Chapter 19

CAPITAL STRUCTURE AND

FIRM VALUE
 OUTLINE
• Assumptions and Definitions
• Net Income Approach
• Net Operating Income Approach
• Traditional Position
• Modigliani and Miller Position
• Taxation and Capital Structure
• Tradeoff Theory
• Signaling Theory
 Capital Structure and Firm Value

Assumptions in the chapter:

1. There is no income tax (corporate or personal).
2. 100% pay out.
3. Identical “subjective” probability distribution of
???
4. Operating income is not expected to grow or
decline over time.
Net Income Approach
D E
ra = rd [ ] + re [ ]
D+E E+D
 Net Operating Income Approach
D E
ra = rd [ ] + re [ ]
D+E E+D

⚫r and
a
rd are constant for all degrees of leverage.
 Traditional Position
⚫ Cost of Debt remains more or less constant up to a
certain degree of leverage but rises thereafter at an
increasing rate.
⚫ Cost of Equity remains more or less constant or rises
only gradually to a certain degree of leverage and
rises sharply thereafter
⚫ Average Cost of Capital (i) decreases to a certain
point, (ii) then remains constant for a moderate
increase in leverage and (iii) rises beyond a certain
point.
 Traditional Position
⚫ Evaluation:
⚫ Not very sharply defined
⚫ Marginal (real) Cost of Debt less than Equity
before optimal cap structure and vice versa.
 Modigliani and Miller Position
⚫ Assumptions:
– Perfect Capital Market
– Rational Investors and Managers
– Homogenous Expectations
– Equivalent Risk Classes
– Absence of Taxes.
⚫ Proposition I (like NOI) (Proved using Arbitrage Argument)

V = E ( EBIT ) / r
⚫ In Equilibrium Identical assets must sell for same price irrespective
of how they are financed.
Arbitrage Argument
Ram Electronics
Ram Electronics
 Modigliani and Miller Prop II
⚫ Proporsition II deals with the cost of equity that
follows from proposition I.
⚫ An increase in Lev leads to increase in EPS but not
the share price… WHY???
⚫ Eg of Ram Electronics contd..
 Modigliani and Miller Prop II

Inc in fin lev inc expected EPS but not the stock price because the
increase in expected/required rate of return offsets the gains of
borrowing.
 Criticisms of MM theory
⚫ Assumption that firms and individuals can borrow on same terms not
practical.
⚫ Limited liability for firms but unlimited liability for individuals.
⚫ Existence of transaction costs makes arbitrage expensive.
⚫ Firms as well as individuals are liable to pay taxes.
⚫ High bankruptcy costs dissuade usage of debt.
⚫ Agency costs high.
⚫ Information asymmetry between agents.
⚫ It may not be possible to place firms into risk classes with returns that
have identical distributions and are perfectly correlated.
 Taxation and Capital Structure
⚫ Corporate Taxes

⚫ Corporate Taxes and Personal Tax

Firm A is all equity and B has 4 Mn in debt at 12%.
At 50% tax rate. It earns more for its investors (D+E)
2,40,000 (7,40,000 – 5,00,000).. What accounts for this
Rs. 2,40,000..
Value of ITS=Kd*D*Tc/Kd
Effect of fin leverage on firm value with
corporate and personal taxes

