Capital Structure theories

The capital structure should be examined from the viewpoint of its impact on the value of the firm. If a capital structure decision affects the total value of the firm, a firm should select such a financing mix as will maximise the shareholders wealth. Such a capital structure is referred to as optimal capital structure. The optimum capital structure may be defined as the capital structure or combination of debt and equity that leads to the maximum value of the firm.

Net income approach

NI approach suggested by Durand Capital structure decision is relevant to the valuation of the firm According to this theory a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as total value of the firm. In this approach he showed that a firm can lower its cost of capital and increase its valuation continually with the use of debt funds.

 According to the Net Income approach, the overall capitalisation rate and the cost of debt remains constant for all degrees of leverage. rA = rD
D + r E D+E E D+E

rA = average cost of capital rD = cost of debt rE = cost of equity D = debt E= equity

It is based on three assumptions There are no taxes Cost of debt is less than equity capitalisation rate or the cost of equity The use of debt does not change the risk perception of the investors

 If the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline while the value of the firm as well as the market price of ordinary shares will increase On the other hand a decrease in leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as market price of equity shares.

 As a result, the weighted average cost of capital tends to decline, leading to an increase in the total value of a firm. Thus, with the cost of debt and cost of equity being constant, the increased use of debt(increase in leverage), will magnify the shareholders earnings and, thereby , the market value of ordinary shares.

Cost of capital

rE rA rD

D/E

 The financial risk perception of the investors does not change with the introduction of debt or change in the leverage implies that due to change in the leverage, there is no change in either the cost of debt or the cost of equity. The implication of the three assumptions of the NI approach is that as the degree of leverage increases, the proportion of cheaper source of funds, that is, debt in the capital structure increases.

 The financial leverage is an important variable to the capital structure of a firm. With proper mix of debt and equity, a firm can evolve a an optimum capital structure which will be the one at which value of the firm will be the highest and overall cost of capital is the lowest. At that structure, the market price would be maximum.

Net Operating Income approach

This theory also proposed by Durand is diametrically opposite to that of Net Income approach. According to this approach, the overall capitalisation rate and the cost of debt remain constant for all degrees of leverage. According to Durand 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. It merely changes 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.

Cost of capital

rE rA rD

D/E

 An increase in the use of debt funds which are cheaper is offset by an increase in the equity capitalisation rate . This happens because equity investors seek higher compensation as they are exposed to greater risk arising from increase in the degree of leverage. They raise the capitalisation rate rE or lower the priceearning ratio.

 Thus the degree of leverage cannot influence the market value and the overall cost of capital. In other words the market evaluates the firm as a whole. Therefore the split of capitalisation between debt and equity is not significant. The value of equity(S) is determined by deducting the total value of the debt(B)( from the total value of the firm(V) Thus S= V-B

 Thus there is nothing such as optimum capital structure. Any capital structure is optimum according to this approach.

Assumptions of this approach

Cost of equity remains constant regardless of the debt equity mix in the capital structure The market capitalises the value of the firm as a whole The increase in cost of debt financing in capital mix offsets in increase in returns to equity shareholders The debt capitalisation rate is constant Corporate income tax does not exist Advantage of debt in capital mix is offset exactly by increase in equity capitalisation rate

Traditional theory
Net Income approach and Net operating Income approach are two extremes as regards the theoretical relationship between financial decisions as determined by the capital structure, the weighted average cost of capital and total value of the firm.

 While the Net Income approach takes the position that the use of debt in the capital structure will always affect the overall cost of capital and the total valuation, the Net Operating Income approach argues that the capital structure is totally irrelevant. The traditional approach is the midway between the NI and NOI approaches. It is also known as intermediate approach.

 It resembles the NI approach in arguing that cost of capital and total value of the firm are not independent of the capital structure. But it does not go along with the view of the NI approach that value of a firm will necessarily increase for all degrees of leverage.

 Regarding one point it agrees with the NOI approach that beyond a certain degree of leverage, the overall cost increases leading to a overall decrease in the total value of the firm. But it differs from the NOI approach in that it does not argue that the weighted average cost of capital is constant for all degrees of capital

Cost of capital

rE

rA
rD

D/E

A to B = debt capacity

 At the optimal structure 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.

 It believes in what may be called Optimal Capital Structure. Such a capital structure where overall cost of capital minimum and total value of the firm is maximum.

Modigliani and Miller theory

A formal theory of capital structure was first proposed by Modigliani and Miller. This approach is similar to the NOI approach. But that approach did not provide justification for the irrelevance of capital structure. The MM approach provides behavioural justification for constant overall cost of capital and therefore total value of the firm.

 The MM approach maintains that the weighted average cost of capital does not change, with a change in the proportion of debt to equity in the capital structure.

