THE CAPITAL STRUCTURE

THEORIES
 Assumptions
• In order to grasp the capital structure and the cost of capital controversy
properly, we make the following assumptions:

1. Firms employ only two types of capital: debt and equity.

2. The total assets of the firm are given. The degree of leverage can be changed
by selling debt to repurchase shares or selling shares to retire debt.

3. Investors have the same expectation about the future operating earnings for a
given firm.

4. The firm had a policy of 100 per cent dividend pay out ratio.

5. The operating earnings of the firm are not expected to grow.

6. The businesses risk is assumed to be constant and independent of capital

structure and financial risk.
 Definitions:
• The following basic definitions will be used:
•
• S = Market value of Equity shares

• D = Market value of debt

• V = Total market value of the firm, (S + D)

• NOI = X = EBIT = Net Operating Income

• R = Interest Charges (i.e., kd D).

• NI = NOI – R = Net Income when corporate taxes do not exist.

• The capitalization rates or costs associated with different
earnings stream and the value of different securities can be
defined as follows:

• Cost of debt = kd = R / D
• Value of debt = D = R / kd
• Cost of equity= Ke = D1 / P + g = E / P + 0 = E / P
• {when D = E, g = rb = 0, since b = retention ratio is 0}
• where,
• D1 = dividend per share,
• E = earning per share,
• P = market price per share, and
• g = growth rate in dividend or earnings.
• Ke = E / P= E.N / P.N =
• = share holders earnings / S = NI / S
• {where N is the total number of equity
shares}
• = (NOI – R) / S = (X – R) / S
• Or value of Equity =S = (X – R) / Ke.
 Weighted Average Cost of Capital (Ko).

• ko = ke ( S /V) + kd (D /V)
• = {(X – R) / S } (S/V) + (R/D) (D/V)
• = (X – R)/V + R / V
• = (X – R + R) / V
• = X/V
• i.e. the overall cost of capital is:
• ko = X / V = NOI / V
• Or value of the firm is
• V = NOI / ko
•
•
 THE MODIGLIANI – MILLER HYPOTHESIS

• Modigliani and Miller (M – M) argue that, in the absence of taxes, a

firm’s market value and the cost of capital remain invariant to the
capital structure changes.

• Assumptions:
• The securities are traded in a ‘prefect capital market’.
• Firms can be grouped into homogeneous risk class (i.e. firms
belong to the same industry).
• The expected NOI is a random variable.
• Firms follow 100% pay out policy.
• No corporate taxes.
 Proposition- I:

• M-M argue that the two firms, identical in all

respects except for their capital structures, can
not command different market values or have
different costs of capital.
• Their opinion is that if two identical firms, except
for the degree of leverage, have different market
values or the costs of capital, arbitrage (or
switching) will take place to enable investors to
engage in ‘personal leverage’ to restore
equilibrium in the market.
• To illustrate arbitrage process, let us suppose that two
firms L (Levered firm) and U (unlevered firm) have the
same expected NOI = X.
• Assume that
• VL > Vu and that an investor holds α fraction of L firm’s
shares.
• The investors expected return in L firm = α (X-kd DL)
• And his investment in L firm = α SL = α (VL – DL)

• The investor can obtain identical return from the U firm at

a lesser cost by resorting to the following arbitrage
operation:
 Arbitrage Process (When VL > Vu)

Transaction Investment Return

Buy fraction α of the U firm’s shares α SU = α VU αX

Borrow α DL on personal account (-) α DL (-) αkd DL
_________ ________
Net Investment α (VU – DL)

Net Return α (X – kd DL)

 Illustration:

• Assume X = Rs. 10,000, kd = 0.06,

• Su = Vu = Rs. 1,00,000,
• SL = Rs. 60,000, DL= 50,000, and
• VL = SL + DL = Rs. 1,10,000.
• If an investor holds 10 percent of L firm’s
shares (i.e. α = 0.10), would it pay to him
to resort to arbitrage?
 Illustration:

• His investment in L firm α SL = α (VL - DL),

• = 0.10 (60,000) = Rs. 6000.
• Return in firm = α (X – kd DL)
• = 0.10 (10,000 – 0.06 x 50,000)
• = Rs. (0.10x7000)=Rs. 700.
 Arbitrage Process

Transaction Investment Return

Buy 10% of U firm’s shares 0.10(1,00,000) 0.10(1,000)
=10,000 = 1,000
Borrow α DL amount - 5,000 -.1(.06x50,000)
i.e. 0.1 (50,000) = -300
__________ __________
Net Investment 5,000
Net Return 700
• Arbitrage would work in the opposite
direction if Vu > VL by resorting to following
arbitrage process.
• If the investor holds α fraction of U firm’s
shares, his return would be α X and
investment α Vu = α Su. He can obtain the
same return for a total outlay of α VL which
is lower than α Vu , if Vu > VL.
• This is shown in following table:
 Arbitrage Process (When Vu > VL)

