A few do’s and don’ts

 Be prepared: do self-study; read cases before you come to class

 Make the class interactive - everyone should participate
 There aren’t always right and wrong answers! If you have a point
of view, feel free to say it with logic
 Excel is your BEST FRIEND!
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My contact details:
M: 9953469882
E: sudhir.vasantmadhavdravid@ibsindia.org
Days in campus : Wednesdays and Fridays
 Capital Structure Theories
 Capital structure: proportion of share capital (equity
+ preference) and debt in the overall capital of the
co
 Optimum Capital Structure: Minimize the weighted
average cost of capital (WHY?)
 Important to understand the relationship between
leverage, and cost of capital- as this has direct
impact on VALUE of the firm (WHY?)
 Capital Structure Theories
 Definitions and symbols
 O = Operating Income (EBIT)
 E = Total value of Equity
 D = Total value of Debt
 I = Interest cost
 EPS = Earnings per share
 V = Total market value of firm (V = E + D)
 ki = Cost of debt = I/D
 ke = Cost of equity (EPS1/P0)
 ko = Overall cost of capital (WACC)
 Relationship between Capital Structure
and Cost of Capital

Why is this important?

Fundamental equations:
V=D+E
V = O/r
Generally, Value = Perpetuity cashflow / Capitalization rate

So, how does capital structure impact cost of capital and firm
value?
 Approaches
 Net Income Approach
 Net Operating Income Approach
 Traditional Position
 Modigliani-Miller
 Proposition I
 Proposition II
Assumptions:
1. No taxes
2. All earnings paid out as dividend
3. Operating income remains constant with time
4. No transaction costs for raising additional capital
 Approaches

 Net Income Approach

Cost of debt and cost of equity remain unchanged when
D/E varies
So, when D/E increases, WACC will.....
 Capital Structure Theories
 Net Income (NI) Approach
 (Key Assumption: Cost of debt, as well as cost of equity do not
change with change in leverage)
 Suggested by Durand
 Change in financial leverage will lead to
change in overall cost of capital and hence,
total value of firm will also change
 Increase in debt-equity ratio will result in
decline of WACC; similarly, decrease in DER
will result in increase in WACC (WHY?)
 Capital Structure Theories
 Net Operating Income Approach
 Diametrically opposite to NI approach
 Capital structure decision is irrelevant to
Value of Firm
 Value of firm depends only on EBIT
 Change in leverage does not lead to any
change in WACC or Value of Firm
 As leverage increases, the return required
by equity holders increases and hence ke
increases, thereby keeping WACC constant
 Capital Structure Theories
 Traditional Approach
 Intermediate between NOI and NI approach
 Through a judicious use of leverage, firm can
increase its Value
 However, as leverage increases beyond a particular
point, the risk perception of the Firm also increases
and hence the expected return on equity as well as
cost of debt increases substantially
 Therefore beyond this point, the WACC starts
increasing with increase in leverage
 That level is the Optimum capital structure
 Capital Structure Theories
 Modigliani-Miller Approach
 Similar to NOI approach
 Provides more behavioral justification to
the theory that Value of Firm is
independent of Capital Structure
 This Behavioral theory is based on
Arbitrage of the Investor
 But…this has limitations: perfect
substitutability of personal leverage with
corporate leverage
 Modigliani-Miller Position
 More rigorous, mathematical basis
 Based on empirical studies
 (rather than rule of thumb)
 Modigliani-Miller Position
 Key Assumptions
 Perfect Capital market : i.e. no asymmetry of info;
transactions are costless; no bankruptcy costs
 Rational Investors : Investors choose a combination of Risk-
Return judiciously and rationally
 Rational Managers: i.e. Managers act to maximize wealth of
Shareholders
 Homogenous expectations : i.e. Investors expectations of
future operating earnings are identical
 Equivalent Risk Classes: i.e. firms can be grouped into
“equivalent risk classes” based on their business risk
 There are no taxes
 M-M Proposition-I
 Value of a Firm = Its Expected Operating Income
divided by discount rate relevant for its risk class.
 Value of firm is independent of its capital structure
 V = D + E = NOI/ko
 Identical to ……..?
 Rational basis for this: Arbitrage Argument
 In equilibrium, identical assets must sell at same price,
irrespective of how they are financed.
 i.e. irrespective of how you “package” a set of cashflows, its
value remains unchanged
 M-M Proposition-I contd
 Investor shall be in a position to sell stake in levered
firm (same NOI, higher valuation)
 Use personal leverage to raise loan
 Invest the total proceeds in unlevered firm (same NOI,
lower valuation)
 Enjoy same return but left with surplus
 If many investors act on this arbitrage opportunity,
supply of L’s shares and demand for U’s shares
increases, thereby price of L’s shares will have
downward pressure and U’s shares will have upward
pressure till their market value is equal
 Unlevered Firm (U) Levered Firm (L)
Operating Income or EBIT 1,50,000 1,50,000
Interest 0 60,000
Equity Earnings 1,50,000 90,000
Cost of equity 15% 16%
Market value of equity 10,00,000 5,62,500
Cost of debt 0 12%
Market value of debt 0 5,00,000
Market value of firm 10,00,000 10,62,500
WACC 15% 14.12%