Assumptions of MM theory perfect capital market information is freely available about the risk and return on all types of securities and there is no problem of asymmetric information; transaction costs are costless, there are no bankruptcy costs; securities are infinitely divisible They can borrow without restrictions on the same terms as the firms do. Rational investors and managers investors rationally choose a combination of risk and return that is more advantageous to them. Managers act in the interest of the shareholders

 Homogenous expectations investors hold identical expectations about future operating earnings. Equivalent risk classes firms can be grouped into equivalent risk classes on the basis of their business risk. Dividend payout ratio is 100%. In other words there are no retained earnings. Absence of taxes

There are four basic propositions of the MM approach The overall cost of capital(k0) and the value of the firm(V) are constant for all degrees of leverage. The total value is given by capitalising the expected stream of operating earnings at a discount rate appropriate for its risk class. The firms value depends on the investing decisions and not the financing decisions. VL = VU

 If the overall cost of capital remains constant, then the only factor which creates an impact on the value of the firm is its generated cash flow from operations. Thus the capital structure is irrelevant for the value of the firm. The MM hypothesis states that the only factor that can create an impact on the shareholders wealth is profitable investment opportunities i.e. investment opportunities having positive NPV.

 The second proposition establishes that a firms leverage has no effect on its weighted average cost of capital (i.e., the cost of equity capital is a linear function of the debt-equity ratio) which means that rE increases to exactly offset the use of cheaper debt.

 According to the third proposition the cut-off rate for investment purposes is completely independent of the way in which an investment is financed. It means that the required rate of return is independent of the financing of decisions of the firm. The third proposition establishes that firm market value is independent of its dividend policy.

 According to the fourth proposition, it establishes that equity-or share-holders are indifferent about a company's financial policy.

MM theory explains the relationship between capital structures, cost of capital and value of the firm under the following two respects When the absence of corporate taxes When the corporate taxes are assumed to exist

When the absence of corporate taxes This approach is identical to NOI approach. According to Modigliani and Miller, whenever there are no taxes the cost of capital and value of the firm are not affected by capital structure or debt equity mix. In other words this theory describes that at any particular situation the cost of capital is not affected by changes in the capital structure i.e. the debt-equity mix is irrelevant in the determination of the total value of the firm.

 Debt is cheaper than equity, but the use of debt increases the financial risk and the cost of equity. This increase in the cost of equity, offsets the advantage of the low cost of debts According to MM approach the total value of firm is determined by its operating income or EBIT

 Value of a firm under MM approach- for firms in the same risk class, the total market value of a firm is given by capitalising the expected NOI by the overall capitalisation rate appropriate to the risk class
value of the firm = expected net operating income expected overall capitalisation rate = NOI rA

 The operational justification for MM hypothesis is arbitrage process. The term arbitrage refers to an act of buying an asset/security in one market(at a lower price) and selling it in another (at higher price). As a result, equilibrium is restored in the market price of a security in different markets. Arbitrage is essentially a balancing process. It implies that a security cannot sell at different prices.

 The MM approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other does not.

 The investors of the firm whose value is higher will sell their shares and instead buy the shares of the firms whose value is lower. MM demonstrate that if investors and firms can borrow at the same rate, then investors can neutralize the impact of the alterations in capital structure made by firms management and, thus create homemade leverage.

 This will continue till the market prices of the two identical firms become identical. Thus the market will restore the value of the low valued firm effectively and the net effect will be zero. Investors will be able to earn the same return with lower outlay

Cost of capital

rE

rA
rD

D/E

 Thus as the debt-equity ratio increases, so does the cost of equity. The increase in the cost of equity compensates the decrease in the cost of debt. Now as the amount of debt increases due to its low cost, the financial risk continues to increase. The high level of debt enhances the default risk of the firm so much so that the new debt investors demand high return because their investment with the firm is exposed to high risk of default.

 Now as the cost of debt increases, the cost of equity increases at slower rate and later on starts decreasing. The cost of equity declines due to high debt payments, as low level of earnings are left for the shareholders. Also, the reason for decline of the cost of equity is that with increased debt, the firms business risk is partially transferred to the debt holders.

 In extreme leveraged condition, they not only own part of the assets but also bear the risk of the firm. If interest payments increase due to increase in the debt level for the same level of EBIT, the earnings available to the shareholders will decrease. Thus as the cost of debt increases, the cost of equity decreases leaving the cost of capital constant.

Value of firm

Value of firm with debt

Value of firm with zero debt

Use of debt in firms capital infrastructure

When the corporate taxes are assumed to exist

 According to MM when taxes are there increased usage of debt increases the firm value. MM model under corporate taxes states that the taxes should be maximised as far as possible i.e. 100% When firms have too much debt or all debt, it becomes unnatural and the financial risk is also maximised. With increase in debt, there arises a lot of problems and risks that are not evident in interest payments, but do take a toll on the management

 The costs associated with extreme leveraging i.e. 100% debt is known as financial distress. The cost of financial distress increases with debt level.

