Capital Structure

MBA FM-2
 Capital Structure

• Capital structure can be defined as the mix of

owned capital and borrowed capital

• Maximization of shareholders’ wealth is prime

objective of a financial manager.
Capitalization and Capital Structure

• Capitalization refers to the total amount of

long-term funds employed by the firm.

• Capital structure signifies the kinds of

securities and their proportion in the total
capitalization of a firm.
 Financial structure and capital structure
• Financial structure is different from capital structure. It
means the composition of the entire liabilities side of the
balance sheet.
• It shows the way in which the firm’s assets are financed.
Financial structure includes long-term as well as short-
term sources of finance.
• Capital structure signifies the proportion of long-term
sources of finance in the capitalization of the firm.
• It is represented by shareholders’ funds and long-term
loans. Capital structure is a part of the financial structure.
 Forms of Capital Structure:
• The capital structure of a new company
generally includes the following:
a) Equity shares
b) Preference shares
c) Debentures or Bonds
d) Long-term loans
 Theories of Capital Structure
The four major theories of approaches which
explain the relationship between capital structure,
cost of capital and valuation of firm are:
1. Net Income (NI) Approach
2. Net Operating Income (NOI)
Approach
3. The Traditional Approach
4. Modigliani-Miller (MM) Approach
 Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no
change in total assets.
 100 % dividend payout ratio, i.e. no retained earnings.
 Business risk of firm is not affected by the financing
mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
 Capital Structure Theories –
A) Net Income Approach (NI)
 Relationship between capital structure and
value of the firm.
 Its
cost of capital (WACC), and thus directly affects the
value of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]
o Corporate income taxes do not exist.
 Capital Structure Theories –
A) Net Income Approach (NI)
The total market value of the firm (V) under the Net
Income Approach is ascertained by the following
formula.
V = S+D
• V = Total market value of the firm
• S = Market value of equity shares
• D = Market value of debt
The overall cost of capital (Ko) Or Weighted average
cost of capital is calculated under
Ko = EBIT/V
 Capital Structure Theories –
A) Net Income Approach (NI)
As the proportion of debt (Kd) in
Cost
capital structure increases, the
WACC (Ko) reduces.

ke, ko ke

ko
kd kd

Debt
 Capital Structure Theories –
B) Net Operating Income (NOI)
 Net
Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
 Asper NOI approach, value of a firm is not dependent
upon its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital i.e.
the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
 Capital Structure Theories –
B) Net Operating Income (NOI)
 NOI propositions –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.
 Modigliani – Miller Model (MM)
Assumption
The MM hypothesis is based on the following
assumption
• There is perfect market. It implies that
(a). Investors are free to buy and sell
securities:
(b). They can borrow freely on the same term
as the firms do;
(c). Investors act in a rational manner.
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
• There are no corporate taxes.
• There are no transaction costs.
• The payout is 100 per cent. That is, all the
earnings are distributed to shareholders.
• Firms can be grouped into homogeneous risk
classes.
 Capital Structure Theories –
C) Modigliani – Miller Model (MM)
When there are corporate taxes:
Modigliani an Miller have recognized that capital
structure would affect the cost of capital and value
of the firm, when there are corporate taxes.
If a firm uses debt in its capital structure, the cost
of capital will decline and market value will
increase. This is because of the deductibility of
interest charges for computation of tax
 Modigliani – Miller Model……
• According to the M-M approach, the value of an
unlevered firm (Which does not use debt ) can be
calculated as follows.
• Value of unlevered firm, Vu = EBIT/ Ke (1-T)
Where EBIT = Earnings Before Interest an Taxes
T = Tax rate Ke = Cost of equity

VL = Vu = (T x D)
Value of levered firm = Value of unlevered firm = (Tax
rate x Debt)
Criticism of MM Approach
1.Markets are not perfect
2. Higher interest for individuals
3. Personal leverage is no substitute for
corporate leverage
4. Transaction costs
5.Corporate taxes
 Capital Structure Theories –
D) Traditional Approach
 The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
 Traditional approach (‘intermediate approach’) is a
compromise between these two extreme approaches.
 Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
 As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
 Capital Structure Theories –
D) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to
higher debt, WACC increases & value of firm decreases.
 Capital Structure Theories –
D) Traditional Approach
 Cost of capital (Ko) is
Cost
reduces initially.
ke  At a point, it settles
 But after this point,
(Ko) increases, due to
ko
increase in the cost of
equity. (Ke)
kd

Debt
Factors affecting Capital Structure Decisions

• The following factors affect the capital

structure and the use of leverage by
management:
– Capital structure policies and targets
– Capital investment financing
– Market conditions
– Asymmetric information
 Capital Structure Policies and Target Capital Structures

