CHAPTE

CAPITAL STRUCTURE: THEORY AND POLICY

R 15
 LEARNING OBJECTIVES
2

 Understand the theories of the relationship between capital structure

and the value of the firm
 Highlight the differences between the Modigliani-Miller view and
the traditional view on the relationship between capital
 structure and the cost of capital and the value of the firm
 Focus on the interest tax shield advantage of debt as well as its
disadvantage in terms of costs of financial distress
 Explain the impact of agency costs on capital structure
 Discuss the information asymmetry and the pecking order theory of
capital structure
 Study the determinants of capital structure in practice
 INTRODUCTION
3

 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:
4

 Net operating income (NOI) approach.

 Traditional approach and Net income (NI) approach.
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal taxes.
 Trade-off theory: costs and benefits of leverage.
 Net Income (NI) Approach
5

 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 debt.
This approach has no basis in
reality; the optimum capital
structure would be 100 per
cent debt financing under NI
approach. The effect of leverage on the cost of
capital under NI approach
 Traditional Approach
6

 The traditional approach

argues that moderate degree Cost
of debt can lower the firm’s
ke
overall cost of capital and
thereby, increase the firm
value. The initial increase in ko

the cost of equity is more than

offset by the lower cost of kd
debt. But as debt increases,
shareholders perceive higher
risk and the cost of equity Debt

rises until a point is reached

at which the advantage of
lower cost of debt is more
than offset by more expensive
equity.
 The traditional theory on the relationship
between capital structure and the firm value
7 has three stages:
 Firststage: Increasing value
 Second stage: Optimum value
 Third stage: Declining value
 Criticism of the Traditional View
8

 The contention of the traditional theory, that moderate

amount of debt in ‘sound’ firms does not really add very
much to the ‘riskiness’ of the shares, is not defensible.

 There does not exist sufficient justification for the

assumption that investors’ perception about risk of
leverage is different at different levels of leverage.
9

IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES
 MM Approach Without Tax:
10 Proposition I
 MM’s Proposition I is
that, for firms in the same
risk class, the total market
value is independent of
the debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to that
risk class.
 MM’s Proposition I: Key
11
Assumptions
 Perfect capital markets
 Homogeneous risk classes
 Risk
 No taxes
 Full payout
 The cost of capital under MM
12
proposition I
 Net Operating Income (NOI)
13
Approach
 According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firm’s capital structure. In the
absence of taxes, an individual holding all the debt
and equity securities will receive the same cash
flows regardless of the capital structure and
therefore, value of the company is the same.
 MM’s approach is a net operating income
approach.
 Arbitrage Process
14

 Suppose two identical firms, except for their capital structures,

have different market values. In this situation, 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.

 On the basis of the arbitrage process, MM conclude that the

market value of a firm is not affected by leverage. Thus, the
financing (or capital structure) decision is irrelevant. It does not
help in creating any wealth for shareholders. Hence one capital
structure is as much desirable (or undesirable) as the other.
 MM’s Proposition II
15

 Financial leverage causes two opposing effects: it increases

the shareholders’ return but it also increases their financial
risk. Shareholders will increase the required rate of return
(i.e., the cost of equity) on their investment to compensate for
the financial risk. The higher the financial risk, the higher the
shareholders’ required rate of return or the cost of equity.
 The cost of equity for a levered firm should be higher than the
opportunity cost of capital, ka; that is, the levered firm’s ke >
ka. It should be equal to constant ka, plus a financial risk
premium.
 Cont…
16

 To determine the levered

firm's cost of equity, ke:

Cost of equity under the MM

 Criticism of the MM Hypothesis
17

 Lending and borrowing rates discrepancy

 Non-substitutability of personal and corporate
leverages
 Transaction costs
 Institutional restrictions
 Existence of corporate tax
 18

RELEVANCE OF CAPITAL
STRUCTURE:
THE MM HYPOTHESIS UNDER
CORPORATE TAXES
19

 MM show that the value of the firm will increase

with debt due to the deductibility of interest
charges for tax computation, and the value of the
levered firm will be higher than of the unlevered
firm.
Example: Debt Advantage: Interest
Tax Shields
20

 Suppose two firms L and U are identical in all respects except that firm L
is levered and firm U is unlevered. Firm U is an all-equity financed firm
while firm L employs equity and Rs 5,000 debt at 10 per cent rate of
interest. Both firms have an expected earning before interest and taxes (or
net operating income) of Rs 2,500, pay corporate tax at 50 per cent and
distribute 100 per cent earnings as dividends to shareholders.
21

