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Capital Structure Theories

y The capital structure of a company refers to the mix of

the long term finances used by the firm. y It is the financing plan of the company. y The objective is to mix the permanent sources of funds used by it in a manner that will maximize the companys market price. y Proper mix of funds is called optimal capital structure.

y Capital structure decision influences the risk and

return of the investors. y The company will have to plan its capital structure at the time of promotion itself and also subsequently whenever it has to raise to additional funds for various new projects. The decision involves amount of funds to be raised and sources from where they are to be raised.

y Factors which affect the capital structure are leverages,

cost of capital, cash flow projections, size of the company, dilution of control, floatation costs. y An optimal capital structure should have the features of profitability, flexibility, control, solvency.

yTheories and capital


y Equity and debt capital are two important sources of

long term finance for a firm. y What should be the proportion of equity and debt in the capital structure of the firm; i.e how much leverage should be employed. y For this we need to know whether there is any relationship between the financial leverage and firm s valuation.

y Capital structure theories have different views, some say that there exits a relationship between the two and some state that there is no relation. Following are some of the assumptions made to understand the relationship between financial leverage and cost of capital. y There is no income/corporate/personal tax. y The firm has a policy of paying its earnings as dividend i.e 100% dividend payout ratio.

y Investors rate the companies identically regarding

their returns.(Earnings before income and taxes). y Net operating income shall remain static i.e neither increase or net decrease over time. y without incurring cost(transaction) a firm can change its capital structure.



Net Income approach

y According to this approach, the cost of equity capital (

ke ) and the cost of debt (kd ) remain unchanged when market value of debt(B) and market value of equity (S) ratio proportion varies. y This means that average cost of capital (ko ) measured as Ko = kd B/(B+S) + ke /B+S declines as B/S increases. This happen because when B/S increases, kd which is lower ke , receives a higher weight in the calculation of Ko .

y Illustration:

XY are identical firm except leverage. Calculate cost of capital of firm A and B. A(Rs) B(Rs) Net operating income(O) 20,000 20,000 Interest on debt(F) 0 5000 Equity earning(E) 20,000 15000 Cost of equity capital(ke ) 12% 12%

Cost of debt capital(kd ) Market value of equity(S) Market value of debt(B) Total value of firm

10% 1,66667 0 166667

10% 125000 50,000 175000

Average cost of capital of A/s 10%*0/1,66667+12%*1,66667/166667=12% Average cost of capital of B/s 10%*50,000/175000+12%*125000/175000=11.43%

Net Operating Income Approach

y According to this approach, the overall capitalization

y y y y

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 K =kdB/ (B+S) + keS/(B+S) Therefore the cost equity can be expressed as ke = K + (K -Kd)(B/S)

Net Operating Income Approach

y Here the ko is constant regardless of the degree of

leverage, the market capitalizes the value of firm as a whole and therefore the breakdown between debt and equity is unimportant. y Therefore the net operating income approach implies that there is no optiomal capital structure.

Net Operating Income Approach

y David Durand advocated that, market value of firm

depends on its net operating income and business risk. y The change in the degree of leverage employed by a firm cannot change these underlying factors, hence the degree of leverage cannot influence the market value or average cost of capital of the firm.

Illustration: Consider 2 firms X & Y which are similar in all respects other than leveraging employed by them .

y Net operating income (O) y Overall capitalization rate y y y y y y

X 15000 0.17 88235 1500 0.12 12500 75735 0.165

Y 15000 0.17 88235 3500 0.12 29167 59068 0.494

(Ke) Total market value (V) Interest on debt (F) Debt capitalization rate (Kd) Market value of the debt (B) or (F/Kd) Market value of equity (S)or (V- B) Degree of leverage (B/S)

y Equity capitalization of X
(O-F) 1- 15000 1500 2- 15000 - 3500

EQUITY EARNING / MARKET VALURE OF EQUITY = 13500/75735 = 17.83 % y Equity capitalization of Y = 11500/59068 = 19.47% OR APPLYING FORMUL A Ke = Ko + (Ko Kd) B/S For X = .17 + (0.17 0.12 ) (0.165) = 17.83% For Y = 0.17 + (0.17 - 0.12 ) (0.494) = 19.47%

Traditional approach

This approach has following prepositions :The cost of Debt (kd) remains more or less constant upto a certain degree of leverage but rises thereafter at an increasing rate. The cost of Equity Capital (ke) remains more or less constant or rises only gradually upto a certain degree of leverage and rises thereafter sharply. The average cost of capital (ko) as a consequence of the above behavior of ke and kd

(a) Decreases upto a certain point (b) Remains more or less unchanged for moderate increases in leverage

(c) Rises beyond a certain point.

