Capital Structure Theories

29-04-2010
Dr. Mercia Selva Malar
 Capital Structure
 Capital structure refers to the mix or proportion of
different sources of finance (debt and equity) to
total capitalisation.
 Optimal capital structure: The firm should select
such a financing mix which maximises its value/
the shareholders’ wealth (or minimises its overall
cost of capital)
Elements of Capital
Structure
 Capital Mix
 Maturity and Priority
 Terms and Conditions
 Currency
 Financial Innovations
 Financial Market Segments
Elements of Capital
Structure
 Capital Mix: The mix of debt and equity
capital. Debt ratio, debt-service coverage
ratio and the funds flow statement are used
to analyse the capital mix.
Elements of Capital
Structure
 Maturity and Priority: Equity is the
most permanent. Among debt CP has
shortest maturity and public debt longest.
Capitalised debt, Secured debt, etc. are
available.
 Firms try to become risk neutral by
matching the maturity of assets and
liabilities.
Elements of Capital
Structure
 Terms and Conditions:
 On debt servicing
 On risk reduction
Elements of Capital
Structure
 Currency:
 Overseas Borrowings less costlier
 Conversion cost
Elements of Capital
Structure
 Financial Innovations:
 To circumvent restrictions

 Hybrid instruments, securitization, etc.

Elements of Capital
Structure
 Financial market segments
 Debt: Public debt or private debt

market
 Debt: Long term or short term

 Debt: Domestic, International, Euro

Framework of Capital
Structure
FRICT Analysis
 Flexibility – Within the debt capacity –
minimum cost, with delay or immediately for
profitable projects
 Risk – Excessive use of debt magnifies risk
 Income – Most advantageous to owners
 Control – Minimum risk of loss of control
 Timing – Feasible to implement at current and
future conditions of the capital market
 Capital Structure Theories
 Explains the theoretical relationship between
capital structure, overall cost of capital (ko)
and valuation (V).
 The four important theories are:

 Net Income Approach (NI)

 Net Operating Income Approach (NOI)

 Modigliani and Miller Approach (MM)

 Traditional Approach
 Net Income Approach (NI)
 Capital structure is relevant as it affects the ko
and V of the firm
 Core of the approach: As the ratio of less
expensive source of funds increases in the
capital structure, ko decreases and V of the firm
increases.
 With a judicious mix of debt and equity a firm
can evolve an optimum capital structure at
which ko would be the lowest and the V of the
firm highest and the market price per share the
maximum
Net Income Approach (NI)
Assumptions

 No corporate tax
 Cost of debt is less than cost of equity

 Use of debt does not change the risk perception of

investors
If the firm is using equity capital alone , the
composite cost of capital will be equal to Ke and
the value of the firm will be minimum.
Net operating Income
Approach (NOI)
 NOI approach is diametrically opposite
to the NI approach.
 Essence: Capital structure decision of a

corporate does not affect its cost of

capital and hence irrelevant
Net operating Income Approach
(NOI)
 The market value of the firm is ascertained
by capitalizing the net operating income at
the composite cost of capital (Ko) which
is considered to be constant
 V= EBIT
Ko
 S= V-B
 S= Value of equity, V= Total value of firm,
 B= Total value of debt
 Net operating Income Approach
(NOI) Argument
 An increase in the proportion of debt in the
capital structure would lead to an increase in
the financial risk to the equity holders. To
compensate for the increased risk, they would
require a higher rate of return (ke) on their
investment. As a result, the advantage of the
lower cost of debt would be neutralised by the
increase in the cost of equity.
Components of the cost of
debt
 Explicit
 Implicit

 Therefore the real cost of debt and

equity would be the same and there is

nothing like an optimum capital
structure
 Modigliani and Miller
Approach
 They concur with NOI
 Provide a behavioral justification for the

irrelevance of capital structure

 They maintain that the cost of capital and

the value of the firm do not change with the

change in leverage
MM Proposition I
 The firm’s market value is not
affected by capital structure; any
combination of debt and equity is
as good as any other
 Arbitrage Process
 Arbitrage or switching will take place to
enable investors to engage in the
personal or homemade leverage as
against the corporate leverage to restore
equilibrium in the market.
 Assumptions of MM I
 Perfect capital markets
 Characteristics:
1. Investors are free to buy and sell
securities
2. Investors can borrow without restrictions
at the same terms as firms do
3. Investors behave rationally
Assumptions of MM I
 Homogeneous risk classes
 Characteristics:
 Firms operate in similar business
conditions
 Firms have similar operating risk
Assumptions of MM I
 Risk: Operating risk is defined in
terms of the Net Operating Income
 No taxes
 Full payment: 100 per cent
dividend pay out
MM Proposition II
 Borrowing increase shareholder
return, but increases financial risk .
The increased financial risk via
increased cost of equity exactly
offsets the increased return; thus
leaving the position of
shareholders unchanged
Criticism of MM Hypothesis
 Lending and borrowing
discrepancy
 Non-sustainability of personal and
corporate leverages
 Transaction costs
 Institutional restrictions
 Existence of corporate tax
Traditional Approach