CAPITAL STRUCTURE

THEORY
CAPITAL STRUCTURE AND VALUE

‘Capital structure decision is one of the

key decisions that focuses on finding
the capital structure with the
objective of maximization of value of
the firm.
‘It is perhaps the key strategic
decision that has occupied much of
the time and attention of
academicians and managers alike
‘The issue revolves around the
question of an optimal capital
structure, if there is any
COMMON ASSUMPTIONS FOR
THE ANALYSIS

‘Following assumptions are required to

arrive at optimal capital structure
- To analyse effects of capital structure one
form of capital needs to be replaced with
another form
- Maximisation of value of the firm is
consistent with maximisation of
shareholders’ wealth
- Optimal capital structure is one that
minimises WACC
- Earning levels remain constant
TARGET CAPITAL STRUCTURE

‘Target capital structure is the debt

equity ratio deemed most appropriate
by the management.
‘Target capital structure is determined
by several factors like
• taxes,
• interest
-And practical issues like
• market practices,
• lenders’ perspectives and
• industry norms
NET INCOME APPROACH

Net Income (NI) approach

‘assumes that capitalisation of the firm is
based on the net income derived by
each supplier of capital discounted at
fixed rates irrespective of levels of debt
Interest i
Cost of Debt; rd = =
Market value of debt D
Earnings for equity shareholders EBIT- i
Cost of Equity; re = =
Market value of equity E
Earnings to all capital suppliers EBIT
WACC; r = =
Market value of the firm D+E
NET INCOME APPROACH

Scenario A Scenario B Scenario C

Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate
Equity, re 20% 20% 20%
Debt, rd 10% 10% 10%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

NET INCOME APPROACH

EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders
Market value of debt 100.00 500.00 900.00
(I/rd)
Market value of equity 2,450.00 2,250.00 2,050.00
(EBIT - I - Taxes)/re

Total Value of the firm 2,550.00 2,750.00 2,950.00

Overall capitalisation rate 19.61% 18.18% 16.95%

(r)

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Capital Structure - Theory
Graphical View NIA

C ost

ke, ko ke

ko
kd kd

D ebt
NET INCOME APPROACH

‘Net Income approach assumes that

capitalisation rates are constant and
increasing debt would reduce overall
capitalization rate (WACC) and
increase the value of the firm ‘Optimal
capital structure under net income
approach is 100% debt
E D
r = re + rd
E + D E + D
TRADITIONAL APPROACH

‘Traditional approach recognises the

advantage of debt only up to certain
level. Any increase in debt beyond a
point causes cost of equity to rise.
 TRADITIONAL APPROACH

‘ Initially the cost of capital for the firm will fall as

cheaper debt replaces expensive equity.
• Even though the cost of equity rises with increased
debt the advantages of debt would outweigh the
increased cost of equity.
• Beyond a certain level of leverage the cost of equity
starts rising disproportionately, more than offsetting
the advantage of debt, raising the overall cost of
capital for the firm.
• Since cost of capital falls initially and then starts rising
there exists a point where cost of capital would be
least.
• This point of least cost of capital would maximise the
value of the firm and is the optimal capital structure.

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Capital Structure - Theory
 TRADITIONAL APPROACH

Scenario A Scenario B Scenario C

Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate
Debt 10% 11% 12%
Equity 20% 20% 30%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 55.00 108.00

EBT 490.00 445.00 392.00

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Capital Structure - Theory
 TRADITIONAL APPROACH

EBT 490.00 445.00 392.00

Taxes Assumed no taxes

Earnings available to 490.00 445.00 392.00

shareholders (EAT)

Market value of debt 100.00 500.00 900.00

(I/rd)
Market value of Equity 2,450.00 2,225.00 1,307.00
(EAT/re)

Value of the Firm, V 2,550.00 2,725.00 2,207.00

Capitalisation rate, WACC 19.61% 18.35% 22.65%

(EBIT/V)

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Capital Structure - Theory
 Traditional Approach
With increasing level of C ost
debt the overall cost of
capital falls initially ke
because cost of debt is
less than the cost of ko
equity, thereafter it
rises because equity
holders expect greater
kd
returns due to
increasing perceived
risk from the debt
holders. D ebt
NET OPERATING INCOME
APPROACH

Net Operating Income (NOI)

approach
- assumes that value of the firm remains
constant because overall capitalisation rate
remains constant
‘Net operating income approach states
that value of the firm is determined by
the earning capacities of the assets and
not by how are they acquired.