Criticism of MM theory
MM theory is based on some assumptions. When these assumptions do not hold good the theory breaks down. Tax differentials the theorys assumption that taxes do not exist is far from reality. Dividends are not taxed whereas tax is levied on capital gains. So the shareholders may prefer dividend to capital gains

 Flotation costs the theory argues that payment of dividend and raising external funds are equivalent. This is not true in practice due to the presence of floatation costs. So a rupee of dividend cannot be replaced by a rupee by external funds. So it is advantageous to retain earnings.

 Transaction costs In the absence of transaction cost a rupee of capital value can be converted into rupee of current income and vice versa. This implies that if dividends are not paid, the shareholders desiring current income can a part of their holdings without incurring transaction cost. Because of the presence of transaction cost, investors may prefer current dividend rather than retained earnings

 Diversification If the company retains the earnings, investors cannot diversify their portfolios. As the investors are willing to pay higher value to the company which pays more current dividend. Uncertainty According to the theory the prices of the two firms which are exactly identical in all respect except with the dividend policy cannot be different. But this is not true due to the bird in hand argument.

 Informational content of dividend(financial signaling) According to this argument dividends contain some information vital to the investors. The payment of dividends conveys the information from the managers to the shareholders about the prospects and profitability of the company.

 When the company changes its dividend policy, investor will assume that it is in response to the expected changes in the firms profitability of the company. When the company changes its dividend policy, investors will assume that it is in response to the expected changes in the firms profitability which will last long.

An increase in the payout ratio implies a permanent increase in the firms expected earnings and vice-versa. So dividend policy becomes relevant because of informational value. The theory accepts the informational content of a dividend but still argue that dividends are irrelevant and that dividends are merely a proxy expected future earnings, which really determines values

or in other words dividend reflects profitability of the company. They cannot by themselves determine the market value of shares.

Trade Off theory

It is also called the agency cost model. It is a modification of MM irrelevance hypothesis of capital structure. This theory argues that the capital structure of any firm is a result of the firms trading off, the advantage arising out of increased leverage in the form of low cost debt and a debt tax shield against potential financial risk(financial distress) that may arise due to increased debt.

 The theory argues that the capital structure of any firm is a result of the firms trading off, the advantages arising out of increased leverage in the form of low cost of debt and a debt tax shield against the potential financial risk or (financial distress) that may arise due to increased debt. Apart from the bankruptcy, financial distress also includes agency costs that arises due to the probability of the firm getting insolvent.

 The shareowners are worried over such affair as they may land up to lose everything under the condition of the firm becoming insolvent or bankrupt.

 There exists an optimal capital structure for every firm at the point where its marginal value of the debt benefits is more than the expected cost of financial distress. The optimal capital structure is determined by the optimal debt-equity ratio. The optimal debt ratio is determined by the trade off between the costs and returns of debt financing.

 Under this theory the firm is expected to set up a target debt equity ratio and then gradually move towards its attainment. Thus the theory states that the firm should have debt and they should exploit all advantages of debt till the point of keeping the financial risk at the minimum.

 More the debt more is the cash available to the cash flow available to the shareholders. The increased cash availability to the shareholders enhances the firm value and its share price. Thus the trade off theory establishes a positive relationship between the (corporate) tax shield and the value of the firm.

 The trade off theory tries to create a balance between the advantages and disadvantages of debt use in a firms capital structure. Like the traditional approach, this theory states that there is an optimal debt equity ratio. The optimal level of debt equity ratio is that mix of debt and equity that not only gives the advantages of debt to the shareholders but also keeps the risk away due to usage of debt.

 Debt equity ratio once established cannot remain constant. It is a dynamic function. It changes with time, with changes in government policies like interest rates and availability of debt etc.

Millers Equilibrium
Merton Miller proposed that with both corporate and personal taxes, capital structures decisions by the firm were irrelevant. This proposition was same as MMs 1st approach of no taxes

 Apart from tax shield uncertainty (because tax savings associated with the use of debt are not certain. If the reported income is low or negative , the tax shield on debt is reduced or eliminated), the presence of taxes on personal income may reduce or possibly eliminate the corporate tax advantage associated with debt Miller initially looks at an environment in which personal taxation is uniform across all investors but differential between investment incomes associated with stocks and bonds

 Merton Miller extends the notion of taxinduced differential returns on securities into a general equilibrium framework in which firms make adjustments in the supply of corporate debt Millers model suggests that in market equilibrium personal and corporate taxes effect cancel out. He assumes that personal tax rate on stock income is zero. Accordingly the model suggests that at the margin the personal tax rate on debt income must equal the corporate tax rate

 When personal taxes equal the corporate tax rate, changes in the proportion of debt in the capital structure do not change the total after tax to the investors

 Millers position is based on the idea that when the market is in disequilibrium, corporations alter their capital structure to take advantage of clienteles of investors in different tax brackets. If there is an abundance of tax-exempt investors, a company will increase the supply of debt. As companies increase the supply of debt, the tax exempt clienteles ability to absorb more debt is exhausted and further debt must be sold to higher tax bracket clientele.

