THE CAPITAL STRUCTURE THEORIES

Assumptions
In order to grasp the capital structure and the cost of capital controversy properly, we make the following assumptions:

1. Firms employ only two types of capital: debt and equity. 2. The total assets of the firm are given. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debt. 3. Investors have the same expectation about the future operating earnings for a given firm. 4. The firm had a policy of 100 per cent dividend pay out ratio. 5. The operating earnings of the firm are not expected to grow. 6. The businesses risk is assumed to be constant and independent of capital structure and financial risk.

Definitions:
The following basic definitions will be used: S = Market value of Equity shares D V = Market value of debt = Total market value of the firm, (S + D)

NOI = X = EBIT = Net Operating Income

R
NI

= Interest Charges (i.e., kd D).

= NOI R = Net Income when corporate taxes do not exist.

 The capitalization rates or costs associated with different earnings stream and the value of different securities can be defined as follows:
Cost of debt = kd =R/D Value of debt = D = R / kd Cost of equity= Ke = D1 / P + g = E / P + 0 = E / P {when D = E, g = rb = 0, since b = retention ratio is 0} where, D1 = dividend per share, E = earning per share, P = market price per share, and g = growth rate in dividend or earnings.

 Ke = E / P= E.N / P.N = = share holders earnings / S = NI / S {where N is the total number of equity shares} = (NOI R) / S = (X R) / S Or value of Equity =S = (X R) / Ke.

Weighted Average Cost of Capital (Ko).

ko = ke ( S /V) + kd (D /V) = {(X R) / S } (S/V) + (R/D) (D/V) = (X R)/V + R / V = (X R + R) / V = X/V i.e. the overall cost of capital is: ko = X / V = NOI / V Or value of the firm is V = NOI / ko

THE MODIGLIANI MILLER HYPOTHESIS

Modigliani and Miller (M M) argue that, in the absence of taxes, a firms market value and the cost of capital remain invariant to the capital structure changes. Assumptions: The securities are traded in a prefect capital market. Firms can be grouped into homogeneous risk class (i.e. firms belong to the same industry). The expected NOI is a random variable. Firms follow 100% pay out policy. No corporate taxes.

Proposition- I:
M-M argue that the two firms, identical in all respects except for their capital structures, can not command different market values or have different costs of capital. Their opinion is that if two identical firms, except for the degree of leverage, have different market values or the costs of capital, arbitrage (or switching) will take place to enable investors to engage in personal leverage to restore equilibrium in the market.

Illustration:
Assume X = Rs. 10,000, kd = 0.06, Su = Vu = Rs. 1,00,000, SL = Rs. 60,000, DL= 50,000, and VL = SL + DL = Rs. 1,10,000. If an investor holds 10 percent of L firms shares (i.e. = 0.10), would it pay to him to resort to arbitrage? His investment in L firm SL = (VL - DL), = 0.10 (60,000) = Rs. 6000. Return in firm = (X kd DL) = 0.10 (10,000 0.06 x 50,000) = Rs. (0.10x7000)=Rs. 700.

Arbitrage Process
Transaction Investment Return

Buy 10% of U firms shares

Borrow DL amount i.e. 0.1 (50,000) Net Investment Net Return

0.10(1,00,000) 0.10(1,000) =10,000 = 1,000 - 5,000 -.1(.06x50,000) = -300 __________ __________ 5,000
700

 Arbitrage would work in the opposite direction if Vu > VL by resorting to following arbitrage process.

Illustration: Assume X = Rs. 10,000, kd = 0.06, Su = Vu = Rs. 1,00,000, SL = Rs, 40,000, DL = Rs. 50,000 and VL = SL + DL = 90,000. If an investor holds 10 % of U firms shares ( = 0.10), how can he be benefited by arbitrage? His investment = Su = .1 (1,00,000) = Rs. 10,000 Return = X = .1 (10,000) = Rs. 1,000.