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NET OPERATING INCOME
APPROACH
Scenario A Scenario B Scenario C

Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalization Rate
Debt 10% 10% 10%
Overall 20% 20% 20%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

NET OPERATING INCOME
APPROACH

EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders (EAT)

Market value of debt 100.00 500.00 900.00

(I/rd)
Market value of firm 2,500.00 2,500.00 2,500.00
(EBIT/r)

Value of equity (E) 2,400.00 2,000.00 1,600.00

Equity capitalisation rate 20.42% 22.50% 25.63%

(EAT/E)

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Capital Structure - Theory
NET OPERATING INCOME
APPROACH

‘Under net operating income approach

the cost of equity rises so as to
compensate the reduced cost of debt
keeping the overall capitalisation rate
constant.
re = r0 + (r0 - rd ) D E

Scenario A : re = 20 + (20 - 10) x 100/2400 = 20.42%

Scenario B : re = 20 + (20 - 10) x 500/2000 = 22.50%
Scenario C : re = 20 + (20 - 10) x 900/1600 = 25.63%

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Capital Structure - Theory
NET OPERATING INCOME APPROACH

Under net
operating income C ost
approach no ke
capital structure
is optimal,
alternatively all ko

capital structures kd
are optimal.
D ebt
MODIGLIANI AND MILLER (MM)
THEORY - WITHOUT TAXES

MM Proposition I without taxes

‘Capital structure is irrelevant.
‘The value of levered firm and
unlevered firm would be equal.
VU = VL

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Capital Structure - Theory
Key Assumptions
 Perfect capital market
 Homogeneous risk class
 No taxes
 No transaction cost
 Full payout
MODIGLIANI AND MILLER (MM)
THEORY - WITHOUT TAXES

MM’s Proposition II without taxes

‘With increasing leverage the cost of
equity rises exactly to offset the
advantage of reduced cost of debt ‘To
keep the value of the firm constant. ‘The
cost of equity for varying levels of debt
is given by:
r e = r0 + (r0 - r d ) D E
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Capital Structure - Theory
MODIGLIANI AND MILLER (MM)
THEORY - WITHOUT TAXES
MM’s Proposition states
that the firm’s value is C ost
independent of its capital ke
structure. With personal
leverage, shareholders
can receive exactly the
same return, with the
same risk, from a levered ko
firm and an unlevered
firm. Thus, they will sell kd
shares of the over-priced
firm and buy shares of
the under-priced firm
until the two values D ebt
equate. This is called M M 's P r o p o s i ti o n II
arbitrage.
MODIGLIANI AND MILLER (MM)
THEORY - WITHOUT TAXES

MM’s Proposition III without taxes

“the cut-off rate for investment
purposes will in all cases be WACC and
will be completely unaffected by the
type of security issued to finance the
investment”.
E D
WACC for levered firm = re + rd
E+D E+D
re = r0 + (r0 - rd ) D E

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Capital Structure - Theory
MODIGLIANI AND MILLER (MM)
THEORY - ARBITRAGE

‘MM Proposition of irrelevance of capital

structure is based on the principle of
arbitrage i.e. the discrepancy in
valuation of levered firm and unlevered
firm would be set right by investors by
selling the overvalued and buying the
undervalued asset

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Capital Structure - Theory
MODIGLIANI AND MILLER (MM)
THEORY - ARBITRAGE

Financial Data of Levered Firm, CODEQ and Unlevered Firm, ALLEQ

Figures in Rs.
ALLEQ CODEQ

EBIT 5,00,000 5,00,000

Interest @ 10% - 1,00,000

EBT 5,00,000 4,00,000

Taxes (Assumed no taxes) - -

EAT 5,00,000 4,00,000

Market value of debt - 10,00,000

Market value of equity, 25,00,000 20,00,000

capitalisation rate 20%
Value of the firm 25,00,000 30,00,000

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MODIGLIANI AND MILLER (MM)
THEORY - ARBITRAGE

Earnings to equity suppliers

Market value of the equity of ALLEQ =
r
Dividend 5,00,000
= = = Rs. 25,00,000
r 0.2
Earnings to equity suppliers
Market value of equity of CODEQ =
r
Dividend 4,00,000
= = = Rs. 20,00,000
r 0.2
Interest
Market value of debt of CODEQ =
rd
1,00,000
= = Rs.10,00,0 00
0.10

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Capital Structure - Theory
MODIGLIANI AND MILLER (MM)
THEORY - ARBITRAGE
‘ An investor owns 10% of CODEQ. Realising that
ALLEQ is going cheap, he decides to sell his holding
in CODEQ. He realises Rs. 2,00,000 (10% of the
market value he holds).
‘ In order to keep his risk profile identical to that of
CODEQ he borrows an amount equal to 10% of debt
of CODEQ.
‘ The cost of his borrowing is assumed identical to
that of CODEQ i.e. 10%.
‘ He borrows Rs. 1,00,000 (10% of the value of debt
of CODEQ).
‘ To keep his position same as before he acquires
10% of ALLEQ by investing Rs. 2,50,000 (10% of
market value of ALLEQ).

