CAPITAL STRUCTURE THEORIES

 Net income (NI) approach.

 Net operating income (NOI) approach.

 Traditional approach and

 MM hypothesis with and without corporate tax.

2
 NET INCOME (NI) APPROACH
 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
3
NET INCOME (NI) APPROACH

4
 TRADITIONAL APPROACH
 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.
5
TRADITIONAL APPROACH

6
 THE TRADITIONAL THEORY: RELATIONSHIP
BETWEEN CAPITAL STRUCTURE AND THE FIRM
VALUE

 First stage: Increasing value

 Second stage: Optimum value

 Third stage: Declining value

7
 CRITICISM OF THE TRADITIONAL 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.

8
 MM APPROACH WITHOUT TAX

 MM’s proposition 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.

9
 MM APPROACH WITHOUT TAX
 Firm’s total Market Value (V) =EBIT/Ke
 Firm’s Market Value of Equity= S=V-D
 Firm’s leverage cost of equity:
Cost of Equity+(Cost of equity- Cost of Debt)

10
 MM APPROACH WITH CORPORATE TAX

 Value of unlevered firm (Vu):

( EBIT/Ko)(1-t)

o Value of levered firm (Vl):

Vl=Vu+tD

11
 NET OPERATING INCOME (NOI) 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.

12
 FINANCIAL DISTRESS

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

obligations to debt-holders.

13
 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

 AGENCY COSTS

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

14
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

 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.
 This implies that firms always use internal finance when available, and
choose debt over new issue of equity when external financing is
required.
 Implications:
 Internal equity may be better than external equity.
 Financial slack is valuable.
 If external capital is required, debt is better. 15
FACTORS DETERMINING THE 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 16
 MEANING OF FINANCIAL LEVERAGE

 The use of the fixed-charges sources of funds, such as debt and

17
preference capital along with the owners’ equity in the capital structure,
is described as financial leverage or gearing or trading on equity.
 The financial leverage employed by a company is intended to earn more
return on the fixed-charge funds than their costs.
 The surplus (or deficit) will increase (or decrease) the return on the
owners’ equity.
 The rate of return on the owners’ equity is levered above or below the
rate of return on total assets.
 DEGREE OF FINANCIAL LEVERAGE

 The degree of financial leverage (DFL) is defined as the percentage

18
change in EPS due to a given percentage change in EBIT:
 OPERATING LEVERAGE

 Operating leverage affects a

19
firm’s operating profit (EBIT).

 The degree of operating % Change in EBIT

DOL 
% Change in Sales
leverage (DOL) is defined as the
 EBIT/EBIT
percentage change in the DOL 
 Sales/Sales
earnings before interest and taxes
relative to a given percentage
change in sales.
COMBINING FINANCIAL AND OPERATING LEVERAGES

 Operating leverage affects a firm’s operating profit (EBIT), while

20
financial leverage affects profit after tax or the earnings per share.

 The degrees of operating and financial leverages is combined to

see the effect of total leverage on EPS associated with a given
change in sales.
 COMBINING FINANCIAL AND OPERATING
LEVERAGES
 The degree of combined leverage (DCL) is given by

21
the following equation:

% Change in EBIT % Change in EPS % Change in EPS

  
% Change in Sales % Change in EBIT % Change in Sales
 LONG-TERM FINANCE
 Ordinary shares provide ownership rights to investors.
 Debentures or bonds provide loan capital to the company, and
investors get the status of lenders.
 Loan capital is also directly available from the financial institutions
to the companies.
 Ordinary Shares–Features
 Claim on Income
 Claim on Assets
 Right to Control
 Voting Rights
 Pre-Emptive Rights
 Limited Liability
 REPORTING OF ORDINARY SHARES
Tata Motors' Share Capital as on 31 March 2008

24
 ORDINARY SHARES–PROS AND CONS
 Advantages
 Permanent Capital
 Borrowing Base
 Dividend Payment Discretion
 Disadvantages
 Cost
 Risk
 Earnings Dilution
 Ownership Dilution

25
 PUBLIC ISSUE OF EQUITY
 Public issue of equity means raising of share capital directly from
the public.

 As per the existing norms, a company with a track record is free to

determine the issue price for its shares.

26
 UNDERWRITING OF ISSUES
 It is legally obligatory to underwrite a public and a rights issue.
 In an underwriting, the underwriters—generally banks, financial
institution, brokers, etc.—guarantee to buy the shares if the issue
is not fully subscribed by the public.
 The agreement may provide for a firm buying by the
underwriters.
 The company has to pay an underwriting commission to the
underwriter for their services.

27
 PRIVATE PLACEMENT

 Private placement involves sale of shares (or other securities) by

the company to few selected investors, particularly the institutional
investors.

 Private placement has the following advantages:

 Size
 Cost
 Speed

28
 RIGHT ISSUE OF EQUITY SHARES

 Selling of Ordinary Shares to the existing shareholders of the

company.
 The shareholder has three options:
 (i) he exercises his rights,
 (ii) he sells his rights, or
 (iii) he does not exercise or sell his rights.

 He will lose under the third option.

29
 RIGHT SHARES – PROS AND CONS

 Advantages
1. Control is maintained
2. Less flotation cost
3. Issue more likely to be successful

 Disadvantages
1. Shareholders lose if fail to exercise their right
2. If shareholding concentrated in hands of FI

30
 PREFERENCE SHARES
 Similarity to Ordinary Shares:
1. Non payment of dividends does not force company to
insolvency.
2. Dividends are not deductible for tax purposes.
3. In some cases, it has no fixed maturity dates.
 Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Preference shareholders have claims on income and assets
prior to ordinary shareholders.
4. Usually do not have voting rights.
31
 PREFERENCE SHARES–FEATURES

1. Claims on Income and Assets

2. Fixed Dividend
3. Cumulative Dividend
4. Redemption
5. Sinking Fund
6. Call Feature
7. Participation Feature
8. Voting Rights
9. Convertibility
32
 PREFERENCE SHARES–PROS AND CONS

 Advantages:
 Risk less leverage advantage
 Dividend postponability
 Fixed dividend
 Limited Voting Rights
 Disadvantages:
 Non-deductibility of Dividends
 Commitment to pay dividends

33
 DEBENTURES

 A debenture is a long-term promissory note for raising loan

capital.
 The firm promises to pay interest and principal as stipulated.
 The purchasers of debentures are called debenture holders.
 An alternative form of debenture in India is a bond.
 Mostly public sector companies in India issue bonds.

34
 DEBENTURES–FEATURES

 Interest Rate
 Maturity
 Redemption
 Sinking Fund
 Buy-back (call) provisions
 Indenture
 Security
 Yield
 Claims on Assets and Income
35
 TYPES OF DEBENTURES

1. Non – Convertible Debentures

2. Fully – Convertible Debentures
3. Partly – Convertible Debentures

36
 DEBENTURES–PROS AND CONS

 Advantages:
 Less Costly
 No ownership Dilution
 Fixed payment of interest
 Reduced real obligation

 Disadvantages:
 Obligatory Payment
 Financial Risk
 Cash outflows
 Restricted Covenants 37
 TERM LOANS–FEATURES

 Maturity
 Direct Negotiations
 Security
 Restrictive Covenants
1. Asset related covenants
2. Liability related covenants
3. Cash flow related covenants
4. Control related covenants
 Convertibility
 Repayment Schedule 38