Capital Structure

Capital Structure

Capital Structure Theories

Max. value of the Firm Min. Cost of Capital

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Characteristics of Debt and Equity Securities

Debt + Equity = Firm Value

D+E=V

Debt: Debt contract is a promise made by the borrower to pay the principled and
stipulated interest amount to the Lender (Investor) on a certain future date

1. Debt a fixed claim

2. Debt Priority
3. Debt Covenants
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Equity: Residual Claim

1. Control
2. Voting Rights
3. Set Corporate Evaluates towards
Management
4. Strategy

Fundamental Contrast

Debt (Fixed Claim) with no control rights Equity (Residual Claim) with all control rights
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Measuring Leverage: The only claim that the firm may issue are debt
and equity and the leverage simply means how much the firm is
financing all its financial operations through debt

1. Levered Debt

2. Levered Equity

Measured through financial ratios and balance sheet ratios

Financial Leverage = Debt/Equity Debt/Capital

Debt + Equity
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Example:
Debt = $1000
Balance Sheet
Equity = $5000

Book Value of Debt/Equity ratio

= $1000/$5000 = 0.20

Debt/Capital = $1000/($1000+$5000) = 0.17

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Suppose the Firm’s debt and equity are trading

Debt equals its book value = $1000

Market value of Equity = (No. of outstanding shares x Market

price)

= $7500 The covenants of debt

like the market value
better reflect the
economic reality than
Debt/Equity Ratio = $1000/$7500 = 0.13 the book value

Debt/Capital ratio = $1000/($1000+$7500) = 0.12

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Common measure of leverage

Combinations of items from the Income Statement and the balance sheet

Debt/EBITDA Cash Flows from Operations

The Financial Ratio that compares the borrowers ability to generate positive cash flows to
meet its obligation of debt repayments

Interest Coverage Ratio = EBITDA/Interest

A company generating $500 of EBITDA and facing concurrent interest obligation of $100
has its interest “covered” five times by its cash flows
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The Financial Effect of Leverage

The effect of leverage on financial performance

Effect of Leverage on EPS and ROE

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Leverage amplifies both the highs and lows of a business performance and,
higher the leverage higher the performance
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The effect of Leverage on Risk

• A debt claim is the safest security that firm can offer to

investors

• Equity holders bear risk Residual Claim

• The amount of risk borne per dollar of equity must rise as

debt (Leverage rises).

• The Effect of Leverage on the Allocation of Risk

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Capital Structure Theories

Capital Structure

Value of the Firm

Affecting the Expected Earnings or the Cost of

Capital
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Assumptions
1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the
shareholders and there are no retained earnings.
4. The total assets are given and do not change. The investment decisions are, in other words,
assumed to be constant.
5. The total financing remains constant. The firm can change its degree of leverage (capital
structure) either by selling shares and use the proceeds to retire debentures or by raising more debt
and reduce the equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of the future
expected EBIT for a given firm.
8. Business risk is constant over time and is assumed to be independent of its capital structure and
financial risk.
9. Perpetual life of the firm.
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Theory One: NET INCOME APPROACH

• According to the Net Income (NI) Approach, suggested by the “Durand”

• The capital structure decision is relevant to the valuation of the firm

• A change in the financial leverage will lead to a corresponding change in the

overall cost of capital as well as the total value of the firm.

• The degree of financial leverage as measured by the ratio of debt to equity is

increased, the weighted average cost of capital will decline
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Assumptions:

1. No taxes

2. the cost of debt is less than the cost of equity

3. the use of debt does not change the risk perception of

investors
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Example:

A company’s expected annual net operating income (EBIT) is Rs 50,000.

The company has Rs 2,00,000, 10% debentures. The equity capitalization
rate (ke) of the company is 12.5 per cent.
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Increase in Value:
let us suppose that the firm has decided to raise the amount of debenture by Rs 1,00,000 and use
the proceeds to retire the equity shares
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Decrease in Value
Let us suppose that the amount of debt has been reduced by Rs 1,00,000 to Rs 1,00,000 and a fresh
issue of equity shares is made to retire the debentures
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Theory Two: NET OPERATING INCOME (NOI) APPROACH

• The essence of this Approach is that the capital structure decision of a firm is
irrelevant.

