FINANCIAL MANAGEMENT-II

TOPIC: CAPITAL STRUCTURE & FIRM VALUE

Theories of Capital Structure

The following approaches explain the relationship between capital structure,
cost of capital and the value of the firm.
1. Net Income (NI) approach
2. Net Operating Income (NOI) approach
3. Traditional approach
4. Modigliani-Miller (MM) approach

Assumptions
However, the following assumptions are made to understand the relationship
between financial leverage and cost of capital
1. There are only two kinds of funds used by a firm i. e. Debt and Equity
2. There is no income tax, corporate or personal tax
3. The firm has a policy of paying its earnings as dividends, i. e. a 100 percent
dividend pay-out ratio is assumed. There is no corporate dividend tax.
4. The firm’s total financing remains constant.
5. The firm has a perpetual life
6. The net operating income is not expected to grow or decline over time.
7. Without incurring transaction costs or floatation costs, a firm can change its
capital structure instantaneously.
8. Perfect capital markets.
1. Net Income Approach
According to this approach, capital structure decision is relevant to the value of
the firm.
The value of the firm on the basis of Net Income Approach can be ascertained
as follows:-
V=S+D
Where,
V = Value of the firm
S = Market Value of Equity
D = Market Value of Debt

Net Income approach was presented by Durand which suggests that the
value of the firm can be increased by decreasing the overall cost of capital
(WACC) through higher debt proportions.
Thus, the NI Approach suggests that with the increase in leverage (proportion
of debt), the WACC decreases and the value of firm increases and vice versa.
The significant conclusion of this approach is that it pleads for the firm to
employ as much debt as possible to maximise the value of the firm and
thereby increase the value per share.
Cost of Equity (Ke) and Cost of Debt (Kd) are assumed not to change with
leverage. As debt increases, it causes weighted average cost of capital to
decrease.
According to this approach, the cost of equity capital (K e) and the cost of debt
capital (Kd) remains unchanged when D/S, the degree of leverage varies. This
means that K0, the overall cost of capital, is measured as:

K0 = Kd (D/D+S) + Ke (S/D+S)
The overall cost of capital declines as D/S increases. This happens because
when D/S increases, Kd, which is lower than Ke, receives a higher weightage in
the calculation of K0.
Under NI approach, the value of the firm will be maximum at a point where
weighted average cost of capital is minimum. Thus, the theory suggests total or
maximum possible debt financing for minimising the cost of capital. The overall
cost of capital and MV of Equity under this approach is as follows:

Net Income
Market Value of Equity = --------------------------------------------
Equity Capitalization Rate (K e)

EBIT
Overall Cost of Capital = --------------------------------------------
Value of the Firm

The following is the graphical representation of net income approach. D/S, the
degree of leverage is plotted on the x-axis, K e, Kd, and Ko are plotted on the y-
axis.

From the graph it is clear that as D/S increases, Ko decreases because the
proportion of debt, the cheaper source of finance, increases in the capital
structure.
Illustration – 1
Two firms X and Y, which are identical in all respects except in the degree of
leverage employed by them. The following is the financial data for these firms:
Particulars Firm X Firm Y
Net Operating Income (0) Rs. 20,000 Rs. 20,000
Interest on Debt (I) Nil Rs. 5000
Equity Earnings (E) Rs. 20,000 Rs. 15000
Cost of Equity (Ke) 12% 12%
Cost of Debt (Kd) 10% 10%
Market Value of Equity Rs. 1,66,667 Rs. 1,25,000
(S = E/Ke)
Market Value of Debt Nil Rs. 50,000
(D = I/Kd)
Total Value of the Firm Rs. 1,66,667 Rs. 1,75,000
(V) = S + D

The overall cost of capital for Firm X:

10% x (0/1,66,667) + 12% x (1,66,667/1,66,667) = 12%
The overall cost of capital for Firm Y:
10% x (50,000/1,75,000) + 12% x (1,25,000/1,75,000) = 11.43%
Illustration-2
Rupa Company’s EBIT is Rs. 5,00,000. The company has 10%, 20 lakh
Debentures. The equity capitalization rate i. e. Ke is 16%.
Calculate:
(a) Market Value of Equity
(b) Value of the Firm
(c) Overall Cost of Capital