Investor owns 10% of L. He sells his stake for Rs 56,250, and takes personal loan of Rs 50,000 at
12% in order to maintain his level of indebtedness as before. Now he invests in 10% of U, which
costs him Rs 1,00,000. He has surplus amount left over of 1,06,250 – 1,00,000 = Rs 6,250

Income from old inv in L Income from new inv in

U
Earning from 10% equity stake 9,000 15,000
Less: interest cost 6,000
Investors Earnings 9,000 9,000
 M-M Proposition-II
 Expected return on equity is equal to expected return
on assets plus a premium.
 The premium is equal to Debt-equity ratio multiplied
by difference between expected return on assets and
expected return on debt
 Ke = ko + (ko – kd)(D/E)
 In other words, rate of return expected by
Shareholders increases with financial leverage
 M-M Proposition-II
 Expected return on equity is equal to expected return
on assets plus a premium.
 The premium is equal to Debt-equity ratio multiplied
by difference between expected return on assets and
expected return on debt
 Ke = ko + (ko – kd)(D/E)
 In other words, rate of return expected by
Shareholders increases with financial leverage
 Beta (E) = Beta of firm + D/E *(Beta of firm – Beta(D))
 Risk increases with leverage, hence, expected return of
shareholders also increases
 Criticisms of MM Theory
 Firms as well as individuals are subject to tax
 Bankruptcy costs can be high
 Agency costs: between management and shareholders;
and between shareholders and creditors
 Managers seem to have a preference for certain means
of financing
 Information asymmetry exists between managers and
investors
 Personal leverage and corporate leverage are not
perfect substitutes for each other
Factors having impact on Capital Structure decision
 Asset Structure (Tangible vs Intangible)
 Stability of Revenues
 Operating Leverage (co with lower op leverage can take on
higher financial leverage)
 Lenders’ covenants regarding Interest coverage, DSCR etc
 Growth Rate : high growth may have to be financed through
debt as, equity financing may involve too much dilution
 Profitability : Highly profitable firms may generate more than
adequate cash from operations, don’t need debt
 Taxes : Higher the tax rate, greater the incentive to use debt
 Control : Fresh issuance of capital = Dilution
 Attitude of Management : Aggressive vs Conservative
 Taxation and Capital Structure
 In general, Firm Value V can be written as
 V = OI (1-tc)/K + tcD where :
 OI = Operating Income = EBIT
 tc = Corporate tax rate
 K = capitalization rate for unlevered firm in same risk class
 D = Total debt
 So the first term is nothing but VU = value of unlevered firm,
2nd term is value of tax shield arising out of tax shield
 Taxation and Capital Structure
 Role of corporate taxes
 Interest is a tax deductible cost; dividend is not
 Leverage gives tax shield
 EPS can be enhanced due to leverage
 Value of Levered firm is > Unlevered Firm
 VL = VU + tcD
 Where VL = value of levered firm
 VU = value of unlevered firm
 tc = corporate tax rate
 D = Total Debt
 So, tcD is the gain from Leverage i.e. tax advantage of debt
 Costs of Financial Distress
 Firm unable to meet financial obligations
 Many reasons: leverage, business cycle, obsolescence,
mismanagement, acts of God….
 May lead to Bankruptcy
 Consequences:
 Disagreements betwn Shareholders and Creditors delay
liquidation, erode value of assets
 Distress sale of assets fetches much lower price
 Legal and admin cost of bankruptcy very high
 Managerial myopia: short term actions jeopardize long term
sustainability of organization
 Loss of confidence in employees, suppliers, customers,
investors, other stakeholders leading to adverse impacts
 First 3 are Direct costs, next 2 are Indirect costs
 Agency Costs
 Managers vs Shareholders
 Shareholders vs Creditors
 Take into account expected value of Cost of Financial
Distress and Agency cost:
 VL= VU + tax adv of debt
– PV of Fin Distress cost – PV of Agency cost
 Signalling Theory
 Firms prefer to rely on internal accruals
 Expected future investment opportunities and
expected future cashflows determine dividend payout
 Dividends are “sticky” in short run
 If internal accruals > capex requirement, surplus used
to invest in marketable securities, or retire debt ,
increase dividend, acquisitions, share buyback
 If internal accruals < unavoidable capex, then firm may
sell down some securities; only after that, it will think
of external financing (why?)
 Pecking order: Internal accruals; debt; mezzcap; Equity
Considerations in Capital Structure Decision
 EBIT-EPS Analysis
 ROI – ROE
 Ratios : Interest coverage, DSCR, fixed assets coverage
ratio
 Max debt-servicing capacity from expected cashflows
 Comparable firms
 Signalling theory, pecking order theory
 FRICTO analysis
 FRICTO Analysis
 Capital structure decision has to be made after
considering several factors