⚫ Exhibit 19.12
 Trade Off Theory
⚫ Cost of financial Distress
– Arguments between SHs and Debt Holders delay
liquidation of assets.
– Asset sales in distress conditions fetch a significantly
lower price.
– Legal and administrative cost.
– Managers become myopic → (lower the quality of the
products, ignore employee welfare etc.)
– Different stakeholders’ commitment gets diluted.
 Trade Off Theory
⚫ Agency Costs:
– SHs have little incentive to limit losses in te event of a
bankruptcy. Hence, managers acting in the interest of
SHs tend to take very high risk.
⚫ Thus, creditors face moral hazard when they lend to a firm that
has a large o/s debt/T.A.
– Therefore, creditors seek protection in the form of
restrictive covenants which in turn reduces operational
freedom (hence inefficiency in production) and also
increases monitoring cost.
 Trade Off Theory
⚫ Effect of Financial Distress and Agency Costs:
– VL= Vu+ tcD- P.V. of expected costs of financial distress
– P.V. of agency costs
 Pecking Order Hypothesis
⚫ Myer (1984) and Myers and Majluf (1984)
proponded that choice of finance arises from the
costs of adverse selection arising out of the
information asymmetry between BETTER
INFORMED MANAGERS AND LESS
INFORMED INVESTORS.
⚫ These costs are lesser for debt than for equity.
Hence, the pecking order!!!
– (i) Internal resources (no cost of adverse selection)
– (ii) Debt (first exhaust target debt capacity)
– (iii) New Equity
 Signalling Theory
⚫ Explains the difference between asymmetric information
and theory of capital structure.
⚫ Myers basically built upon the work of Gordon (1961).
Gordon’s main findings were:
– Firms prefer to rely on internal accruals
– Expected future investment opportunity and Expected CFs
influence target D/P.
⚫ Dividends tend to be sticky in short run. They are raised
only when firm is confident it could be sustained.
⚫ If internal accruals exceed its cap ex requirements, it will
invest in marektable securities, retire debt, raise dividends,
resort to acquisitions or buy back shares.
⚫ If internal accruals were less, first draw on marketable
securities, debt, convertible debt and then equity.
 Signalling theory
⚫ An assumption of trade off theory is that of
symmetry in information.
⚫ However…
⚫ Eg. Alpha Ltd has 10,00,000 o/s equity shares
selling at Rs. 18 per share. Mgmt. believes that
Intrinsic value is Rs. 22.
⚫ Mgmt has identified a new project that needs
⚫ Rs. 10,00,000 as external finance and has an
expected NPV of Rs. 100,000. Should Alpha
undertake the project…
 Alpha Ltd…
⚫ Info asymmetry is resolved before new equity issue
(220+10+1)/(10+.45455)
⚫ Info asymmetry is resolved immediately after the new
equity issue (220+10+1)/(10+.55,556)
⚫ Info asymmetry is resolved immediately after new equity
issue, but the project has a higher NPV
(220+10+3)/(10+.55,556)
⚫ The project is financed using debt: (Info assymetry
disappears) because new share price is (220+10)/10
⚫ Mgmt believes that firm has bleak prospects not reflected in
share prices. (Intrinsic value is say Rs. 15)
⚫ =(150+10)/10.55556
 Summary
⚫ CASE I: If eq. undervalued due to info.
Assym…firm should rely on debt

⚫ CASE II: If eq. shares are overvalued due to info

asymmetry then issue equity even if no +ve NPV
projects are there.

⚫ Pecking order is rational in CASE I.

 Merton Miller Argument
⚫ MM Cap Struc Irrelevance theory holds even in a world
were corporate and personal taxes exist
⚫ Assume (i) no tax on equity income, (ii) corporate taxes for
companies are constant.
⚫ First all equity-→ issue debt to investors whose debt income
is not taxed →To induce investors to invest further in debt
one needs to give re/(1-tpd)
⚫ Co. will issue debt till the time the tpd = tc.
⚫ If tc > tpd → Only _____. O.w.
⚫ Hence, the supply curve for debt capital remains horizontal
for a given risk adjusted discount rate: re/(1-tc)
 Merton Miller Argument
⚫ Exhibit 19.13
Tools to choose the correct Capital Structure
1. EBIT-EPS Analysis: How sensitive is EPS to a change in
EBIT.
• How to find the break even EBIT level:
(x-I1) (1-t)/n1= (x-I2) (1-t)/n2
2. RoI RoE Analysis
 Tools to choose the correct Capital
Structure
2. RoI RoE Analysis
 Tools to choose the correct Capital
Structure
2. RoI RoE Analysis
 Tools to choose the correct Capital
Structure
3. Ratio Analysis (Interest coverage, Cashflow
coverage, debt service coverage, fixed assets
coverage)
4. CF analysis
 ASSUMPTIONS

To examine the relationship between capital structure and

cost of capital, the following simplifying assumptions are
commonly made:

• No income tax

• 100 percent dividend payout

• Identical subjective probability distributions of

operating income
• No growth
 FOCUS OF ANALYSIS

I Annual interest charges

rD = =
D Market value of debt

P Equity earnings
rE = =
E Market value of equity

O Operating income
rA = =
V Market value of the firm

D E
r A = rD + rE
D+E D+E

What happens to rD, rE, and rA when financial leverage, D/E, changes?
 NET INCOME APPROACH
According to this approach, rD and rE remain unchanged when D/E
varies. The constancy of rD and rE with respect to D/E means that rA
declines as D/E increases.
Rates of
return

rE

rA
rD

D/E
 NET OPERATING INCOME APPROACH
According to this approach the overall capitalisation rate (rA) and
the cost of debt (rD) remain constant for all degrees of leverage.
Hence
rE = rA + (rA – rD) (D/E)
Rates of
return

rE

rA

rD

D/E
 TRADITIONAL POSITION

Rates of
return
rE

rA
rD

D/E
 MODIGLIANI AND MILLER (MM)
POSITION

• Perfect Capital Market

• Rational Investors and Managers

• Homogenous Expectations

• Equivalent Risk Classes

• Absence of Taxation
 MM PROPOSITION I
The value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure.
V = D + E = O/r
where V = market value of the firm
D = market value of debt
E = market value of equity
O = expected operating income
r = discount rate applicable to the risk class to which
the firm belongs
 MM PROPOSITION II

The expected return on equity is equal to the expected rate

of return on assets, plus a premium. The premium is equal

to the debt-equity ratio times the difference between the

expected return on assets and the expected return on debt

rE = rA + (rA – rD) (D/E)

 THE RISK-RETURN TRADEOFF

As leverage increases, equity shareholders require a higher

return because equity beta increases.