Solution:
Statement showing Value of the Firm
Particulars Amount (Rs.)
Net Operating Income (EBIT) 5,00,000
Less: Interest on Debentures (10% of Rs. 20,00,000) 2,00,000
Earnings available to Equity Shareholders (Net Income) 3,00,000
Equity Capitalisation Rate (Ke) 16%
Market Value of Equity (S) = NI/Ke = (3,00,000/16%) 18,75,000
Market Value of Debt (D) 20,00,000
Total Value of the Firm (V = S + D) 38,75,000

EBIT 5,00,000
Overall Cost of Capital = ----------------------------- = ---------------------------- =
12.90%
Value of the Firm 38,75,000
2. Net Operating Income (NOI) Approach

NOI means Earnings before Interest and Tax (EBIT). According to this approach,
capital structure decisions of the firm are irrelevant.

The net operating income position has been advocated eloquently by David
Durand. According to him, the market value of a firm depends on its net
operating income and business risk.

The change in the degree of leverage employed by a firm cannot change these
underlying factors. Changes take place in the distribution of income and risk
between debt and equity without affecting the total income and risk which
influence the market value of the firm. Hence, the degree of leverage cannot
influence the market value or the average cost of capital of the firm.

Any change in leverage will not lead to any change in the total value of the firm
and the market price of shares, as the overall cost of capital is independent of
the degree of leverage. As a result, the division between debt and equity is
irrelevant.

As per this approach, an increase in the use of debt which is apparently

cheaper is offset by an increase in the equity capitalisation rate. This happens
because equity investors seek higher compensation as they are opposed to
greater risk due to the existence of fixed return securities in the capital
structure.

According to the net operating income approach, the overall capitalisation rate
and the cost of debt remain constant for all degrees of leverage. Therefore, in
the following equation, Ko and Kd are constant for all degrees of leverage.

K0 = Kd x (D/D+S) + Ke x (S/D+S)
Therefore, the cost of equity can be expressed as:

Ke = K0 + (K0 – Kd) x (D/S)

The behaviour of Kd, Ke and Ko in response to changes in D/S is shown

graphically as:

The critical assumption with this approach is that K 0 is constant, regardless of

the degree of leverage. The market capitalises the value of the firm as a whole
and therefore, the breakdown between debt and equity is unimportant. An
increase in the use of supposedly “cheaper” debt funds is compensated exactly
by the increase in the required equity return.

As the firm increases its degree of leverage, it becomes riskier. Investors

penalise the stock by raising required equity return with a view to increase the
debt-equity ratio. As long as Kd remains constant, Ke is a constant linear
function of the debt-to-equity ratio. Because the cost of capital of the firm, K 0,
cannot be altered through leverage, the net operating income approach
implies that there is no optimal capital structure.
Illustration – 3
Consider two firms MN and XY which are similar in all respects other than the
degree of leverage employed by them. The following is the financial data of
both these firms:
Particulars Firm MN Firm XY
Net Operating Income Rs. 15000 Rs. 15000
Overall Capitalisation Rate (K0) 17% 17%
Total Market Value (V) Rs. 88, 235 Rs. 88,235
Interest on Debt (I) Rs. 1500 Rs. 3500
Debt Capitalisation Rate (Kd) 12% 12%
Market Value of Debt (D = I/Kd) Rs. 12,500 Rs. 29, 167
Market Value of Equity (S = V – D) Rs. 75, 735 Rs. 59,068
Degree of Leverage (D/S) 0.165 0.494
Equity Earnings (EBIT – I = EBT) 13,500 11,500

The equity capitalisation rates of firms MN and XY are:

Firm MN
Equity Earnings 13,500
= -------------------------------------------------- = ----------------------- = 17.83%
Market Value of Equity 75,735

Firm XY
Equity Earnings 11,500
= -------------------------------------------------- = ----------------------- = 19.47%
Market Value of Equity 59,068

The Equity capitalisation rates for the above firms can also be calculated as
follows:
Ke = K0 + (K0 – Kd) x (D/S)
Firm MN: Ke = 0.17 + (0.17 – 0.12) (0.165) = 17.83%
Firm XY: Ke = 0.17 + (0.17 – 0.12) (0.494) = 19.47%
Illustration – 4
Amita Ltd.’s operating income is Rs. 5,00,000. The firm’s cost of debt is 10%
and currently the firm employs Rs. 15,00,000 of debt. The overall cost of
capital of the firm is 15%.
Calculate:
(a) Total Value of the firm
(b) Cost of Equity