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Capital Structure - Theory
MODIGLIANI AND MILLER (MM)
THEORY - ARBITRAGE

Cash flow and returns for investor swapping position Rs. Swapping

position - Cash flow

Initial cash flow

Selling 10% of CODEQ +2,00,000
Borrowing +1,00,000
Investing 10% in ALLEQ - 2,50,000
Surplus (Deficit) cash + 50,000
If invest in If invest in
CODEQ ALLEQ

Returns
10% of shareholders’ fund 40,000 50,000
Less: Borrowing cost - 10,000
Net Income 40,000 40,000

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Assumptions and Limitations of
MM’s Theory of Irrelevance

‘Identical expectations of earnings

‘All earnings are distributed
‘No transaction cost
‘Free and instantaneous flow of
information
‘Absence of taxes
‘Replication of leverage in personal
capacity, the home made leverage

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Capital Structure - Theory
MM’s APPROACH WITH
CORPORATE TAXES

Financial Data of Levered and Unlevered Firms under Taxes

Rs.

ALLEQ CODEQ

EBIT 5,00,000 5,00,000

Interest @ 10% - 1,00,000

EBT 5,00,000 4,00,000

Taxes @ 40% 2,00,000 1,60,000

EAT 3,00,000 2,40,000

Earnings available to suppliers 3,00,000 3,40,000

of debt and equity

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Capital Structure - Theory
MM’s APPROACH WITH
CORPORATE TAXES

VL = VU + T x D
EBIT (1 T)
VU =
r0

VL = V U + Value of Tax Shield

EBIT x (1 T) T x D x rd
= +
r0 rd
EBIT (1 T)
= + TD
r0
MM’s APPROACH WITH
CORPORATE TAXES

‘MM Proposition II under taxes

recognises that with increasing debt
the cost of equity would rise though at
a lesser rate than what it would in the
absence of taxes

D
r e = r0 + (1 T )( r0 rd )
E

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Capital Structure - Theory
MM’s APPROACH WITH
CORPORATE TAXES

‘MM Proposition III under taxes

recognizes that with increasing debt
the cost of capital too would rise
though at a lesser rate than what it
would in the absence of taxes
E D
WACC = re + r d (1 - T )
L
D+E D+E
9 10
= 26 67 + 10 (1 - 0 4 )
19 19
= 15 79 %

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Capital Structure - Theory
MM’s APPROACH WITH
CORPORATE TAXES

‘ In the presence of corporate tax the optimal

capital structure would be 100% debt
according to MM propositions
M & M POSITION (with taxes) M & M POSITION (With Taxes)
VALUE OF THE FIRM CAPITALISATION RATES
Rates of
Value Return
VL re

PVTS=TxD
r0 r
VU
rd(1-T)

D/E D/E

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MM’s THEORY OF IRRELEVANCE

MMs Propositions - With and Without Corporate Taxes

Without Taxes With Taxes

Proposition I VL = VU VL = VU + PVTS
Value of the firm
VL = E + D VU = EBIT (1-T)/r0

Proposition II D D(1- T)
Cost of equity re =r0 +(r0 - rd ) re = r0 + (r0 - rd )
E E

Proposition III WACCU = WACCL = r0 WACCL = WACCU( 1 -

PVTS
)
D +E
Cost of capital D D E D(1 - T)
WACC;r = re + rd WACCL ;r = re + rd
E+D E+D E +D E+D

37
Capital Structure - Theory
MILLER’s MODEL

‘With personal taxes the value of the

tax shield declines by the amount of
personal taxes
‘Differential personal tax rates on
interest and dividend and capital gains
makes debt beneficial for the firm as
long as
(1 - td)>(1-T) (1-te) Net tax
advantage of debt = (1 - td) - (1 -
T) (1 - te)
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Capital Structure - Theory
MILLER’s MODEL

 Miller’s Model incorporates personal taxes to

determine the value of the firm and
substantiates the MM proposition with taxes
when personal taxes are equal on dividend
income and interest incomes.
Value of All Equity Firm
Cash flow to equity holders
=
Post tax cost of equity, r0 (1 - t e )
EBIT(1 - T)(1 - t e )
=
r0 (1 - t e )
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LEVERAGE AND FINANCIAL
DISTRESS

‘MMs and Miller propositions suggest

capital structure in favour of debt but
is not observed in practice.
‘Along with the advantage of tax shield
the debt also brings with it the cost of
financial distress and agency cost of
debt, which offset the tax advantages

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Capital Structure - Theory