Capital Structure Theories

eBay, the world s online marketplace founded in 1995, providers an online platform for the sale of goods and services of individuals and businesses around the world. In 2003, 95 million users from more than 150 countries listed 941 million items on the site. eBay s global community of buyers and sellers grew by more than 33 million people during that year. It took eBay 8 years to reach $1 billion in annual revenue in 2002. just 1 year later, eBay s annual revenue doubled to $ 2.17 billion. To support this growth & expand eBay continues to make acquisitions & invest capital in technology infrastructure, marketing, product development etc. In its 2003 annual report, eBay announced that its capital expenditure were expected to total $315 million during 2004, in addition to the cost of the company s acquisitions. To fund such growth, eBay raised funds from operating activities and by issuing more than $700 million in common stocks during 2003. While eBay has been able to meet its capital needs primarily from operating activities and the issuance of common stock, other corporations rely more on issuance of long-term debt. Each method of raising capital has its unique costs & benefits.

Objective of the Firm

The objective of a firm should be directed towards the maximization of the firm s value. The capital structure or financial leverage decision should be examined from the point of its impact on the value of the firm.

Capital Structure Theories

Net Income (NI) approach. Net operating income (NOI) approach. Traditional approach. MM hypothesis.

Net Income (NI) Approach

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 introduction of more & more debt capital.

Example
Company Operating Income Interest Expenses Owner s Income Cost of Equity Cost of Debt Market Value of Equity Market Value of Debt Total Value of the Firm Overall Cost of Capital Alpha 100 0 100 10% NA 1000 Nil 1000 10% Beta 100 25 75 10% 5% 750 500 1250 8% Gamma 100 50 50 10% 5% 500 1000 1500 6.67%

The effect of leverage on the cost of capital under NI approach

Net Operating Income (NOI) Approach

According to NOI approach the value of the firm remains constant irrespective of its degree of leverage. The theory assumes that each firm has a predetermined capitalization rate. In case firm increases leverage by employing more debt, it becomes more riskier. The advantage of using cheaper debt financing will be offset by higher cost of equity due to its increased riskiness.

Example
Company Operating Income Interest Expenses Owner s Income Cost of Capital Cost of Debt Market Value of the Firm Market Value of Debt Market Value of Equity Cost of Equity Delta 200 0 200 10% NA 2000 Nil 2000 10% Sigma 200 50 150 10% 5% 2000 1000 1000 15% Omega 200 80 120 10% 5% 2000 1600 400 30%

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 firm can attain optimal capital structure by judicious use of leverage. The cost of debt remains constant upto a certain level of leverage and rises gradually thereafter. The cost of equity rises at a slow pace upto a certain degree of leverage and increases rapidly thereafter. The cost of capital initially declines due to moderate use of leverage and rises sharply thereafter.

Example
A firm is expecting a net operating income of $150,000 on a total investment of $1000,000. the cost of equity capital is 10%, if the firm has no debt. But it would increase to 10.56% when the firm substitute equity capital by issuing Debentures of $300,000. Further it would go up to 12.5%, when $600,000 debentures are issued. Assuming that $300,000 debentures can be issued at 6% interest rate where as $600,000 debentures are can be raised at 7% interest.

No Debt Net Operating Income Interest Payment Net Income Cost of Equity Mkt Value of Equity Mkt Value of Debt Value of Firm Avg. cost of Capital 1,50,000 Nil 1,50,000 10% 15,00,000 Nil 15,00,000 10%

6% Debt of Rs. 3,00,000 1,50,000 18,000 1,32,000 10.56% 12,50,000 3,00,000 15,50,000 9.7%

7% Debt of Rs. 6,00,000 1,50,000 42,000 1,08,000 12.5% 8,64,000 6,00,000 14,64,000 10.3%

What Debt-Equity Ratio Maximize the Value of the firm?

The value of the firm(V) = B + S Where, B= Mkt Value of Debt S = Mkt Value of Equity The firm should pick the debt-equity ratio that makes the Pie (the total Value) as big as possible. Why debt is required to maximize the value of the firm?