Solution:
(i) Statement showing Value of the Firm
Particulars Amount (Rs.)
Net Operating Income (EBIT) 5,00,000
Less: Interest on Debentures (10% of Rs. 15,00,000) 1,50,000
Earnings available to Equity Shareholders (Net Income) 3,50,000
Total Cost of Capital (Ko) given 15%
Total Value of the Firm (V) = EBIT/Ko = (5,00,000/15%) 33,33,333
Market Value of Debt (D) 15,00,000
Market Value of Equity (S) = V - D 18,33,333

(ii) Calculation of Cost of Equity

Earnings available to Equity shareholders
Ke = ----------------------------------------------------------
Market Value of Equity (S)

EBIT – Interest paid on Debt

Ke = ----------------------------------------------------------
Market Value of Equity (S)

5,00,000 – 1,50,000
= ---------------------------------------------------------
18,33,333
 3,50,000
= ---------------------------------------------------------
18,33,333

= 19.09%

Alternatively, Ke can be calculated as follows:

Ke = K0 + (K0 – Kd) x (D/S)
Or, Ke = 0.15 + (0.15 – 0.10) x (15,00,000/18,33,333)
= 0.15 + 0.05 (0.8181)
= 19.09%
III. Traditional Approach
The traditional approach has the following propositions:
i. The traditional approach was propounded by Ezra Soloman in 1963.

ii. This approach is the compromise between NI approach and NOI approach.
The traditional approach rejects both extreme prepositions of relevance
approach of NI theory and irrelevance approach of NOI theory.

iii. This approach neither assumes constant cost of equity (ke) and declining
Weighted Average Cost of Capital (WACC) like NI approach, nor increasing cost
of equity and constant cost of debt (Kd) and overall cost of capital (Ko) like NOI
approach.

iv. In this approach, the cost of debt capital K d remains more or less constant
up to a certain degree of leverage but rises thereafter at an increasing rate.

v. The cost of equity capital Ke remains more or less constant or rises only
gradually up to a certain degree of leverage and rises sharply thereafter.

vi. Cost of equity is larger than the cost of debt at any capital structure, i.e.,
Ke>Kd at any value of debt ratio.

vii. The weighted average cost of capital K 0 as a consequence of the above

behaviour of Ke and Kd:

(a) decreases up to a certain point (b) remains more or less unchanged for
moderate increases in leverage thereafter, and (c) rises beyond a certain point.
The following is a graphical representation of the Traditional approach:

The principal implication of the approach is that the cost of capital is

dependent on the capital structure and there is an optimal capital structure
which minimizes the cost of capital.

In the above graph, it is the point X which is the optimal capital structure. At
the optimal capital structure, the real marginal cost of debt and equity is the
same.

Optimum capital structure occurs at the point where value of the firm is
highest and the cost of capital is the lowest.

Before the optimal point the real marginal cost of debt is less than the real
marginal cost of equity and beyond the optimal point the real marginal cost of
debt is more than the real marginal cost of equity.
Thus, the traditional approach implies that the cost of capital is dependent
on the capital structure of the firm and that there is an optimal capital
structure.
This approach favours that as a result of financial leverage up to some point,
cost of capital comes down and value of firm increases. However, beyond
that point, reverse trends emerge.

The traditional approach suggests that cost of capital is a function of

leverage. It declines with Kd (debt) and starts rising. This means that there is a
range of capital structure in which cost of capital is minimised.

According to net operating income approach, capital structure decisions are

totally irrelevant. Modigliani-Miller supports the net operating income
approach but provides behavioural justification. The traditional approach
strikes a balance between these two extremes.

Main Highlights of the Traditional Approach

(a) The firm should strive to reach the optimal capital structure and its total
valuation through a judicious use of both debt and equity in capital structure.
At the optimal capital structure, the overall cost of capital will be minimum
and the value of the firm will be maximum.

(b) Value of the firm increases with financial leverage up to a certain point.
Beyond this point, the increase in financial leverage will increase its overall
cost of capital and hence the value of the firm will decline. This is because the
benefits of use of debt may be so large that even after offsetting the effect of
increase in cost of equity, the overall cost of capital may still go down.