• Any change in leverage will not lead to any change in the total value of the
firm and the market price of shares as well as the overall cost of capital is
independent of the degree of leverage.
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Overall Cost of Capital/Capitalization Rate (k0) is Constant

Residual Value of Equity

The value of equity is a residual value which is determined by deducting
the total value of debt (B) from the total value of the firm (V).
Symbolically, Total market value of equity capital (S) = V – B.
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Changes in Cost of Equity Capital

𝑬𝒒𝒖𝒊𝒕𝒚 𝒄𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆

( 𝑘
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
𝑒 )

𝑘 𝑒 =𝑘 0 + ( 𝑘 0 − 𝑘 𝑖 )
[ ]
𝐵
𝑆
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Explicit cost
is the rate of
interest paid
on debt.
Cost of Debt
Implicit cost
is the increase
in cost of equity
due to increase in
debt.

As a result, the real cost of debt and the real cost of equity, according to the NOI
Approach, are the same𝑘 and equal 0
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Q. Assume the figures given in Example 15.1: operating income Rs 50,000; cost of
debt, 10 per cent; and outstanding debt, Rs 2,00,000. If the overall capitalisation rate
(overall cost of capital) is 12.5 per cent, what would be the total value of the firm and
the equity-capitalisation rate?
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Firm Increases its Debt
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MODIGLIANI-MILLER (MM) APPROACH
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Third theory: Modigliani and Miller (MM) Theories of Capital
Structure

Basic Propositions
There are three basic propositions of the MM Approach:

I. The overall cost of capital (k0) and the value of the firm (V) are independent of
its capital structure. The k0 and 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.
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The assumptions of M.M. Hypothesis are:
1. (i) Perfect capital markets;
(ii) Investors are rational;
(iii) There are no transaction costs;
(iv) Securities are infinitely divisible;
(v) No investor is large enough to influence market price of securities;
(vi) There are no floatation costs.

2. There are no taxes. Alternatively, there are no differences in tax rates

between capital gains and dividends.

3. A firm has a fixed investment policy which will not change over a period of
time. Financing of new investments will not change in the required rate of
return.
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II. The second proposition of the MM Approach𝑘 is that the is equal

𝑒 to the
capitalization rate of a pure equity stream plus a premium for financial risk
equal to the difference between the pure equity-capitalization rate (ke) and
times the ratio of debt to equity.

MM proposition II states that the corporate’s cost of equity (ke) consists of

two elements: (i) ko, the required, rate of return on the total assets of the
firm whose value depends on the business risk; and (ii) (ko – ki) B/S which
is determined by the company’s capital structure.5 For a zero-debt
company, this component is zero. As the company starts using debt, the ke
increases and the equity-investor is to be compensated for it.
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III The cut-off rate for investment purposes is completely

independent of the way in which an investment is financed.
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Proposition I The basic premise of the MM Approach

(proposition I) is that, given the above assumptions, the total
value of a firm must be constant irrespective of the degree of
leverage (debt-equity ratio). Similarly, the cost of capital as
well as the market price of shares must be the same regardless
of the financing-mix.

Operation of Arbitrage Process.

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Q. Assume there are two firms, L and U, which are identical in all respects
except that firm L has 10 percent, Rs 5,00,000 debentures. The earnings
before interest and taxes (EBIT) of both the firms are equal, that is, Rs
1,00,000. The equity-capitalisation rate (ke) of firm L is higher (16 per cent)
than that of firm U (12.5 per cent).
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Trade-off Theory

It trades off the advantage of debt financing (interest tax shields)

against the costs of financial distress (consisting of higher interest
rates and bankruptcy costs).
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Signalling Theory

as per the signaling theory, debt issues are considered as

“good news” and share issues as “bad news”, the underlying
principle being that the management would prefer to issue
overvalued security. The theory suggests that since share
issue sends a negative signal, which in turn, causes decline in
share prices even when future prospects are bright, the firm
should maintain some reserve borrowing capacity by keeping
relatively low levels of debt than suggested by the trade-off
theory.
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Pecking-Order Theory

The pecking-order theory enumerates the preferred order of

financing, that should be followed by the corporates in practice.
The firms prefer internal financing/retained earnings to
external financing.
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In a nutshell, the financing choices in order of

preferences are:

(1) retained earnings,

(2) non-convertible debt,
(3) preference shares,
(4) hybrid securities like convertible debentures,
(5) equity.
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Implications of the Pecking-Order

(1)No Target-Capital Structure

(2) Relatively Less Use of Debt by Profitable Firms

(3) Need to Build-up Cash Reserves

(4) Tax-shield on Interest is Secondary

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