Capital Structure Theories

eBay, the “world’s online marketplace” founded in 1995, providers an online platform for the sale of goods and services of individuals and businesses around the world. In 2003, 95 million users from more than 150 countries listed 941 million items on the site. eBay’s global community of buyers and sellers grew by more than 33 million people during that year. It took eBay 8 years to reach $1 billion in annual revenue in 2002. just 1 year later, eBay’s annual revenue doubled to $ 2.17 billion. To support this growth & expand eBay continues to make acquisitions & invest capital in technology infrastructure, marketing, product development etc. In its 2003 annual report, eBay announced that its capital expenditure were expected to total $315 million during 2004, in addition to the cost of the company’s acquisitions. To fund such growth, eBay raised funds from operating activities and by issuing more than $700 million in common stocks during 2003. While eBay has been able to meet its capital needs primarily from operating activities and the issuance of common stock, other corporations rely more on issuance of long-term debt. Each method of raising capital has its unique costs & benefits.

Objective of the Firm
• The objective of a firm should be directed towards the maximization of the firm’s value. • The capital structure or financial leverage decision should be examined from the point of its impact on the value of the firm.

MM hypothesis.Capital Structure Theories – – – – Net Income (NI) approach. Net operating income (NOI) approach. . Traditional approach.

the overall cost of capital declines and the firm value increases with introduction of more & more debt capital.Net Income (NI) Approach • According to NI approach. • As a result. . both the cost of debt and the cost of equity are independent of the capital structure • They remain constant regardless of how much debt the firm uses.

67% .Example Company Operating Income Interest Expenses Owner’s Income Cost of Equity Cost of Debt Market Value of Equity Market Value of Debt Total Value of the Firm Alpha 100 0 100 10% NA 1000 Nil 1000 Beta 100 25 75 10% 5% 750 500 1250 Gamma 100 50 50 10% 5% 500 1000 1500 Overall Cost of Capital 10% 8% 6.

The effect of leverage on the cost of capital under NI approach .

. • In case firm increases leverage by employing more debt. • The theory assumes that each firm has a predetermined capitalization rate. • The advantage of using ‘cheaper’ debt financing will be offset by higher cost of equity due to its increased riskiness. it becomes more riskier.Net Operating Income (NOI) Approach • According to NOI approach the value of the firm remains constant irrespective of its degree of leverage.

Example Company Operating Income Interest Expenses Owner’s Income Cost of Capital Cost of Debt Market Value of the Firm Market Value of Debt Market Value of Equity Delta 200 0 200 10% NA 2000 Nil 2000 Sigma 200 50 150 10% 5% 2000 1000 1000 Omega 200 80 120 10% 5% 2000 1600 400 Cost of Equity 10% 15% 30% .

• The cost of equity rises at a slow pace upto a certain degree of leverage and increases rapidly thereafter.Traditional Approach • The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby. • The cost of capital initially declines due to moderate use of leverage and rises sharply thereafter. . • The firm can attain optimal capital structure by judicious use of leverage. • The cost of debt remains constant upto a certain level of leverage and rises gradually thereafter. increase the firm value.

56% when the firm substitute equity capital by issuing Debentures of $300.000 debentures can be issued at 6% interest rate where as $600. when $600. Assuming that $300.000.Example A firm is expecting a net operating income of $150.000. Further it would go up to 12.000 on a total investment of $1000. if the firm has no debt. .000 debentures are can be raised at 7% interest. the cost of equity capital is 10%. But it would increase to 10.000 debentures are issued.5%.

000 Net Income Cost of Equity Mkt Value of Equity Mkt Value of Debt Value of Firm Avg.000 Nil 6% Debt of Rs.7% 1. cost of Capital 1.000 9.000 15.08.000 Nil 15.50.00.000 10% 1.000 42.000 3.000 10% 15.000 18.00.00.No Debt Net Operating Income Interest Payment 1.50.000 6.5% 8.00.64.000 12.50.000 1. 6.32. 3.000 1.50.50.000 7% Debt of Rs.00.000 10.64.00.3% .56% 12.000 10.000 14.50.