However, if financial leverage increases beyond an acceptable limit, the risk

of debt investor may also increase, consequently cost of debt also starts
increasing. The increasing cost of equity owing to increased financial risk and
increasing cost of debt makes the overall cost of capital to increase.
Illustration – 5
The following is a numerical Illustration of the traditional approach. This table
shows the average cost of capital for a firm which has a net operating income
(EBIT) of Rs.1,25,000 that is split variously between interest and equity
earnings depending on the degree of leverage employed by the firm.

Where,

F = Interest on Debt capital

E = Equity Earnings
Kd = Cost of Debt
Ke = Cost of Equity
B = Debt Capital
S = Equity Capital
V = Value of the firm
K0 = Overall cost of capital
IV. Modigliani and Miller Approach (MM Approach)

The NOI approach is definitional or conceptual and lacks behavioural

significance. It does not provide operational justification for irrelevance of
capital structure.

However, Modigliani-Miller approach provides behavioural justification for

constant overall cost of capital and, therefore, total value of the firm.

The approach is based on further additional assumptions like:

 Capital markets are perfect. All information is freely available and there
are no transaction costs.
 All investors are rational.
 Firms can be grouped into ‘Equivalent risk classes’ on the basis of their
business risk.
 Non-existence of corporate taxes

Based on the above assumptions, Modigliani-Miller derived the following

three propositions.

(i) The total market value of the firm which is equal to the total MV of debt and
market value of equity is independent of the degree of leverage and is equal to
its expected operating incomes discounted at the rate appropriate to its risk
class.

Value of Firm = MV of Equity + MV of Debt = Expected NOI/k

(ii) The expected yield on equity is equal to the risk-free rate plus a premium
which is equal to the debt-equity ratio times the difference between K 0 and the
cost on debt, Kd as determined as per the following equation:

Ke = K0 + (K0 – Kd) x D/S

(iii) Weighted average cost of capital is not affected by financial decision, as
both investment and financing decisions are independent.

It is evident from the above diagram that the weighted average cost of capital
(K0) is constant and not affected by leverage.

The operational justification of Modigliani-Miller hypothesis is explained

through the functioning of the arbitrage process and substitution of
corporate leverage by personal leverage.
Arbitrage Effects

Arbitrage refers to buying asset or security at lower price in one market and
selling it at a higher price in another market. As a result, equilibrium is
attained in different markets.

This is illustrated by taking two identical firms of which one has Debt in the
capital structure while the other does not. Investors of the firm whose value is
higher will sell their shares and instead buy the shares of the firm whose value
is lower. They will be able to earn the same return at lower outlay with the
same perceived risk or lower risk. They would, therefore, be better off.

The value of the levered firm can neither be greater nor lower than that of an
unlevered firm according to this approach. The two must be equal. There is
neither advantage nor disadvantage in using debt in the firm’s capital
structure.

The approach considers capital structure of a firm as a whole pie divided into
equity, debt and other securities. No matter how the capital structure of a firm
is divided among debt, equity, etc., there is a conservation of investment
value. Since the total investment value of a corporation depends upon its
underlying profitability and risk, it is invariant with respect to relative changes
in the firm’s financial capitalisation.

According to MM, since the sum of the parts must equal the whole, therefore,
regardless of the financing mix, the total value of the firm stays the same.

The shortcomings of this approach are that the arbitrage process as

suggested by Modigliani-Miller will fail to work because of imperfections in
capital market, existence of transaction cost and presence of corporate
income taxes.
Illustration: When value of levered firm is more than the value of unlevered
firm

There are two firms N and M, having same earnings before interest and taxes i.
e. EBIT of Rs. 20,000. Firm M is a levered company having a debt of Rs.
1,00,000 @7% rate of interest. The cost of equity of N company is 10% and of
M company is 11.50%.

Find out how arbitrage process will be carried on?

Solution:

Particulars Firms
N M
NOI/EBIT Rs. 20,000 Rs. 20,000
Debt -- Rs. 1,00,000
Ke 10% 11.50%
Kd -- 7%

NOI – Interest
Market Value of Equity = -------------------------
Ke

20,000
SN = ------------------------- = Rs. 2,00,000
10%

20,000 - 7000
SM = ------------------------- = Rs. 1,13,043
11.50%
Value of the firm N = Rs. 2,00,000

Value of the firm M = Rs. 1,13,043 + 1,00,000 = [V = S + D]

= Rs. 2,13,043

Assume you have 10% share of levered company i. e. M.