 Flexibility
 Risk
 Income
 Control
 Timing
 Others
 FRICTO Analysis
 Flexibility- the impact of alternative financing choices
on the company's ability to raise funds in the future. A
company that has flexibility will always have access to
financial markets and can also take the financing type
of its preference

 Risk- the impact of alternative financing choices on the

risks the company and its stakeholders are exposed to.
As a rule-of-thumb, taking on more debt increases the
risks of both creditors and shareholders
 Risks
 Business Risks
 Variability of EBIT
 Influenced by volatility in market demand, price (commercial
risk), input costs, cost structure
 Financial Risks
 Risk arising out of financial leverage
 Due to high burden of financial commitment (interest and
repayment)
 FRICTO Analysis
 Income- the impact of alternative financing choices on
the company's income. A company whose EBIT is
above its financing indifference point will be able to
increase its earnings per share (EPS) by taking on
additional debt.
 Control- the impact of alternative financing choices on
the amount of control over the company held by each
shareholder. In general, issuing additional common
shares will dilute this control.
 FRICTO Analysis
 Timing- the impact of market conditions on alternative
financing choices. From time to time, financial markets
shift from one preferred type of financing to another,
thereby affecting companies' debt-equity mix choices.
 E.g. Co may want to maintain a particular D/E ratio, but it
may not be desirable to issue fresh equity EVERY time it
raises some debt
 Other factors- the impact of alternative financing
choices on other issues, or the impact of such issues
on these choices. For example, the potential reduction
in the cost and risks of debt financing that would be
brought about by posting collateral.
 Other factors to be considered for Capital
Structure decision
 Tax advantage of debt
 Corporate Strategy and financial policy to be well
integrated
 Raise the financing proactively, not reactively
 Keep a control on Translation exposure
 Know the Lending norms and covenants of banks,
rating agencies
 Innovative instruments … can be double edged sword
 Transparency, Communicate with Investor community