy, and agency costs combined

Cost of Capital (%)

Minimum Cost of Capital Point

Net tax effect Optimal Financial Leverage

Financial Leverage (B/S)

Bankruptcy Costs, Agency Costs, and Taxes

Value of levered firm = Value of firm if unlevered + Present value of tax-shield benefits of debt - Present value of bankruptcy and agency costs

As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.