Therefore, investment in 10% of equity of levered company = 10% x 1,13,043 =

Rs. 11,304.3

Return will be 10% of (20,000 – 7000) = Rs. 1300

Alternate strategy will be:

Sell your 10% share of levered firm for Rs. 11, 304.3 and borrow 10% of levered
firms debt i. e. 10% of Rs. 1,00,000 and invest the money i. e. 10% in unlevered
firm’s stock.

Total resources/Money we have = 11,304.3 + 10,000 = Rs. 21,304.3 and you

invest 10% of 2,00,000 = Rs. 20,000

Surplus cash available with you is = 21,304.3 – 20,000 = Rs. 1304.3

Your return = 10% of EBIT of Unlevered firm – Interest to be paid on borrowed

funds

i. e. = 10% of Rs. 20,000 – (7% of Rs. 10,000) = 2000 – 700 = Rs. 1300

i. e. your return is same i. e. Rs. 1300 which you are getting from ‘N’ company
before investing in ‘M’ company.

But still, you have Rs. 1304.3 excess money available with you. Hence, you are
better off by doing arbitrage.
Illustration: When value of Unlevered firm is more than the value of levered
firm

There are two firms U and L having same NOI of Rs. 20,000 except that the firm
L is a levered firm having a debt of Rs. 1,00,000 @7% and cost of equity of U
and L are 10% and 18% respectively.

Show how arbitrage process will work.

Solution:

Particulars Firms
U L
NOI/EBIT Rs. 20,000 Rs. 20,000
Debt -- Rs. 1,00,000
Ke 10% 11.50%
Kd -- 7%
Value of Equity Capital
20,000 (20,000 – 7000)
(EBIT – Interest) -------------------- --------------------------------
(S) = ------------------------- 10% 11.50%
Ke
= Rs. 2,00,000 = Rs. 72,222
Value of Debt Capital
(D) NIL = Rs. 1,00,000
Value of the Firm
[V = S + D] Rs. 2,00,000 Rs. 1,72,222

Assume you have 10% shares of Unlevered firm i. e. investment of 10% of Rs.
2,00,000 = Rs. 20,000 and Return @10% on Rs. 20,000.
Return on Investment will be 10% of earnings available for equity i. e. 10% x
20,000 = Rs. 2000

Alternative Strategy:

Sell your shares in unlevered firm for Rs. 20,000 and buy 10% shares of levered
firm’s equity plus debt.

i. e. 10% equity of levered firm = 7222

10% debt of levered firm = 10,000

Total Investment = 17,222

Your resources are Rs. 20,000

Surplus cash available = Surplus – Investment = 20,000 – 17,222 = Rs. 2778

Your return on investment is:

7% on Debt of Rs. 10,000 = 700

10% on Equity i. e. 10% of earnings available for equity holders i.e. 10% of
(20,000 – 7000) = 10% x 13000 = 1300

Total return = (700 + 1300) = Rs. 2000

i. e. in both the cases the return received is Rs. 2000 and still you have excess
cash of Rs. 2778.

Hence, you are better off i. e. you will start selling unlevered company shares
and buy levered company’s shares thereby pushing down the value of shares
of unlevered firm and increasing the value of levered firm till equilibrium is
reached.
Illustration:

Consider two firms P and Q similar in all respects except in their capital
structure. Firm P is financed by only equity, firm Q is financed by a mixture of
equity and debt. The following are the financial particulars of the two firms.

The market value of the levered firm Q is higher than that of the unlevered
firm P. MM argue that in such a situation equity holders would sell their equity
investment in firm Q and invest in the equity of firm P resorting to personal
leverage.

Assume you have 1% share of levered company i. e. Q.