XYZ Ltd. has currently no debt in its capital structure. The firm is considering to issue debt to buyback some of its equity.
Current Asset Debt Equity (Net Worth) Interest Rate MV of Shares Share Outstanding $8000 Nil $8000 10% $20 400 Proposed $8000 $4000 $4000 10% $20 200

Current Capital Structure Recession RoA EBIT Interest Equity Earnings RoE EPS 5% $400 Nil $400 5% $1.00 Stable 15% $1200 Nil $1200 15% $3.00 Boom 25% $2000 Nil $2000 25% $5.00

Proposed Capital Structure Recession 5% $400 $400 Nil 0 0 Stable 15% $1200 $400 $800 20% $4.00 Boom 25% $2000 $400 $1600 40% $8.00

EBIT-EPS Analysis
Existing Capital structure = Equity Capital of Rs.10 million (FV = Rs.10 each) The company plans to raise additional capital of Rs.10 million for financing an expansion project. In this context the company is evaluation two alternative financing plans: (i) Issue equity share (ii) Issue debenture carrying 14% interest. Applicable tax rate is 50%. What will be the EPS under two alternative financing plans for two levels of EBIT say Rs.2 million and Rs.4 million.

Modigliani Miller Proposition

MM s Proposition: Key Assumptions Perfect capital markets. All investors have homogeneous expectations and belong to similar risk class. Securities are issued and traded in the market are infinite divisible. There are no transaction costs and taxes. All participants in the market are rational.

Proposition I
The market valuation of a firm is independent of its capital structure and is determined by capitalizing its expected return at the rate appropriate to its risk class. The value of the firm is computed by discounting the future stream of operating income. The average cost of capital is equal to the capitalization rate which is constant for a given firm.

Proposition I
M-M has convincing argument that a firm cannot change the total value of its outstanding securities by changing the proportion of capital structure. In other words the value of the firm is always the same under different capital structure.

Arbitrage Process
MM have cited the arbitrage process to support their proposition that the value of a levered firm cannot be higher than the value of an unlevered. Conversely the value of an unlevered firm cannot be higher than the value of a levered firm. The investors are able to replicate any combination of capital structure by substituting the corporate leverage with Home-made Leverage . Home made leverage refers to the personal borrowing made by the investors in the same ratio as a levered firm. Hence, corporate leverage is not something unique.

Example
Lambda Ltd. Total Capital Employed Equity Capital 5% Debenture Net Operating Income Interest Expenses Owners Earnings Equity Capitalization Rate 10,000 Nil 10,000 10% 100,000 100,000 Theta Ltd. 100,000 50,000 50,000 10,000 2500 7500 12.5%

Mr. Miller holds 10% equity of the Theta Ltd.

Critics
Risk Association Counter: Margin Trading Institutional Investors

XYZ Ltd. has currently no debt in its capital structure. The firm is considering to issue debt to buyback some of its equity.
Current Asset Debt Equity (Net Worth) Interest Rate MV of Shares Share Outstanding $8000 Nil $8000 10% $20 400 Proposed $8000 $4000 $4000 10% $20 200

Current Capital Structure Recession RoA EBIT Interest Equity Earnings RoE EPS 5% $400 Nil $400 5% $1.00 Stable 15% $1200 Nil $1200 15% $3.00 Boom 25% $2000 Nil $2000 25% $5.00

Proposed Capital Structure Recession 5% $400 $400 Nil 0 0 Stable 15% $1200 $400 $800 20% $4.00 Boom 25% $2000 $400 $1600 40% $8.00

Proposition II
The financial risk premium is a function of leverage applied. The cost of equity will be equal to the cost of capital in all equity firm. As the firm starts introducing cheaper debt in the capital structure to reduce cost of capital, the financial risk of the firm increases. Due to increase in the financial risk, the equity holders demand higher returns which push up the cost of equity. Thus, the benefit obtained by the use of cheaper debt is exactly offset due to the rise in the cost of equity.

Previous Example

 Real World Scenario: (i) Industry Standard (ii) Market condition Two unrealistic assumptions: (i) Taxes were ignored (ii) Bankruptcy costs and other agency costs were ignored.

