CAPITAL STRUCTURE:

THEORY AND POLICY

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Outline:-
• Meaning of capital structure
• Importance of designing of capital
structure
• Theories of capital structure

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 Definition of Capital Structure
• ―Capital structure is essentially concerned with how
the firm decides to divide its cash flows into two
broad components, a fixed component that is
earmarked to meet the obligations toward debt capital
and a residual component that belongs to equity
shareholders”-P. Chandra.

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 The importance of designing a proper
capital structure

• Value Maximization
• Cost Minimization
• Increase in Share Price
• Investment Opportunity

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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.

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 Capital Structure Theories:
6

 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.

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 Net Income (NI) Approach
7

• 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 The effect of leverage on the cost of
financing under NI capital under NI approach
approach.
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IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES

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 MM Approach Without Tax:
9 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.

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 MM’s Proposition I: Key
10 Assumptions
Perfect capital markets
Homogeneous risk classes
Risk
No taxes
Full payout

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 The cost of capital under MM
11 proposition I

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 Net Operating Income (NOI)
12 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.

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 Arbitrage Process
13

 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.

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 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 aMSfinancial
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risk premium.
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 Cont…
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• To determine the
levered firm's cost
of equity, ke:

Cost of equity under the MM

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 Criticism of the MM
16 Hypothesis
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.

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 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,

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 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:

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 Value of the Levered Firm
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 Value of the levered firm
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 Implications of the MM Hypothesis
with
24 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.

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 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)—costs of
financial distress—that may also offset the
advantage of the interest shield.

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 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.

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 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:

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 Corporate and Personal Tax
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Rates in India
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 favorably.
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

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 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
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 Miller’s Model
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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  
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 Aggregate supply and demand
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for borrowing

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 Traditional Approach
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• The traditional approach

argues that moderate Cost
degree of debt can lower
the firm’s overall cost of
ke

capital and thereby,

ko
increase the firm value.
The initial increase in the
cost of equity is more than kd
offset by the lower cost of
debt. But as debt
increases, shareholders Debt

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

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 Criticism of the Traditional
35 View
 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.

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 Thank You

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