Transaction Investment Return

Buy fraction α of L firm’s shares α SL α (X – kd DL)

= α (VL - DL)
Buy fraction α of L firm’s debt α DL α kd DL
_____________
Total Investment α (SL + DL) = α VL __________
Total Return
αX
 Illustration:

• Assume X = Rs. 10,000, kd = 0.06, Su = Vu

• = Rs. 1,00,000, SL = Rs, 40,000, DL = Rs.
50,000 and VL = SL + DL = 90,000.
• If an investor holds 10 % of U firm’s
shares,how can he be benefited by
arbitrage?
 Illustration:

• His investment = α Su = .1 (1,00,000)

• = Rs. 10,000
• Return = .1 (10,000) = Rs. 1,000.
 Arbitrage Process (When Vu > VL)

Transaction Investment Return

Buy 10% of L firm shares 0.1(40,000) 0.1(10,000

= 4000 - .6x50,000) =700
Buy 10% of L firm’s debt 0.1(50,000) 0.1(.06x50,000)
= 5000 =300
___________
___________
Total Investment Rs9,000
Total Return Rs1,000
 THE M-M HYPOTHESIS AND CORPORATE TAXES

• M-M’s argument that the value and the cost of

capital of a firm remains constant with leverage
will not hold good when corporate income taxes
are assumed to exist.
• They revise their earlier opinion and recognize
that the value of the firm will increase or the cost
of capital will decrease with leverage due to the
deductibility of interest charges for tax
computation.
• The value of levered firm will be greater than
the unlevered firm.
Assume two firms L-levered and U –unlevered are
having the following capital structure:

• U firm
Equity 20,000 Asset 20,000
_______ _______
20,000 20,000
 L firm
Rs Rs
8% Debt 10,000 Assets 20,000
Equity 10,000

_______
_____
20,000
20,000
If rate of return is same for both the firms and is equal to r=20%,

following is the income statement ( Assume tax rate is 40%).

U firm L firm

EBIT 4,000 4,000

Less: interest 0 800
_______ ______
Pretax income 4,000 3,200
Tax 40% 1,600 1280
_______ _______
Net income to equity holders 2,400 1,920
________ _______
Total income to both debt holders and 0+2,400 800+1920
equity holders =2,400 =2,720
Interest tax shield 320
• PV of tax shield = Rs320 / .08 = Rs4,000
• PV of U-firm, if ke = 10%
• Vu = Su = Rs2,400 / .10 = Rs24,000

• PV of L-firm
• VL = Rs2400 /0.10 + Rs320 / .08
• = Rs24,000 + Rs4000
• = Rs28,000
How do interest tax shields contribute to the
value of stockholders’ equity ?

• MM’s proposition I amounts to saying that the

value of a pie does not depend on how it is
sliced. The pie is the firm’s assets, and the
slices are the debt and equity claims. If we hold
the pie constant, then a rupee more of debt
means a rupee less of equity value.
• But there is really a third slice, the government’s.
 Normal balance Sheet (market value)

Debt Asset value

Equity (present value of after-
tax cash flows)

Total value Total Assets

 Expanded Balance Sheet (Market value)

Debt XXX Pretax asset value XXX

Govt’s claim (PV of (PV of pre-tax cash flows)
future tax) XXX
Equity XXX

Total pretax value XXX Total pretax assets XXX

 Balance Sheet of U-Firm (Book Value)

Rs Rs
Equity 20,000 Asset value 20,000
_____ _____
20,000 20,000
 Balance Sheet of U-Firm (Market Value)

Rs Rs
Equity 24,000 Asset value 24,000
_____ (PV of after tax _____
24,000 cash flow) 24,000
 Expanded Balance Sheet of U Firm (MV)

Rs Rs
Equity 24,000 Pretax Asset
(2400/.1) value
Govt’s claim 20,000 2400/.1 24,000
(1600/.08) 1600/.08 20,000
_______ _______
44,000 44,000
 Balance Sheet of L-Firm (Book Value)

Rs Rs
Debt 10,000 Asset value 20,000
Equity 10,000
_____ _____
20,000 20,000
 Balance Sheet of L-Firm (Market Value)

Rs Rs
Debt 10,000 Asset value
Equity 18,000 (PV of after tax cash
flow)
Value of U firm 24,000
(2400/.1)
PV of Tax Shield 4,000
_____ (320/.08) _____
28,000 28,000
 Expanded Balance Sheet of L Firm (MV)