Arbitrage Process (When Vu > VL)

Transaction Buy 10% of L firm shares Buy 10% of L firms debt Investment 0.1(40,000) = 4000 0.1(50,000) = 5000 ___________ Rs9,000 Return 0.1(10,000 .6x50,000) =700 0.1(.06x50,000) =300 ___________ Rs1,000

Total Investment Total Return

THE M-M HYPOTHESIS AND CORPORATE TAXES

M-Ms argument that the value and the cost of capital of a firm remains constant with leverage will not hold good when corporate income taxes are assumed to exist. They revise their earlier opinion and recognize that the value of the firm will increase or the cost of capital will decrease with leverage due to the deductibility of interest charges for tax computation. The value of levered firm will be greater than the unlevered firm.

Assume two firms L-levered and U unlevered are having the following capital structure:
U firm Equity 20,000 Asset _______ 20,000 20,000 _______ 20,000

L firm
8% Debt Equity
Rs 10,000 Assets 10,000 _____ 20,000 Rs 20,000

_______ 20,000

If rate of return is same for both the firms and is equal to r=20%, following is the income statement ( Assume tax rate is 40%). U firm EBIT Less: interest Pretax income Tax 40% Net income to equity holders Total income to both debt holders and equity holders Interest tax shield 4,000 0 _______ 4,000 1,600 _______ 2,400 ________ 0+2,400 =2,400 L firm 4,000 800 ______ 3,200 1280 _______ 1,920 _______ 800+1920 =2,720 320

 PV of tax shield = Rs320 / .08 = Rs4,000 PV of U-firm, if ke = 10% Vu = Su = Rs2,400 / .10 = Rs24,000 PV of L-firm VL = Rs2400 /0.10 + Rs320 / .08 = Rs24,000 + Rs4000 = Rs28,000

Balance Sheet of U-Firm (Book Value)

Rs Equity 20,000 Asset value _____ 20,000 Rs 20,000 _____ 20,000

Balance Sheet of U-Firm (Market Value)

Rs Equity 24,000 Asset value _____ (PV of after tax 24,000 cash flow) Rs 24,000 _____ 24,000

Balance Sheet of L-Firm (Book Value)

Rs Debt Equity 10,000 Asset value 10,000 _____ 20,000 Rs 20,000 _____ 20,000

Balance Sheet of L-Firm (Market Value)

Rs
Debt Equity 10,000 18,000 Asset value (PV of after tax cash flow) Value of U firm (2400/.1) PV of Tax Shield (320/.08)

Rs

24,000 4,000 _____ 28,000

_____ 28,000

 When corporate taxes are incorporated, the after-tax earnings of the firm will be; Xt = X t (X kd D)= X tX + t kd D = (1-t)X + t kd D; -----(1) where, Xt = the after-tax earnings, t = corporate tax rate, and other variables as defined earlier.
When the firm does not employ debt (i.e. kd D = 0), the eq (1) becomes Xt = (1-t)X = Earning streams of shareholders of U firm. But if the firm employs debt capital, the earnings stream of the levered firms equity and debt holders will be more by t kd D (the tax savings).


1. 2.

The after-tax earnings of the firm,Xt is the sum of the two components:
An uncertain income stream, (1-t)X and, A certain tax saving of t kd D.

Thus, to determine VL, the uncertain stream (1-t)x is to be capitalized at Kou (or Ke) and the certain stream t kd D is to be discounted by a lower rate kd. Thus, the value of the levered firm will be: VL = (1-t)x / Kou + t kd D / Kd = Vu +tD ---------(2) {Since (1-t)x / Kou = Vu}

When t is positive VL increases continuously with leverage. This is shown in the following figure:

Value

Vu

PV of interest tax shield

D /V

Why excessive debt can not be used?

No one would expect the formula to apply at extreme debt ratios. There are several reasons: First, its wrong to think of debt as fixed and perpetual; a firms ability to carry debt changes over time as profits and firm value fluctuate. Second, you cant use interest tax shields unless there will be future profits to shield and no firm can be absolutely sure of that. Finally and most importantly, firms that borrow incur other costsbankruptcy costs, for example offsetting the present value of the tax shield.