Why debt is required to maximize the value of the firm? .What Debt-Equity Ratio Maximize the Value of the firm? • The value of the firm(V) = B + S Where. B= Mkt Value of Debt S = Mkt Value of Equity The firm should pick the debt-equity ratio that makes the Pie (the total Value) as big as possible.

Current Asset Debt Equity (Net Worth) Interest Rate MV of Shares Share Outstanding $8000 Nil $8000 10% $20 400 Proposed $8000 $4000 $4000 10% $20 200 . The firm is considering to issue debt to buyback some of its equity. has currently no debt in its capital structure.XYZ Ltd.

00 Proposed Capital Structure Recession 5% $400 $400 Nil 0 0 Stable 15% $1200 $400 $800 20% $4.00 Boom 25% $2000 Nil $2000 25% $5.00 .00 Stable 15% $1200 Nil $1200 15% $3.00 Boom 25% $2000 $400 $1600 40% $8.Current Capital Structure Recession RoA EBIT Interest Equity Earnings RoE EPS 5% $400 Nil $400 5% $1.

EBIT-EPS Analysis Firm I Equity Capital 10% Debt No.000 Nil 1000 3000 Firm II 6. of Outstanding Shares Operating Income Tax rate 40% 10.000 4000 600 3000 .

10 million for financing an expansion project. What will be the EPS under two alternative financing plans for two levels of EBIT say Rs. In this context the company is evaluation two alternative financing plans: (i) Issue equity share (ii) Issue debenture carrying 14% interest.10 million (FV = Rs.4 million.Existing Capital structure = Equity Capital of Rs.10 each) The company plans to raise additional capital of Rs. .2 million and Rs. Applicable tax rate is 50%.

• All investors have homogeneous expectations and belong to similar risk class.Modigliani Miller Proposition • MM’s Proposition: Key Assumptions • Perfect capital markets. . • Securities are issued and traded in the market are infinite divisible. • There are no transaction costs and taxes. • All participants in the market are rational.

Proposition I • The market valuation of a firm is independent of its capital structure and is determined by capitalizing its expected return at the rate appropriate to its risk class. . • The average cost of capital is equal to the capitalization rate which is constant for a given firm. • The value of the firm is computed by discounting the future stream of operating income.

.Proposition I • M-M has convincing argument that a firm cannot change the total value of its outstanding securities by changing the proportion of capital structure. • In other words the value of the firm is always the same under different capital structure.

corporate leverage is not something unique. • The investors are able to replicate any combination of capital structure by substituting the corporate leverage with “Home-made Leverage”.Arbitrage Process • MM have cited the arbitrage process to support their proposition that the value of a levered firm cannot be higher than the value of an unlevered. • Home made leverage refers to the personal borrowing made by the investors in the same ratio as a levered firm. • Conversely the value of an unlevered firm cannot be higher than the value of a levered firm. • Hence. .

100.000 Theta Ltd.000 Nil 10. Total Capital Employed Equity Capital 5% Debenture Net Operating Income Interest Expenses Owners Earnings Equity Capitalization Rate 10. .000 10% 100.000 50. Miller holds 10% equity of the Theta Ltd.Example Lambda Ltd.000 50.000 100.000 2500 7500 12.000 10.5% Mr.

Critics • Risk Association Counter: Margin Trading Institutional Investors .

• As the firm starts introducing cheaper debt in the capital structure to reduce cost of capital.Proposition II • The financial risk premium is a function of leverage applied. the benefit obtained by the use of cheaper debt is exactly offset due to the rise in the cost of equity. the equity holders demand higher returns which push up the cost of equity. • The cost of equity will be equal to the cost of capital in all equity firm. . • Due to increase in the financial risk. • Thus. the financial risk of the firm increases.