 You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered
firm L’s investors are ahead of the unlevered firm U’s investors by Rs 250.
You may also note that the tax liability of the levered firm L is Rs 250 less
than the tax liability of the unlevered firm U. For firm L the tax savings
has occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5 ×
(0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,
 Value of Interest Tax Shield
22

 Interest tax shield is a cash inflow to the firm and therefore, it is

valuable.
 The cash flows arising on account of interest tax shield are less
risky than the firm’s operating income that is subject to business
risk. Interest tax shield depends on the corporate tax rate and the
firm’s ability to earn enough profit to cover the interest payments.
 The corporate tax rates do not change very frequently.
 Under the assumption of permanent debt, the present value of the
present value of interest tax shield can be determined as follows:
 Value of the Levered Firm
23
 Value of the levered firm
24
 Implications of the MM
Hypothesis with
25
Corporate Taxes
 The MM’s “tax-corrected” view suggests that, because of the
tax deductibility of interest charges, a firm can increase its
value with leverage. Thus, the optimum capital structure is
reached when the firm employs almost 100 per cent debt.

 In practice, firms do not employ large amounts of debt, nor

are lenders ready to lend beyond certain limits, which they
decide.
 Why do companies not employ
extreme level of debt in practice?
26

 First,we need to consider the impact of both corporate

and personal taxes for corporate borrowing. Personal
income tax may offset the advantage of the interest tax
shield.

 Second, borrowing may involve extra costs (in addition

to contractual interest cost)—costs of financial distress—
that may also offset the advantage of the interest shield.
FINANCIAL LEVERAGE AND
CORPORATE AND PERSONAL
TAXES
27
Companies everywhere pay corporate tax on their earnings. Hence,
the earnings available to investors are reduced by the corporate tax.
 Further, investors are required to pay personal taxes on the income
earned by them.
 Therefore, from investors’ point of view, the effect of taxes will
include both corporate and personal taxes.
 A firm should thus aim at minimizing the total taxes (both
corporate and personal) to investors while deciding about
borrowing.
 How do personal income taxes change investors’ return and value?
 It depends on the corporate tax rate and the difference in the personal
income tax rates of investors.
 Limits to Borrowings
28

 The attractiveness of borrowing depends on corporate tax rate, personal tax rate
on interest income and personal tax rate on equity income.

 The advantage of borrowing reduces when corporate tax rate decreases, or when
the personal tax rate on interest income increases, or when the personal tax rate
on equity income decreases.

 When will a firm stop borrowing?

 A firm will stop borrowing when (1 – Tpd) becomes equal to (1 – Tpe) (1 – T).
Thus, the net tax advantage of debt or the interest tax shield after personal taxes
is given by the following:
Corporate and Personal Tax Rates
in India
29

 In India, investors are required to pay tax at a

marginal rate, which can be as high as 30 per cent.
 Dividends in the hands of shareholders are tax-
exempt.
 Capital gains on shares are treated favourably.
 In India, companies are required to pay dividend tax
at 15 per cent (as in 2010) on the amount distributed
as dividend.
30

Combined Income of Investors:

Unequal Personal Tax Rates
 Miller’s Model
31

 To establish an optimum capital structure both corporate and personal

taxes paid on operating income should be minimised. The personal tax
rate is difficult to determine because of the differing tax status of
investors, and that capital gains are only taxed when shares are sold.

 Merton miller proposed that the original MM proposition I holds in a

world with both corporate and personal taxes because he assumes the
personal tax rate on equity income is zero. Companies will issue debt up
to a point at which the tax bracket of the marginal bondholder just equals
the corporate tax rate. At this point, there will be no net tax advantage to
companies from issuing additional debt.

 It is now widely accepted that the effect of personal taxes is to lower the
estimate of the interest tax shield.
 Miller’s Model
32

After-tax earnings of Unlevered Firm:

T
X  X (1  T )(1  Te )
Value of Unlevered Firm:
X (1  T )(1  Te )
Vu 
ku
After-tax earnings of Levered Firm:
T
X  ( X  kd D )(1  T )(1  Te )  kd D (1  Td )
 X (1  T )(1  Te )  kd D(1  Td )  kd D(1  Td )(1  Te )
Value of Levered Firm:
X (1  T )(1  Te ) kd D  (1  Td )  (1  T )(1  Te ) 
Vl  
ku (1  Te ) kd (1  Tb )
 (1  T )(1  Te ) 
 Vu  D 1  
 (1  Tb ) 
 Aggregate supply and demand for
33
borrowing
 34

THE TRADE-OFF THEORY: COSTS OF

FINANCIAL DISTRESS AND AGENCY
COSTS
 Financial Distress
35

 Financial distress arises when a firm is not able to meet its

obligations to debt-holders.
 For a given level of debt, financial distress occurs because
of the business (operating) risk . with higher business risk,
the probability of financial distress becomes greater.
Determinants of business risk are:
 Operating leverage (fixed and variable costs)
 Cyclical variations
 Intensity of competition
 Price fluctuations
 Firm size and diversification
 Stages in the industry life cycle
 Costs of Financial Distress
36

 Financial distress may ultimately force a company

to insolvency. Direct costs of financial distress
include costs of insolvency.