Rs Rs
Debt 10,000 Value of U firm 24,000
Equity 18,000 (2400/.1)
______ PV of Tax Shield 4,000
V=D+E 28,000 (320/.08) ______
Govt’s claim 16,000 28,000
(1280/.08) PV of Tax 16,000
______ (1280/.08) ______
44,000 44,000
• When corporate taxes are incorporated, the after-tax earnings of the
firm will be;
• Xt = X – t (X – kd D)= X – tX + t kd D
• = (1-t)X + t kd D; -----(1)
• where,
• Xt = the after-tax earnings,
• t = corporate tax rate, and other variables as defined earlier.

• When the firm does not employ debt (i.e. k d D = 0), the eq (1)
becomes
• Xt = (1-t)X = Earning streams of shareholders of U firm.
• But if the firm employs debt capital, the earnings stream of the levered
firm’s equity and debt holders will be more by t k d D (the tax savings).
• The after-tax earnings of the firm,Xt is the sum of the two
components:
1. An uncertain income stream, (1-t)X and,
2. A certain tax saving of t kd D.

• Thus, to determine VL, the uncertain stream (1-t)x is to be

capitalized at Kou (or Ke) and the certain stream
• t kd D is to be discounted by a lower rate kd.

• Thus, the value of the levered firm will be:

• VL = (1-t)x / Kou + t kd D / Kd
• = Vu +tD ---------(2) {Since (1-t)x / Kou = Vu}
When t is positive VL increases continuously with leverage.
This is shown in the following figure:

• Value

• PV of interest tax shield

• Vu

• D /V
• The equation (2) can be rewritten as follows:
• VL = Vu + t D,
• or 1= Vu / VL + t λ (setting D/V = λ )
• or VL = Vu / (1 – t λ ) -------- (3)
• The equation (3) implies that VL is maximum
when t>0 and λ = 1.
• Theoretically the value of shares will become
zero at this point.
• The after – tax cost of capital can be determined
as follows:
• ko = Xt / VL = (1-t)X / VL +t kd D/ VL
• = (1-t)X / VL + t kd λ ( since λ = D/ VL)
• = (1-t)X (1-t λ) /Vu + t kd λ
• = (1-t λ) (1-t)X /Vu + t kd λ
• = ku(1-t λ) + t kd λ
• = ku – λ(ku – kd)t
k0 is minimum when λ =1. This is shown in the
following figure

• ku

• k0
• kd

• D/V
 Why excessive debt can not be used?

• No one would expect the formula to apply at extreme debt ratios.

• There are several reasons:

• First, it’s wrong to think of debt as fixed and perpetual; a firm’s
ability to carry debt changes over time as profits and firm value
fluctuate.
• Second, you can’t use interest tax shields unless there will be future
profits to shield – and no firm can be absolutely sure of that.
• Finally and most importantly, firms that borrow incur other costs-
bankruptcy costs, for example – offsetting the present value of the
tax shield.
 Cost of Financial Distress

• Financial distress occurs when the firm finds it difficult to

honour the obligations of creditors. The extreme form of
financial distress is insolvency. Insolvency could be very
expensive. It involves legal costs. The firm may have to
sell its assets at ‘distress’ prices.

• Financial distress reduces the value of the firm.

• Value of levered firm = value of unlevered firm + PV of
tax shield – PV of financial distress
• Thus, VL = Vu +TD – PVFD
The following figure shows how the trade-off between the
tax benefits and the costs of distress determines optimal
capital structure.
 Trade-off Theory of capital Structure

• Financial managers often think of the firm’s debt-equity

decision as a trade-off between interest tax shields and
the costs of financial distress.
• This trade-off theory of capital structure recognizes that
target debt ratios may vary from firm to firm.
• Companies with safe, tangible assets and plenty of
taxable income to shield ought to have high target ratios.
• Unprofitable companies with risky, intangible assets
ought to rely primarily on equity financing.
But what are the facts? Can the trade-off theory of
capital structure explain how companies actually
behave?
• The answer is “yes and no”.
• On the “yes” side, the trade-off theory successfully
explains many industry differences in capital structure.
High-tech growth companies, for example, whose assets
are risky and mostly intangible, normally use relatively
little debt. Airlines can and do borrow heavily because
their assets are tangible and relatively safe.
• On the “no” side, there are a few things the trade-off
theory cannot explain. It can not explain why some of the
most successful companies thrive with little debt.
 The Pecking Order of Financing Choices

• The pecking-order theory starts with asymmetric

information. Under asymmetric information managers
know more about their companies’ prospects, risks, and
values than do outside investors.