• Am implication of the M-M proposition I is that WACC is constant form given firm regardless the capital structure. • The expected return on equity is positively related to leverage. • • 𝐷 𝐷 WACC = ×Kd + ×Ke 𝐷+𝐸 𝐷+𝐸 𝐷 Ke = Ko + (Ko.Previous Example • The market requires only a 15% expected return for the unlevered firm but it requires a 20% expected return for the levered firm.Kd) 𝐸 [Assumption: No tax] .

• Analogy: • Real World Scenario: (i) Industry Standard (ii) Market condition • Two unrealistic assumptions: (i) Taxes were ignored (ii) Bankruptcy costs and other agency costs were ignored. .

. • Value of pie is maximized for the capital structure paying the least taxes. the value of the firm is positively related to debt. • Both equity share holders & income tax authorities have claims on the firm’s earnings. • Managers should choose capital structure that the income tax authorities hates the most.Taxes in M-M Capital Structure • In the presence of corporate taxes.

The firm is considering two alternative capital structure.X ltd. The corporate tax rate is 35% . Under Plan-II the company would have Rs.10 lakh each year. Under Plan-I the company would have no debt in its capital structure. expects EBIT of Rs.40 lakh debt carries interest of 10%. Its entire earnings after tax is paid out as dividend.

• PV of tax shield: [tc × Kd × D]/Kd • Value of levered Firm: is the value of an all equity firm plus the present value of tax shield. the firm will pay [tc × Kd × D] less with the debt.• Value of Tax Shield: tc × Kd × D • That is whatever the taxes that a firm would pay each year without debt. . • M-M Proposition I: Corporate leverage lower tax payments.

The corporate tax rate is 35% implying after tax earnings of $100. The cost of debt capital is 10%. What will be the net value of Z Ltd. . The company expects to generate $153. The firm is considering capital restructuring to allow $200 of debt.85 in EBIT In perpetuity. all earnings after tax are paid out as dividend.Example Z Ltd is currently an unlevered firm. Unlevered firm in the same industry have a cost of equity capital of 20%.

• The possibility of bankruptcy has a negative effect on the value of the firm. . • The cost associated with the bankruptcy that lower the value.Bankruptcy Risk/ Bankruptcy Cost • Debt provides tax benefits but also put pressure of fixed payments. where the ownership of the firm’s assets is legally transferred to bondholders. • The ultimate distress is bankruptcy.

.Indirect costs of Financial Distress • • • • Loss of Customer Loss of suppliers Loss of employees Distressed sale of assets.

2. The firm may not merge with another firm. These agreements called ‘Protective Covenants’. Limitations are placed on the amount of dividends a company may pay.Protective Covenants Shareholders take insurance against their own selfish interest and frequently make agreements with bondholders in the hope of lower rates. 1. 5. . 3. The firm may not sell or lease its major assets without approval by the lender. The firm may not issue additional long term debt. The firm may not pledge any of its assets to other lender. 4.

. and choose debt over new issue of equity when external financing is required. • This also implies that firms always use internal finance when available. • The manner in which managers raise capital gives a signal of their belief in their firm’s prospects to investors.PECKING ORDER THEORY • The “pecking order” theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information.

Equity Financing (case of undervaluation when issue further equity). Debt Financing (no dilution of equity holdings) 3.PECKING ORDER THEORY of Financing 1. Preference Capital 4. Retained earnings (no flotation costs) 2. Signaling Theory: .

Strategic Determinants of Capital Structure Type of asset financed Nature of industry Degree of competition Product life cycle Financial policy of the firm Past & present capital structure Credit rating Exception: Microsoft Case .

(Data richness and company specific changes). Estimation period: Beta is sensitive to the length of estimation period.Beta & Leverage • One common method of estimating the company’s stock beta is to use a market model. Period of return interval: Use of smoothing technique: .

• The unlevered beta is often referred as the asset beta.5 instead 0.4 .4 and the corporate tax rate is 30%. • What would the company’s equity beta if companies debt equity ratio were 0. • Then we need to adjust the leverage. because it reflects only the business risk of the assets. • Suppose a company has an equity beta of 1.Asset Beta • The beta of the comparable firm is first unlevered by removing the effects of its financial leverage. a debt equity ratio is 0.5.

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