Therefore, investment in 1% of equity of levered company = 10% x 13,33,333 =

Rs. 13,333

Return will be 1% of (200,000 – 40,000) = Rs. 1600

Alternate strategy will be:

Sell your 1% share of levered firm for Rs. 13,333 and borrow 1% of levered
firms debt i. e. 1% of Rs. 8,00,000 at 5 percent interest on personal account
and invest the money i. e. 1% in unlevered firm’s stock i. e. firm P

Total resources/Money we have = 13,333 + 8000 = Rs. 21,333 and you invest
1% of 2,00,000 = Rs. 20,000

Surplus cash available with you is = 21,333 – 20,000 = Rs. 1333

Your return = 1% of EBIT of Unlevered firm – Interest paid on borrowed funds

i. e. = 1% of Rs. 200,000 – (5% of Rs. 8000) = 2000 – 400 = Rs. 1600

i. e. your return is same i. e. Rs. 1600 which you are getting from ‘P’ company
before investing in ‘Q’ company.

But still, you have Rs. 1333 excess money available with you. Hence, you are
better off by doing arbitrage.

The action of a number of investors undertaking similar arbitrage transactions

result in driving up the price of firm P shares, lower its equity capitalization
rate, drive down the price of firm Q, and increase its equity capitalization rate.

This process of arbitrage will continue till there is no further opportunity for
reducing one’s investment outlay and achieving the same return. As a result,
the average costs of capital, Ko, would be the same.
Capital Structure and Taxation Effects

The leverage irrelevance theorem of MM is valid if the perfect market

assumptions underlying their analysis are satisfied. However, in the face of
imperfections characterising the real-world capital markets, the capital
structure of a firm may affect its valuation.

Presence of taxes is a major imperfection in the real world. This section

examines the implications of corporate and personal taxes for the capital
structure.

When taxes are applicable to corporate income, debt financing is

advantageous. This is because dividends and retained earnings are not
deductible for tax purposes; interest on debt is a tax-deductible expense. As a
result, the total income available for both stockholders and debt-holders is
greater when debt capital is used.

In their 1963 article, they recognised that the value of the firm will increase or
cost of capital will decrease where corporate taxes exist. As a result, there will
be some difference in the earnings of equity and debt-holders in levered and
unlevered firm. The value of levered firm will be greater than the value of the
unlevered firm by an amount equal to amount of debt multiplied by
corporate tax rate.

Illustration:

There are two firms Company A and Company B having net operating income
of Rs. 15,00,000 each. Company B is a levered company whereas Company A is
all-equity company. Debt employed by company B is of Rs. 7,00,000 @11%.

The Corporate tax rate applicable to both the companies is 25%.

Calculate earnings available for equity and debt for both the firms.
Solution:

Statement of calculation of earnings available to equity holders and

debtholders
Particulars Companies
A B
Net Operating Income Rs. 15,00,000 Rs. 15,00,000
Less: Interest on Debt -- Rs. 77,000
(11% of Rs. 7,00,000)
Profit before Tax 15,00,000 14,23,000
Less: Taxes @25% 3,75,000 3,55,750
Profit after Tax 11,25,000 10,67,250
(or, Earnings available
to Equity shareholders)
Total Earnings available 10,67,250 + 77000
to both Equity holders 11,25,000
and Debt holders = 11,44,250

As we can see that the earnings in case of Company B is more than the
earnings of Company A because of tax shield available to shareholders of
Company B due to the presence of debt structure in Company B. The market
value of the firm increases with the increase in financial leverage.

The interest payment of Rs.77000 made by the levered firm brings a tax shield
of Rs.19,250 (Rs.77000 x Tax rate@25%). Therefore, the combined income of
the debtholders and stockholders of firm B is higher by this amount.

The present value of tax shield associated with interest payments, assuming
debt to be perpetual in nature would be equal to:

tc x D X r
Present value of tax shield = ------------------------------------ = tc x D
r
Where,
tc = Corporate tax rate
D = Debt Capital
r = interest rate on Debt
In general, when corporate taxes are considered the value of the firm that is
levered would be equal to the value of the unlevered firm increased by the tax-
shield associated with debt, i.e.,

Value of Levered Firm = Value of Unlevered Firm + tc x D

i. e. 25% x 77000 = Rs. 19,250 i. e. difference in the income of two companies’

earnings i. e. 11,44,250 (L) – 11,25,000 (UL) = Rs. 19,250.

Other things being equal, greater the leverage, greater is the value of the firm.
This implies that the optimal strategy of a firm should be to maximise the
degree of leverage in its capital structure.
When Personal Taxes are considered along with Corporate Taxes and
investors pay the same rate of personal taxes on debt returns as well as stock
returns, the advantage of corporate tax in favour of debt capital remains
intact.