E = A + D/E (A - D)

where E = equity beta

A = asset beta

D/E = debt-equity ratio

D = debt beta
 CRITICISMS OF MM THEORY

• Firms and investors pay taxes

• Bankruptcy costs can be high

• Agency costs exist

• Managers tend to prefer a certain sequence of financing

• Informational asymmetry exists

• Personal and corporate leverage are not perfect

substitutes
 CORPORATE TAXES
When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
In general
O ( 1 - tC)
V = + tC D
r
where V = value of the firm
O = operating income
tC = corporate tax rate
r = capitalisation rate applicable to the unlevered firm
D = market value of debt
It means:
Value of levered firm = Value of unlevered firm + Gain from leverage
VL = VU + tC D
 CORPORATE TAXES AND
PERSONAL TAXES
When personal taxes are considered along with corporate taxes, the tax
advantage of a rupee of debt is:
(1 – tc) (1 – tpe)
1–
(1 – tpd)
where tc = corporate tax rate
tpd = personal tax rate on debt income
tpe = personal tax rate on equity income
Example : Suppose tc = 50 percent, tpe = 5 percent, and tpd = 30 percent.
The tax advantage of every rupee of debt is:
(1 – 0.5) (1 – 0.05)
1– = 0.32 rupee
(1 – 0.3)
LEVERAGE AND FIRM VALUE
IN THE PRESENCE OF TAXES
 COST OF FINANCIAL DISTRESS

A high level of debt may lead to financial distress that

entails certain costs:
Direct Costs
• Delay in liquidation may diminish asset value
• Distress sale fetches lower price
• Legal and administrative costs are high
Indirect Costs
• Managers become myopic
• Stakeholders dilute their commitment
 AGENCY COSTS

• There is an agency relationship between the

shareholders and creditors of firms that have
substantial amounts of debt. Hence lenders impose
restrictive covenants and monitor the behaviour of the
firm.

• The loss in efficiency on account of restrictions on

operational freedom plus the cost of monitoring (which
are almost invariably passed on to shareholders)
represent agency costs associated with debt.
 TRADEOFF MODEL

Value of
the firm Value of the firm considering
the tax advantage of debt

Financial distress costs and

agency costs
Value of the firm considering
the tax advantage and financial
distress and agency costs

Value of the
unlevered firm

D/E
 PECKING ORDER OF FINANCING

• There is a pecking order of financing which goes as

follows:
• Internal finance (retained earnings)
• Debt finance
• External equity finance

• Given the pecking order of financing, there is no well-

defined target debt-equity ratio, as there are two kinds
of equity, internal and external. While the internal
equity is at the top of the pecking order, the external
equity is at the bottom.
 SIGNALING THEORY

• Noting the inconsistency between trade-off theory and

the pecking order of financing, Myers proposed a new
theory, called the signaling, or asymmetric information,
theory of capital structure.

• A critical premise of the the trade-off theory is that all

parties have the same information and homogeneous
expectations. Myers argued that there is asymmetric
information and divergent expectations which explains
the pecking order of financing observed in practice.
 SUMMING UP
• Several positions have been taken on the relationship between capital
structure and firm value (or cost of capital)
• According to the net income approach the average cost of capital
declines as the leverage ratio increases
• According to the net operating income approach, the cost of capital does
not vary with capital structure
• According to the traditional approach, the cost of capital decreases upto
a point, remains more or less unchanged for moderate increases in
leverage thereafter, and rises beyond that at an increasing rate
• Modigliani and Miller (MM) restated and amplified the net operating
income approach in terms of two basic propositions: (a) the value of a
firm is independent of its capital structure. (b) The expected return on
equity is equal to the expected return on assets, plus a premium. The
premium is equal to the debt-equity ratio times the difference between
the expected return on assets and the expected return on debt
• The beta of a firm’s equity may be expressed as:
E = A + D/E (A – D)
• The imperfections in the real world cast their shadow over the leverage
irrelevance theorem of MM
• The value of a firm, when corporate taxation is considered, is :
V = [O (1 – tc) + tcD]/r
• When personal taxes are considered, along with corporate taxes, the
gain in the value per rupee of debt is equal to :
[1 – (1 – tc) (1 – tpe) / (1 – tpd)]
• Considering the tax effect and financial distress and agency costs, the
value of a levered firm is:
Value of the unlevered firm
+ Tax advantage of debt
- Financial distress and agency cost
• In the real world, firms seem to follow a pecking order of financing
which goes as follows; internal finance, debt finance, and external
equity. Myers explains this with the help of the signaling theory