The principal implication of this approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimises the cost of capital.

At the optimal capital structure, the real marginal cost of debt and equity is the same.

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.


Following table shows the average cost of capital for a firm which has net operating income of Rs 1,25,000 that is spilt variously between interest and equity earnings depending on the degree of leverage employed by the firm.

F Rs 0 25000 35000 45000 55000 65000 75000 85000 95000 105000

E Rs 1,25000 100000 90000 80000 70000 60000 50000 40000 30,000 20,000

Kd (%) 6.0 6.0 6.5 6.5 7.0 7.5 9.0 11.0 15.0 18.0

Ke (%) 10.5 10.5 11.0 11.0 11.5 12.0 14.0 16.0 18.0 20.0

B Rs 0 416667 538462 692308 785714 866667 833333 772727 633333 583333

S Rs 1190476 952381 818182 727273 608696 500000 357143 250000 166667 100000

V Rs 1190476 1369048 1356664 1419581 1394410 1366667 1190476 1022727 800000 683333

Ko (%) 10.50 9.13 9.21 8.81 8.96 9.15 10.50 12.22 15.63 18.29

Where, F = Interest on debt E = Equity earnings Kd = Cost of debt capital Ke = Cost of equity capital B = Market value of debt S = Market value of equity or E/Ke V = Total market value Ko = Average cost of capital

Miller and Modigliani approach

y -Modigliani and Miller in their paper have stated that

the relationship between leverage and the cost of capital is explained by the net operating income approach in terms of three basic propositions. y -They argue against the traditional approach by offering behavioral justification for having the cost of capital,(Ko),remain constant throughout all degrees of leverage .It is therefore essential to spell out the assumptions underlying their analysis.

Capital markets are perfect, information is costless and

readily available to all investors, there are no transactions costs and all securities are infinitely divisible. Investors are rational about risk and return. The m & m theory implies that expected probability distribution values of expected operated earnings for all future periods are the same as present operating earnings.

Firms can be grouped into equivalent return classes

on the basis of their business risk.  There is no corporate or personal income tax.

y MM derived the three proportions based on the assumptions discussed i. 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. symbolically it is represented as : Vj = Sj + Vj = Oj/Pk Where rj = total market value of the firm sj= market value of equity of the firm bj= market value of the debt of the firm oj= expected operating income of the firm pk= discount rate applicable to the risk class k to which the risk class j belongs

y The expected yield on equity ij is equal to pk plus a

premium which is equal to the debt-equity ratio times the difference between k and the yield on debt r . y Symbolically is represented as : ij= Pk + (Pk - r) BJ/Sj

y -The manner in which an investment is financed does not

affect the cut off rate for the investment decision making for a firm in a given risk class. - The proposition emphasizes the point that cost of capital is not affected by the financing decisions as both investment and financing decisions are independent.

Criticisms of MM Proposition
y - In the face of imperfections in the capital markets. The

capital structure of a firm may affect the valuation i.e the firms valuations

and cost of capital may change with changes in its capital structure. - Dividends and retained earnings are not deductible for tax purposes, whereas interest on debt is a tax-deductible. Hence the combined income of stockholders and debtholders is greater when debt capital is used. The optimal strategy of the firm should be to maximize the degree of leverage in its capital structure.

y When the personal taxes are considered along with the

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 favor of debt capital remain intact. y The probability of bankruptcy for a leverage firm is higher than for an unleveraged firm, other things being equal. The probability increasing at an increasing rate as a debtequity ratio increases .

Agency costs
y Whenever creditors a approached by a firm to obtain debt capital, they impose certain restriction on the firm in the form of protective covenants incorporated in the loan contract. y They could be in the form of obtaining prior approval of creditors for matter relating to key managerial ,appointments , maintenance of current ratio alone certain level, restriction on the constraints on the additional issue of the capital, limitation on the further investments. y All these covenants entrails additional costs known as agency costs or monitoring costs and impair the operating agency of the firm.