Illustration:

Consider two firms A and B having an expected net operating income of

Rs.5,00,000 which are similar in all respects except in the degree of leverage
employed by them. Firm A employs no debt capital whereas firm B has
Rs.20,00,000 in debt capital on which it pays 12 percent interest.

The corporate tax rate applicable to both the firms is 50% and a 30% personal
tax rate to debt as well as stock returns. The income to stockholders and
debtholders of both the firms is shown below.

Personal Taxes and Income of Debtholders and Stockholders

From the above table, it is clear that although the combined post-tax income
to stockholders and debtholders decreases in both the firms, the proportional
advantage of debt remains unaffected because the combined income of
stockholders and debtholders is still higher by Rs. 84000 i. e. 48% in the
levered firm.
If the personal tax rate is tp the tax advantage of debt becomes: tc D (1 – tp).
i. e. 50% x 2,40,000 x (1 – 0.70) = Rs. 84000 i. e. difference in the combined
income of two companies’ earnings i. e. 2,59,000 (L) – 1,75,000 (UL) = Rs.
84,000.
The above formula is valid when personal tax rate applicable to stock as well as
debt income is same as in the above Illustration.

However, it is not the same in many countries including India. Stock income,
which includes dividend income and capital gains is taxed at a lower rate when
compared to that of debt income.

When the tax rate on stock income (t ps) differs from the tax rate on debt
income
(tpd), the tax advantage of debt capital may be expressed as:

B = Debt Capital
Bankruptcy Costs

Existence of bankruptcy costs is another important imperfection affecting the

capital structure. Capital Market when perfect, has no costs associated with
bankruptcy.

Assets of a bankrupt firm can be sold at their economic values and legal and
administrative expenses are not present. However, in the real world, there
are costs associated with bankruptcy.

Under distress conditions, assets are sold at a significant discount below their
economic values. Moreover, costs like legal and administrative costs
associated with bankruptcy proceedings are high. Finally, an impending
bankruptcy entails significant costs in the form of sharply impaired operational
efficiency.

The probability of bankruptcy for a levered firm is higher than for an

unlevered
firm, other things being equal. Beyond a threshold level, the probability of
bankruptcy increases at an increasing rate as the debt-equity ratio increases.
This means that the expected cost of bankruptcy increases when the debt-
equity ratio increases.

Investors expect a higher rate of return from a firm which is faced with the
prospect of bankruptcy, as bankruptcy costs represent a loss that cannot be
diversified away. The following figure is a graphical representation of the
relationship between the required rate of return on equity, K e, and the
leverage ratio, D/S.
Difference Between Corporate and Home-made (Personal) Leverage

The following are some differences between corporate and personal leverage:

 In the propositions given, MM has stated that the premium of the

levered firm over unlevered firm would be abolished by resorting to
personal leverage by the investors. However, he had assumed that the
rate at which an individual borrows would be the same at which the
corporate borrows. In reality, an individual may not be able to borrow
on his personal account at the same rate of interest as a company can
do. In India, the average rate of interest on personal borrowings is
higher than the average rate of interest on corporate borrowings.

 The creditors simply refuse to lend individuals who want to employ a

high leverage ratio. Therefore, an individual cannot adopt a leverage as
high as a company can do.

 The liability of an individual borrower towards the borrowed amount on

his account is unlimited whereas the equity stockholders of a company
have limited liability irrespective of the company’s level of borrowing.
Agency Costs

Whenever creditors are approached by a firm to obtain debt capital, they

impose certain restrictions on the firm in the form of some protective
covenants incorporated in the loan contract. They could be in the form of
obtaining prior approval of the creditors for matters relating to key managerial
appointments, maintenance of current ratio above a certain level, restriction
on the rate of dividend during the currency of the loan, constraints on the
additional issue of capital, limitation on further investments etc.

The above said restrictions generally entail legal and enforcement costs
which also impair the operating efficiency of the firm. All these costs referred
to as monitoring costs or agency costs, detract from the value of the firm.