• Asymmetric information affects the choice between

internal and external financing and between new issues
of debt and equity securities. This leads to a pecking
order, in which investment is financed
• first with internal funds,
• then by new issues of debt; and
• finally with new issues of equity.
 Debt and Equity Issues with Asymmetric Information

• To the outside world A & B companies are identical.

Current expectations price each company’s share at
Rs100. However investors have learned from experience
that the current expectations are frequently bettered or
disappointed and accordingly the true value lower or
higher:
• A B
• True value could be higher, say Rs120 Rs120
• Best current estimate 100 100
• True value could be lower, say 80 80
• Suppose both companies need to raise new money.
They can issue either debt or equity.
• One financial manager thinks that actual price should be
more than Rs 100 (at least Rs120). Hence share should
not be issued at Rs100. It is better to issue Debt.
• Another financial manager thinks in a different way:
• Shares are traded at a higher price. It should not be
Rs100. It is better to issue shares now.
• Why doesn’t the optimistic manager simply
educate investors?

• Now suppose there are two press releases:

1. A will issue Rs120 lakh of bonds.
2. B will issue Rs 120 lakh new shares.
As a rational investor, you learn two
things.
1. Financial manager (A) is optimistic and
Financial manager (B) is pessimistic.
2. Financial manager (B) is stupid to think
that investors would pay Rs100 per
share.
• Smart financial managers think this
through ahead of time. The end
result? Both will issue debt.
 Implications
• Firms prefer internal finance
• They adapt their target dividend payout ratios.
• When internally generated cash flows > capital
expenditures, the firms pays off debt or invests in
marketable securities.
• When internally generated cash flows < capital
expenditures, the firms draws down its cash balance or
sells its marketable securities.
• If external finance is required, firms issue the debt first
and then equity.
• The pecking order explains
• Why the most profitable firms generally borrow less – not
because they have low target debt ratios but because
they don’t need outside money.

• Less profitable firms issue debt because they do not

have internal funds sufficient for their capital investment
• This theory explains the inverse intra-industry
relationship between profitability and financial
leverage.
• The pecking order is less successful in
explaining inter-industry differences in debt
ratios. (High tech industry –low debt, electricity
generating industry-high debt)
 Factors Affecting the capital
Structure Decision
• Factors that favour Borrowing.
• Factors that Discourage (Excessive)
Borrowing.
 Factors that favour Borrowing.

• Primary factor: Corporate income tax

• Debt is a device that allows firms to reduce their
corporate income tax because interest expenses are tax
deductible whereas dividends and retained earnings are
not.
 Important Secondary Factors

• Agency Cost of Equity:

• Retention of control
• Information asymmetry
• Structure of country’s financial system
• When banks are state-owned and can be both lenders and
shareholders of the same company, they are more likely to help that
company avoid bankruptcy. This may explain why some large
companies in countries such as France, Germany, Italy, and Japan
usually have higher debt ratios than their counterparts in the United
States or the United Kingdom.
 Factors that Discourage
(Excessive) Borrowing.

• Primary factor:
• Costs of financial distress
• Higher Debt = Higher probability of Financial
Distress
• Excessive debt increases the probability that the
firm will experience financial distress. And the
higher the probability of financial distress, the
larger the present value of the expected costs
associated with financial distress and the lower
the value of the firm.
• Firms that face higher probability of financial
distress include
• companies with pretax operating profits that are
cyclical and volatile (firms with high business risk such as
high technology companies carry relatively less debt than, say,
utility companies),
• companies with a relatively large amount of
intangible and illiquid assets (software companies have
lower debt ratios than airline or utility companies), and
• companies with products that require after-sale
service and repair (Car manufacturer generally have low
debt ratios than a food company).
 Important Secondary factors

• Agency costs of debt

• Dividend policy
• Excessive debt may constrain the firm’s ability to adopt a stable
dividend policy.

• Financial flexibility
• Excessive debt may reduce the firm’s financial flexibility, that is, its
ability to quickly seize a value-creating investment opportunity.
 Is There A Preference for Retained
Earnings?
• Contrary to securities, retained earnings
do not have issue costs.
 Do Firms Have a Preferred Order in Their
Choice of Financing?
• There is evidence that firms usually raise capital
according to pecking order.
1. Retained earning first (no issue cost).
2. Debt
3. Equity.
• Why do firms issue first debt then equity?
1. The desire of current owners to retain control.
2. The role of debt to reduce agency cost (free cash
flow).
3. Asymmetric information between managers and
outside investors