• A company’s target capital structure is one that achieves

an optimal mix of debt and equity. Due to the difficulty of
estimating a company’s cost of equity and the cost of
financial distress, capital structure policies tend to be
debt-oriented, setting the company’s borrowing limits,
e.g., “debt as a maximum of X% of total capital.”
• Not all companies have capital structure policies;
however, they are crucial for frequent borrowers due to
the risks associated with too much leverage. In some
industries, a capital structure mix may be dictated by
regulators.
 Debt Rating

• Debt rating is a system of measuring a company’s ability to manage and

pay its debt practically. As the debt rises, the rating agencies tend to lower
the ratings of the company’s debt to reflect higher credit risk. A lower
rating signifies higher risk to both equity and debt capital providers, who
demand higher returns. Rating agencies such as Moody’s and Fitch perform
financial analyses of the company’s ability to pay its debt, as well as an
analysis of the bond’s indenture.
• The agencies assess information regarding the bond and issuer, including
the bond’s characteristics and indenture, and provide investors with an
assessment of the company’s ability to pay. Managers consider the
company’s debt rating in their capital structure policies. Because the cost
of capital is tied directly to the bond ratings, managers must be aware of
their company’s bond ratings. The cost of debt increases significantly when
a bond rating drops from investment grade to speculative grade.
 Market Value vs. Book Value

• While the market value of equity and debt is used to establish

the ideal capital structure, company capital structure targets
frequently utilize book value instead for the following reasons:
• Market values can change dramatically, but they rarely have an
impact on the optimum level of borrowing.
• The amount and types of capital invested by the company, not
the company itself, is of main significance to management.
• The capital structure policy ensures that management can
borrow quickly and at a cheap cost. Lenders and rating agencies
use book values of debt and equity in their calculation
measures.
 Financing Capital Investments
• Key financing decisions are typically tied to investment spending. Management will
examine the asset’s or investment’s characteristics and requirements at the time of
financing, and the company’s overall capital structure after the investment has been
made.
• Assets suited for leverage include real estate and infrastructure assets, which are
generally easy to market cash-generative, and typically regarded as strong collateral by
lenders. In contrast, those with minimal tangible assets are less attractive to lenders.
• Companies mitigate risk by matching the cash flows and maturity structures of their
assets and liabilities. Asset liability misalignment increases the risk of default and cost
of capital for companies.
• Financing may already be in place for some ventures. An example would be the
purchase of an established business.
• Foreign investments are frequently financed in large part with debt, either to hedge
currency risk by borrowing in the same (foreign) currency as revenues produced or to
cut taxes if tax rates are higher in the foreign jurisdiction.
 Market Conditions
• When selecting when, how much, and what type of capital to
issue, managers pay close attention to the price of their
company’s shares and market interest rates on its loans.                
• A firm’s debt cost equals the risk-free rate plus a risk premium
unique to the organization. Above the risk-free benchmark rate,
the risk premium, or credit spread, reflects issuer-specific risk
considerations as well as broader credit market circumstances.
Debt costs are lower for more creditworthy enterprises with
robust and predictable cash flows, lower risk, and higher debt
ratings. On the other hand, less profitable corporations have
higher debt costs due to higher cash flow volatility and/or
predictability, higher risk, and lower debt ratings.
 Information Asymmetries and Signaling
• Managers have more information about a company’s performance and
prospects—including future investment opportunities—than outsiders,
resulting in asymmetric information—an unequal distribution of
information.
• Because there is a greater potential for conflicts of interest, debt and
equity capital providers demand higher returns from companies with
increased asymmetry in information. In other words, investors know that
management has access to more information about the business and will
use this information when raising capital.
• Companies will avoid equity financing for retained earnings or issuing debt.
The pecking order theory suggests that managers will prefer financing from
internally generated funds, then debt, and finally equity. Additionally,
managers will tend to issue equity if they believe their stock is overvalued.
 Agency Costs

• Internal costs incurred due to competing interests of shareholders

(principals) and the management team are agency costs (agents). Items
such as subsidized dinners, a corporate jet fleet, and chauffeured
limousines are examples of “perquisite consumption” that executives
might lawfully authorize for themselves at a cost to shareholders.
• The costs arising from this conflict of interest have been called the agency
costs of equity. Certain actions are taken to mitigate this risk, such as
requiring audited financial statements, holding an annual meeting, using
noncompete employment contracts and insurance to guarantee
performance.
• Agency theory predicts that a reduction in agency costs of equity results
from an increase in the use of debt. The more financially leveraged a
company is, the less room management has to take on more debt or spend
money foolishly.