 Companies will stop issuing debt when the marginal personal tax rate of a clientele investing in the instrument equals the corporate tax rate. At this point, the market for debt and stock is said to be in equilibrium, and an individual company no longer can increase its total value by increasing or decreasing the amount of debt in its capital structure

Rate of interest

r r*

Volume of debt D

D*

When the corporate taxes are assumed to exist

 The intercept of the demand curve is the taxexempt equivalent of the pure rate of interest. All tax-exempt securities, including equity which is assumed tax-exempt in the Miller framework, yield certainty-equivalent returns equal r* The horizontal stretch of the demand curve reflects the demand for corporate bonds by tax-exempt individuals and organizations.

 Thus, to entice more investors in progressively higher tax brackets to buy bonds, corporations must pay higher interest rates. The upward sloping demand curve depicts this phenomenon. The intersection of the demand curve with the horizontal line determines the equilibrium.

Pecking Order hypothesis

It was developed by Myers in 1984. According to the theory the capital structure is dependent upon the preference of the firm to finance its operations and investment activities with internally generated funds rather than externally generated funds. In times of excessive need of funds when firms have to go for external financing apart from internal financing, debt is preferred over equity.

 In its simplest form it suggests a positive relationship between leverage and growth opportunities. Debt typically grows when investment exceed retained earnings and falls when investment is less than retained earnings. Thus there is a negative relationship between leverage and profitability. In its more complex form managers are concerned with future as well as current financing costs.

 Balancing current and future costs, firms with large expected growth opportunities can possibly maintain a low risk debt capacity in order to avoid financing future investments with new equity offerings. Therefore the according to the complex version the firms with larger expected investments exhibit less current leverage.

 According to the model higher earnings should result in less leverage. The hierarchy of financing choices is due to the adverse selection costs associated with new equity issues in the presence of informational asymmetry.

 Firms demonstrate their own preferences as to the type and amount they take from different sources of finance. The theory states that the firm exhibits a typical hierarchy of different sources of funds and usually show a preference for internal earnings. When firms go for external financing, they prefer debt to equity capital.

 Thus the most preferable and acceptable source of capital for firms is shown to be retained earnings followed by borrowings and by convertible bonds then as a last resort by new equity issues.

 The theory can be explained from the perspective of asymmetric information and the existence of transaction costs. The firms preference of funding source is determined by the asymmetric information that arises because the firms manager carry far much better information than the shareholders.

 The reason for such asymmetric information is that the managers are insiders and work actively in the organisation while the shareholders are passive workers and not actively involved in the day to day working of the firm.

 There exists discrepancy between the firms real value and the firms market value as investors have lesser and inferior information about the firm as compared to the management. So the managers prefer to issue new securities only when the market price of the firm is higher than the real value of the firm i.e. firms share price is overvalued.

 As intelligent investors become aware of the fact that the firm issues securities which are overvalued then they will refrain from buying it. Thus the security price will be lowered due to lack of demand. The undervaluation may eat up the net present value created by the firm. Therefore the firms prefer to finance from internal funds instead of issuing overvalued securities.

 The clear line between debt and equity has been blurred with the use of innovative financial instruments. This blurring means that traditional classification of either debt or equity are no longer as meaningful.

Informational asymmetry in the valuation of firm

Myers proposed a new theory called the Signaling or asymmetric information theory of capital structure. Corporate insiders have no more information about the firm than the outsiders. This term is used to describe the notion that investors can be somewhat suspicious of equity offerings--managers may not be willing or able to tell all they know-- and drive down a company's stock price.

 Informational asymmetries certainly exist in financial markets in the real world, as long as there are firm insiders and outsiders. One example is related to the principle-agent problem. Managers supposedly act in the interests of the shareholders, but often have conflicting self-interests. Managers are examples of firm insiders, and only they know the true internal projections for the likelihood of success of firm projects.

 Therefore, there exist informational asymmetry between insiders and outsider investor including the shareholder. These investors can rely on the firms observable actions to generate some information about the internal projections for the success of the project. Because of this information asymmetry, there is a mismatch between the insiders of the firm and the outside investors whenever the firm needs external funds to finance a project.

 This "insider's advantage" has been cited in much of the post-M&M literature as one of the reasons that decisions to issue debt or equity can affect the value of a company. While investor suspicion can affect the value of a company's securities, so can another "information problem": many investors just don't have the resources to get to know small companies. As a result, these companies have to pay a higher price for financing.