Taxes in M-M Capital Structure

In the presence of corporate taxes, the value of the firm is positively related to debt. Both equity share holders & income tax authorities have claims on the firm s earnings. Value of pie is maximized for the capital structure paying the least taxes. Managers should choose capital structure that the income tax authorities hates the most.

X ltd. expects EBIT of Rs.10 lakh each year. Its entire earnings after tax is paid out as dividend. The firm is considering two alternative capital structure. Under Plan-I the company would have no debt in its capital structure. Under Plan-II the company would have Rs.40 lakh debt carries interest of 10%. The corporate tax rate is 35%

 Value of Tax Shield: tc Kd D

That is whatever the taxes that a firm would pay each year without debt, the firm will pay [tc Kd D] less with the debt.

PV of tax shield: [tc Kd D]/Kd Value of levered Firm: is the value of an all equity firm plus the present value of tax shield. M-M Proposition I (under Tax): Corporate leverage lower tax payments.

Example
Z Ltd is currently an unlevered firm. The company expects to generate $153.85 in EBIT In perpetuity. The corporate tax rate is 35% implying after tax earnings of $100. all earnings after tax are paid out as dividend. The firm is considering capital restructuring to allow $200 of debt. The cost of debt capital is 10%. Unlevered firm in the same industry have a cost of equity capital of 20%. What will be the net value of Z Ltd.

Bankruptcy Risk/ Bankruptcy Cost

Debt provides tax benefits but also put pressure of fixed payments. The ultimate distress is bankruptcy, where the ownership of the firm s assets is legally transferred to bondholders. The possibility of bankruptcy has a negative effect on the value of the firm. The cost associated with the bankruptcy that lower the value of the firm.

Indirect costs of Financial Distress

Loss of Customer Loss of suppliers Loss of employees Distressed sale of assets

Agency Costs: Selfish Strategy

Protective Covenants
Shareholders take insurance against their own selfish interest and frequently make agreements with bondholders in the hope of lower rates. These agreements called Protective Covenants . 1. Limitations are placed on the amount of dividends a company may pay. 2. The firm may not pledge any of its assets to other lender. 3. The firm may not merge with another firm. 4. The firm may not sell or lease its major assets without approval by the lender. 5. The firm may not issue additional long term debt.

PECKING ORDER THEORY

The pecking order theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information. The manner in which managers raise capital gives a signal of their belief in their firm s prospects to investors. This also implies that firms always use internal finance when available, and choose debt over new issue of equity when external financing is required.

PECKING ORDER THEORY of Financing

1. Retained earnings (no flotation costs) 2. Debt Financing (no dilution of equity holdings) 3. Preference Capital 4. Equity Financing (case of undervaluation when issue further equity). Signaling Theory:

Strategic Determinants of Capital Structure

Type of asset financed Nature of industry Degree of competition Product life cycle Financial policy of the firm Past & present capital structure Credit rating Exception: Microsoft Case

Capital structure ratios for selected U.S. nonfinancial firms (5 year Average)
Debt as a percentage of market value of equity and debt High Leverage Air Transport Building Construction Hotel and Lodging Paper mills Low Leverage Biological product Computers Drugs Electronic Packaged software 4.44 3.77 5.81 7.09 2.27 59.67 40.39 57.78 53.61

Capital structure ratios for selected Indian. nonfinancial firms (3 year Average 2004-2007)
Debt as a percentage of market value of equity and debt High Leverage Textile Construction Hotel and Tourism Health Services Low Leverage Mining Communication IT 26.83 23.08 9.09 80.00 56.52 50.00 50.00

[Debt/Debt+Equity] for selected industries in India in 2008

Industries Computer Software Media FMCG Automobile Telecom Drug &Pharma Cement Electricity Generation Steel Real Estate Electricity Distribution Air Transport [Debt/Debt+Equity] (%) 15 23 24 30 30 33 38 45 45 48 66 90

Asset Beta
The beta of the comparable firm is first unlevered by removing the effects of its financial leverage. The unlevered beta is often referred as the asset beta, because it reflects only the business risk of the assets. Then we need to adjust the leverage. Suppose a company has an equity beta of 1.5, a debt equity ratio is 0.4 and the corporate tax rate is 30%. What would the company s equity beta if companies debt equity ratio were 0.5 instead 0.4