Capital Structure Policy

CONTENTS
Capital structure theories
Practical considerations
Capital structure decision

Capital Structure Theories

Two types of theories:
Theories which emphasize Relevance of
capital structure:
Net Income theory
Traditional theory
Theories which emphasize Irrelevance of
capital structure:
Net Operating Income theory
Modgiliani-Miller theory

Key Relationships
Interest

Market Value of Debt

Cost of Debt

Market Value of Equity

Equity Earnings
Cost of Equity

Market Value of Firm Market Value of Debt Market Value of Equity

Operating Income
Cost of Capital

Operating Income Interest Equity Earnings

Cost of Capital WACC

Net Income Theory

Cost of debt kD and cost of equity kE
are not influenced by variations in D/E
ratio
The WACC decreases with increase in
the use of debt and vice versa
Hence the total value of firm increases
with the use of debt
So capital structure influences the
value of firm

NET INCOME APPROACH

According to this approach, rD and rE remain unchanged when D/E varies. The
constancy of rD and rE with respect to D/E means that rA declines as D/E increases.

Rates
of
return
rE

rA
rD

D/E

Traditional Position
Cost of debt remains more or less constant up to
a certain D/E ratio
Cost of equity remains more or less constant up
to a certain D/E ratio and rises sharply thereafter
Due to this behaviour of kD & kE the WACC (k)
shows the following pattern:
It decreases up to a certain D/E ratio
Remains almost constant for moderate increases
in D/E ratio thereafter
Rises when the D/E ratio increases further

TRADITIONAL POSITION

Rates
of
return

rE

rA
rD

D/E

Net Operating Income

Theory
The overall capitalisation rate (k) and the cost
of debt (kD ) remain constant for all D/E ratios
Market value of a firm depends only on its NOI
and business risk
Variations in leverage do not affect these
factors
Changes in D/E ratio only change the
distribution of total income and risk between
debt & equity without changing the total
income & risk themselves

NET OPERATING INCOME APPROACH

According to this approach the overall capitalisation rate (rA) and the cost of debt
(rD) remain constant for all degrees of leverage. Hence
rE = rA + (rA rD) (D/E)

Rates
of
return

rE

rA
rD

D/E

Net Operating Income

Theory
Only cost of equity (kE ) varies with
changes in leverage because
variations in leverage cause
variations in financial risk of the firm
The relationship between cost of
equity (kE ), cost of debtD(kD ) and
k E k(k)
(kis:- k D )
cost of capital

Modigliani Miller Hypothesis

Assumptions:
Perfect capital markets
Rational investors & managers
Homogeneous expectations
Equivalent risk classes
Absence of taxes
Personal leverage can be substituted
for corporate leverage

Modigliani Miller
Hypothesis
Proposition 1:

The value of a firm is independent of its

capital structure. It is equal to the expected
operating income divided by the discount
rate appropriate to the risk class of the firm.

O
V

V = Market value of firm, D = Market value

r

of debt, E = Market value of equity, O =

Expected operating income, r = Discount
rate applicable to the risk class

Modigliani Miller
Hypothesis
Proposition 2:

The cost of equity is a linear function of D/E ratio:

D
rE r (r - rD )
E
rE = Cost of equity or Expected return on equity
rD = Cost of debt or Expected return on debt
r = Expected return on assets of the firm
= Expected return on equity of an unlevered firm
= Cost of capital of an unlevered firm

MM Hypothesis: Argument
Arbitrage argument
Investments which provide the same
income and have the same risk must have
the same market price
If there is any price difference investors will
sell the higher priced investment and buy
the lower priced investment (in order to get
the same income at a lower cost)
This continues to happen until the market
prices are equal for both

Criticisms of MM Theory
Both firms & investors alike have to pay
taxes on their income
Bankruptcy costs do exist & are quite high
Agency costs exist due to the conflict of
interests between shareholders & managers,
and between shareholders & creditors
Information asymmetry: Managers have
more information than investors
Investors can not substitute personal
leverage for corporate leverage

MM Theory With Corporate

Taxes
O(1 - t)
Value of Unlevered firm:
VU

rU
VU = value of unlevered firm,
O = Operating income = EBIT, t =
Corporate tax rate,
rU = Cost of capital for unlevered firm
Value of Levered firm (VL ):
VL VU Tax Benefit of Debt

Tax Benefit of Debt Present Value of Tax Shields

VL VU t D

(Proposition 1)

t rD D
tD
rD

Implications of MM theory
The conclusions are based on several strong
assumptions which are not true in real life
Hence there is a strong possibility that the
capital structure does affect the value of firm
This means that for any firm there is possibly
an optimal capital structure at which the
value of the firm is maximized
So the financial manager can create
additional value for the investors by
attaining the optimal capital structure

Tradeoff Theory

Firms face two types of costs related to debt:

1. Bankruptcy costs, 2. Agency costs
Bankruptcy Costs:
Deterioration in the value of assets
Distress selling of assets at much lower prices
Legal & administrative costs
Deterioration in quality
Loss of talented employees & lack of
commitment adversely affecting sales, costs &
profits

Tradeoff Theory

Agency Costs:
Conflict between shareholders & managers
Conflict between shareholders & creditors
Due to the conflict No.2 they impose restrictive covenants
& monitor the firm
The restrictions cause loss of operational flexibility &
efficiency & loss of market value
Monitoring entails costs in the form of auditors
fees/expenses on credit rating/compliance costs
Additional agency costs of debt include high interest
rates charged to the firm
Together they give rise to agency costs of debt

Tradeoff Theory

According to Tradeoff theory:

Value of levered firm =

Value of unlevered firm + Tax advantage of

debt

- Present value of bankruptcy costs

- Present value of agency costs

When debt is increased up to a certain point tax
advantage of debt exceeds the costs of bankruptcy
& agency
Beyond that tax advantage is lower than these costs
There is an optimal D/E ratio at which the value of
the firm is maximised

TRADEOFF MODEL

Value of
the firm

Value of the firm considering

the tax advantage of debt

Financial distress costs and

agency costs
Value of the firm considering
the tax advantage and financ
distress and agency costs
Value of the
unlevered firm

D/E

Signaling Theory &

Pecking Order Hypothesis
Managers have more information than investors.
This is called asymmetric information.
Due to asymmetric information financing
decisions of the firm sends signals to the capital
markets
Issue of debt indicates that future prospects are
good whereas issue of equity indicates that
future prospects are not good and also that the
current share price overvalued
Financing by retained earnings does not send
ve signal

Signaling Theory &

Pecking Order Hypothesis
Hence firms follow a pecking order in their
financing choices in the order shown
below:
Internal finance: retained earnings
Secured debt
Unsecured debt
External equity
So there is no optimal capital structure

Theories & Industry Insights

Tradeoff theory explains well industry
differences in capital structure
Power generating cos. & oil refineries use
more debt
Software cos. have less debt
Tradeoff theory cannot explain the differences
in capital structure observed within an
industry
Pecking order theory explains the differences
in capital structure within an industry

Practical Considerations

Stability of sales
Tangibility of assets
Operating fixed costs
Growth opportunities
Profitability
Taxes
Control

Practical Considerations
Norms followed by banks & rating
agencies
Capital market conditions
Internal conditions of the firm
Maintaining financial flexibility
Attitude of management

Capital Structure Decision

EBIT-EPS analysis
ROI-ROE analysis

 EBIT-EPS Analysis:
Based on the relationship between EBIT & EPS

(EBIT - I)(1 - t)

Helps
two alternative
financing
EPS
in deciding between
(Assuming
No Preference
Dividend)
n
plans (D/E mix)
Decision is made with reference to the EBIT-EPS
indifference point
It is that level of EBIT at which EPS is same for both
financing plans
The financing plan should maximise the EPS for any
level of EBIT

 ROI-ROE Analysis:
Based on the relationship between ROI & ROE

D
ROE ROI (ROI - r)( ) (1 - t)
E

Helps in deciding between two alternative financing

Assuming
No Preference Dividend
plans
(D/E mix)
Decision is made with reference to the ROI-ROE
indifference point
It is that level of ROI at which ROE is same for both
financing plans
Purpose is to maximise ROE for any level of ROI

 3. The following information is collected

from Unique Industries Ltd:
EBIT
Rs. 400 million
Corporate tax rate
36 percent
Market value of debt
Rs. 600 million
Capitalisation rate for an unlevered firm
in the same risk class is 20 percent
Calculate the value of the co. as per MM
theory.

 4. Pioneer Enterprises Ltd. has an existing capital

structure consisting entirely of equity shares amounting
to Rs. 20 million of par value Rs. 10 each. The firm is
planning to raise Rs. 20 million of additional capital for
expanding its operations. There are two financing
alternatives:
Issue 2 million equity shares at par
Issue at 12% debentures at par

The tax rate is 50%.

At what EBIT level both plans would yield the same

EPS? Which financing plan should it use at EBIT levels
above & below this level?

 5. Alpha Products Ltd. which has an

investment requirement of Rs. 200 million
is considering two proposed capital
structures:
Capital Structure
D/E Ratio

1.00

The average cost of debt is constant

10%. However the ROI may fluctuate. The
tax rate is 50%. At what ROI both capital
structures would yield the same ROE?
Which capital structure should be used at
ROI above & below this level?

Minimum Suggested Study

Plan

Textbook: Prasanna Chandra

Vital:
Ch.19 (p477): All modules
Ch.20 (p510): Modules 20.1, 20.2

Desirable:
Ch.20: Modules 20.3 20.8

Homework
Textbook: Prasanna Chandra
All problems in Ch.19

THANK YOU