 Financial distress, with or without insolvency, also

has many indirect costs. These costs relate to the
actions of employees, managers, customers,
suppliers and shareholders.
 Cont…
37
 Value of levered firm under
corporate
38
taxes and financial distress

With more and more debt, the costs of financial distress increases and
therefore, the tax benefit shrinks. The optimum point is reached when
the marginal present values of the tax benefit and the financial distress
cost are equal. The value of the firm is maximum at this point.
 Agency Costs
39

 In practice, there may exist a conflict of interest among

shareholders, debt holders and management.
 These conflicts give rise to agency problems, which
involve agency costs.
 Agency costs have their influence on a firm’s capital
structure.
 Shareholders–Debt-holders conflict

 Shareholders–Managers conflict

 Monitoring and agency costs

PECKING ORDER THEORY
40

 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.
 The pecking order theory is able to explain the negative inverse
relationship between profitability and debt ratio within an industry.
 However, it does not fully explain the capital structure differences
between industries.
 Implications:
41

 Internal equity may be better than external

equity.
 Financial slack is valuable.
 If external capital is required, debt is better.
CAPITAL STRUCTURE
PLANNING AND POLICY
42

 Theoretically, the financial manager should plan an

optimum capital structure for the company. The optimum
capital structure is one that maximizes the market value
of the firm.
 The capital structure should be planned generally,
keeping in view the interests of the equity shareholders
and the financial requirements of a company.
 While developing an appropriate capital structure for its
company, the financial manager should inter alia aim at
maximizing the long-term market price per share.
 Elements of Capital Structure
43

1. Capital mix
2. Maturity and priority
3. Terms and conditions
4. Currency
5. Financial innovations
6. Financial market segments
 Framework for Capital
Structure:
44
The FRICT Analysis
 Flexibility
 Risk
 Income
 Control
 Timing
 APPROACHES TO ESTABLISH
TARGET CAPITAL STRUCTURE
45

1. EBIT—EPS approach for analyzing the

impact of debt on EPS.
2. Valuation approach for determining the impact
of debt on the shareholders’ value.
3. Cash flow approach for analyzing the firm’s
ability to service debt.
 EBIT-EPS Analysis
46

 The EBIT-EPS analysis is a first step in deciding about a firm’s

capital structure.
 It suffers from certain limitations and does not provide
unambiguous guide in determining the level of debt in practice.
 The major shortcomings of the EPS as a financing-decision
criterion are:
 It is based on arbitrary accounting assumptions and does not reflect
the economic profits.
 It does not consider the time value of money.
 It ignores the variability about the expected value of EPS, and
hence, ignores risk.
 Valuation Approach
47

 The firm should employ debt to the point where the marginal
benefits and costs are equal.
 This will be the point of maximum value of the firm and
minimum weighted average cost of capital.
 The difficulty with the valuation framework is that managers
find it difficult to put into practice.
 The most desirable capital structure is the one that creates the
maximum value.
 Cash Flow Analysis
48

 Cash adequacy and solvency

 In determining a firm’s target capital structure, a key issue is
the firm’s ability to service its debt. The focus of this analysis is
also on the risk of cash insolvency—the probability of running
out of the cash—given a particular amount of debt in the
capital structure. This analysis is based on a thorough cash flow
analysis and not on rules of thumb based on various coverage
ratios.
 Components of cash flow analysis
 Operating cash flows
 Non-operating cash flows
 Financial cash flows
 Cash Flow Analysis Versus EBIT–
49
EPS Analysis
 Thecash flow analysis has the following advantages over
EBIT–EPS analysis:
1. It focuses on the liquidity and solvency of the firm over a long-
period of time, even encompassing adverse circumstances. Thus,
it evaluates the firm’s ability to meet fixed obligations.
2. It goes beyond the analysis of profit and loss statement and also
considers changes in the balance sheet items.
3. It identifies discretionary cash flows. The firm can thus prepare
an action plan to face adverse situations.
4. It provides a list of potential financial flows which can be utilized
under emergency.
5. It is a long-term dynamic analysis and does not remain confined
to a single period analysis.
 Practical Considerations in
50
Determining Capital Structure
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack
7. Sustainability and Feasibility
8. Control
9. Marketability and Timing
10. Issue Costs
11. Capacity of Raising Funds