Monitoring costs are a function of the level of debt in the capital structure.
When the amount of debt is considerably less, then the creditors may limit
their
monitoring activity. But if the level of debt is high, then they may insist on
continuous monitoring which entails substantial costs.
PECKING ORDER THEORY OF CAPITAL STRUCTURE

 The Pecking Order Theory, also known as the Pecking Order Model,
relates to a company’s capital structure. Made popular by Stewart Myers
and Nicolas Majluf in 1984, the theory states that managers follow a
hierarchy when considering sources of financing.

 The pecking order theory states that managers display the following
preference of sources to fund investment opportunities: first, through
the company’s retained earnings, followed by debt, preferred stock and
choosing equity financing as a last resort.

The following diagram illustrates the pecking order theory:

 The pecking order theory arises from the concept of asymmetric

information. Asymmetric information, also known as information failure,
occurs when one party possesses more (better) information than
another party, which causes an imbalance in transaction power.

 Company managers typically possess more information regarding the

company’s performance, prospects, risks, and future outlook than
external users such as creditors (debt holders) and investors
(shareholders). Therefore, to compensate for information asymmetry,
external users demand a higher return to counter the risk that they are
taking. In essence, due to information asymmetry, external sources of
finance demand a higher rate of return to compensate for higher risk.

 In the context of the pecking order theory, retained earnings financing

(internal financing) comes directly from the company and minimizes
information asymmetry. As opposed to external financing, such as debt
or equity financing where the company must incur fees to obtain
 external financing, internal financing is the cheapest and most
convenient source of financing.

 When a company finances an investment opportunity through external

financing (debt or equity), a higher return is demanded because
creditors and investors possess less information regarding the company,
as opposed to managers. In terms of external financing, managers prefer
to use debt over equity – the cost of debt is lower compared to the cost
of equity.

 The issuance of debt often signals an undervalued stock and confidence

that the board believes the investment is profitable. On the other hand,
the issuance of equity sends a negative signal that the stock is
overvalued and that the management is looking to generate financing by
diluting shares in the company.

 When thinking of the pecking order theory, it is useful to consider the

seniority of claims to assets. Debtholders require a lower return as
opposed to stockholders because they are entitled to a higher claim to
assets (in the event of a bankruptcy). Therefore, when considering
sources of financing, the cheapest is through retained earnings, second
through debt, and third through equity.

 The trade-off theory predicts optimal capital structure, while the pecking

order theory does not predict an optimal capital structure.
TRADE-OFF THEORY OF CAPITAL STRUCTURE

 It’s a business model that involves offsetting the costs of debt against
the benefits of debt. A company must decide how much debt finance
and how much equity finance to use by balancing the advantages and
disadvantages of each.

 Companies finance themselves using funds from both debt and equity.
Debt refers to loans from outside sources, while equity is money the
firm's owners or shareholders invest in the business. The key is getting
the balance right between the two.

 The trade-off theory says the cost of debt is always lower than the cost
of equity because tax can be deducted from the interest on debt. Debt
may be cheaper but it carries with it the risk of not being able to make
payments on time, which could result in insolvency.

 Debt-holders have first priority on the company’s assets if it goes

bankrupt as the firm can only pay shareholders after meeting its debt
obligations. Ultimately, the company has to find an optimal capital
structure that minimises the cost of financing while also minimising the
risk of bankruptcy.

 This theory of capital structure which suggests that firms decide their

capital structure only taking into consideration the advantages and
disadvantages of debt. 

 The trade-off theory states that the optimal capital structure is a trade-
off between interest tax shields and cost of financial distress.

 Value of firm = Value if all-equity financed + PV(tax shield) - PV(cost of

financial distress).
= Value of Unlevered firm + PV of Tax shield – PV of Financial
distress
 The trade-off theory can be summarized graphically. The starting point is
the value of the all-equity financed firm illustrated by the black
horizontal line in the above Figure. The present value of tax shields is
then added to form the red line.

 PV(tax shield) initially increases as the firm borrows more, until

additional borrowing increases the probability of financial distress
rapidly. In addition, the firm cannot be sure to benefit from the full tax
shield if it borrows excessively as it takes positive earnings to save
corporate taxes.

 Cost of financial distress is assumed to increase with the debt level.

 The cost of financial distress is illustrated in the diagram as the

difference between the red and blue curve. Thus, the blue curve shows
firm value as a function of the debt level. Moreover, the graph suggests
an optimal debt policy exists which maximizes firm value.