CHAPTER 15

CAPITAL STRUCTURE: THEORY AND POLICY

LEARNING OBJECTIVES
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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
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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:
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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
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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
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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 initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

Cost ke

ko

kd

Debt

The traditional theory on the relationship between capital structure and the firm value has three stages:
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First stage: Increasing value Second stage: Optimum value Third stage: Declining value

Criticism of the Traditional View
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The contention of the traditional theory, that moderate amount of debt in µsound¶ firms does not really add very much to the µriskiness¶ 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.

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IRRELEVANCE OF CAPITAL STRUCTURE:
NOI APPROACH AND THE MM HYPOTHESIS WITHOUT TAXES

MM Approach Without Tax: Proposition I
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MM¶s Proposition I is that, for firms in the same risk class, the total market value is independent of the debtequity 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 Assumptions
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Perfect capital markets Homogeneous risk classes Risk No taxes Full payout

The cost of capital under MM proposition I
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Net Operating Income (NOI) Approach
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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
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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
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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«
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To determine the levered firm's cost of equity, ke:

Cost of equity under the MM

Criticism of the MM Hypothesis
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Lending and borrowing rates discrepancy Non-substitutability of personal and corporate leverages Transaction costs Institutional restrictions Existence of corporate tax

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RELEVANCE OF CAPITAL STRUCTURE:
THE MM HYPOTHESIS UNDER CORPORATE TAXES

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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
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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.

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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
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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
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Value of the levered firm
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Implications of the MM Hypothesis with Corporate Taxes
The MM¶s ³tax-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?
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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)²costs of financial distress² that may also offset the advantage of the interest shield.

FINANCIAL LEVERAGE AND CORPORATE AND PERSONAL TAXES
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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
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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
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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 taxexempt. 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.

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Combined Income of Investors: Unequal Personal Tax Rates

Miller·s Model
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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
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After-tax earnings of Unlevered Firm: X ! X (1  T )(1  Te ) Value of Unlevered Firm: Vu ! X (1  T )(1  Te ) ku
T

After-tax earnings of Levered Firm: X ! ( X  k d D )(1  T )(1  Te )  k d D (1  Td )
! X (1  T )(1  Te )  kd D (1  Td )  k d D (1  Td )(1  Te )
T

Value of Levered Firm: Vl ! X (1  T )(1  Te ) k d D ?(1  Td )  (1  T )(1  Te )A  ku (1  Te ) k d (1  Tb )

« (1  T )(1  Te ) » ! Vu  D ¬1  ¼ (1  Tb ) ½ ­

Aggregate supply and demand for borrowing
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THE TRADE-OFF THEORY: COSTS OF FINANCIAL DISTRESS AND AGENCY COSTS

Financial Distress
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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
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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«
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Value of levered firm under corporate 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
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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
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The ³pecking 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:
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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
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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
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1. 2. 3. 4. 5. 6.

Capital mix Maturity and priority Terms and conditions Currency Financial innovations Financial market segments

Framework for Capital Structure: The FRICT Analysis
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Flexibility Risk Income Control Timing

APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE
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1. 2. 3.

EBIT²EPS approach for analyzing the impact of debt on EPS. Valuation approach for determining the impact of debt on the shareholders¶ value. Cash flow approach for analyzing the firm¶s ability to service debt.

EBIT-EPS Analysis
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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
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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
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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 insolvency²the probability of running out of the cash²given 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. Operating cash flows Non-operating cash flows Financial cash flows

Components of cash flow analysis 
 

Cash Flow Analysis Versus EBIT²EPS Analysis
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The cash flow analysis has the following advantages over EBIT±EPS analysis:
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2.

3.

4.

5.

It focuses on the liquidity and solvency of the firm over a longperiod of time, even encompassing adverse circumstances. Thus, it evaluates the firm¶s ability to meet fixed obligations. It goes beyond the analysis of profit and loss statement and also considers changes in the balance sheet items. It identifies discretionary cash flows. The firm can thus prepare an action plan to face adverse situations. It provides a list of potential financial flows which can be utilized under emergency. It is a long-term dynamic analysis and does not remain confined to a single period analysis.

Practical Considerations in Determining Capital Structure
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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Assets Growth Opportunities Debt and Non-debt Tax Shields Financial Flexibility and Operating Strategy Loan Covenants Financial Slack Sustainability and Feasibility Control Marketability and Timing Issue Costs Capacity of Raising Funds