Cost of Financial Distress

Financial distress occurs when the firm finds it difficult to honour the obligations of creditors. The extreme form of financial distress is insolvency. Insolvency could be very expensive. It involves legal costs. The firm may have to sell its assets at distress prices. Financial distress reduces the value of the firm. Value of levered firm = value of unlevered firm + PV of tax shield PV of financial distress Thus, VL = Vu +TD PVFD

The following figure shows how the trade-off between the tax benefits and the costs of distress determines optimal capital structure.

Trade-off Theory of capital Structure

Financial managers often think of the firms debt-equity decision as a trade-off between interest tax shields and the costs of financial distress. This trade-off theory of capital structure recognizes that target debt ratios may vary from firm to firm. Companies with safe, tangible assets and plenty of taxable income to shield ought to have high target ratios. Unprofitable companies with risky, intangible assets ought to rely primarily on equity financing.

But what are the facts? Can the trade-off theory of capital structure explain how companies actually behave? The answer is yes and no. On the yes side, the trade-off theory successfully explains many industry differences in capital structure. High-tech growth companies, for example, whose assets are risky and mostly intangible, normally use relatively little debt. Airlines can and do borrow heavily because their assets are tangible and relatively safe. On the no side, there are a few things the trade-off theory cannot explain. It can not explain why some of the most successful companies thrive with little debt.

The Pecking Order of Financing Choices

Firms prefer internal finance They adapt their target dividend payout ratios. When internally generated cash flows > capital expenditures, the firms pays off debt or invests in marketable securities. When internally generated cash flows < capital expenditures, the firms draws down its cash balance or sells its marketable securities. If external finance is required, firms issue the debt first and then equity.

 The pecking order explains Why the most profitable firms generally borrow less not because they have low target debt ratios but because they dont need outside money. Less profitable firms issue debt because they do not have internal funds sufficient for their capital investment

Factors Affecting the capital Structure Decision

Factors that favour Borrowing. Factors that Discourage (Excessive) Borrowing.

Factors that favour Borrowing.

Primary factor: Corporate income tax
Debt is a device that allows firms to reduce their
corporate income tax because interest expenses are tax deductible whereas dividends and retained earnings are not.

Important Secondary Factors

Agency Cost of Equity: Retention of control Information asymmetry Structure of countrys financial system

When banks are state-owned and can be both lenders and shareholders of the same company, they are more likely to help that company avoid bankruptcy. This may explain why some large companies in countries such as France, Germany, Italy, and Japan usually have higher debt ratios than their counterparts in the United States or the United Kingdom.

Factors that Discourage (Excessive) Borrowing. Primary factor: Costs of financial distress

 Excessive debt increases the probability that the firm will experience financial distress. And the higher the probability of financial distress, the larger the present value of the expected costs associated with financial distress and the lower the value of the firm.

 Firms that face higher probability of financial distress include companies with pretax operating profits that are cyclical and volatile (firms with high
business risk such as high technology companies carry relatively less debt than, say, utility companies),

companies with a relatively large amount of intangible and illiquid assets (software companies have lower debt ratios than airline or utility companies), and companies with products that require after-sale service and repair (Car manufacturer generally have low debt ratios than a food company).

Important Secondary factors

Agency costs of debt Dividend policy
Excessive debt may constrain the firms ability to adopt a stable dividend policy.

Financial flexibility
Excessive debt may reduce the firms financial flexibility, that is, its ability to quickly seize a value-creating investment opportunity.

EPS calculation
X Ltd. Needs Rs 10 lakh for expansion. The expansion is expected to yield an annual EBIT of Rs160,000. In choosing a financial plan, the X Ltd. has an objective of maximising earnings per share. It is considering the possibility of issuing equity shares and raising debt of Rs 1,00,000, or Rs400,000 or Rs600,000. The current market price per share is Rs25 and is expected to drop to Rs 20 if the funds are borrowed in excess of Rs500,000. Funds can be borrowed at the rates indicated below: (a) up to Rs. 100,000 at 8% (b) over Rs 100,000 up to Rs500,000 at 12% (c ) over Rs500,000 at 18%. Assume a tax rate of 50 per cent. Determine the EPS for three financial alternatives.