Capital Struct Theories

8/9/2019 Capital Struct Theories

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COST OF EQUITY Ke

COST OF DEBT Kd

WACC

Leveraged firm and Unleveraged firm

BASICS and TERMINOLOGY


2/17

FOR FINANCIAL LEVERAGE- EPS, ROE

FOR CAPITAL STRUCTURE THEORIES- IMPACTON THE VALUE OF A FIRM

VALUE = VALUE AS EQ + VALUE AS DEBT

VALUE = NET EARNINGS Ke/WACC

BASICS and TERMINOLOGY


3/17

NET INCOME APPROACHFinancial Plan

Unlevered Levered

1. Earnings before interest and taxes, EBIT 1000 1000

2. Less: interest, INT 0 150

3. Profit before taxes, PBT = EBIT INT 1000 850

Ke .10 .10

Value of the equity 10000 ?

Kd .05Value of the debt 3000

Value of the firm 10000 ?

WACC .10 ?


4/17

NET INCOME APPROACHFinancial Plan

Unlevered Levered




Ke .10 .10

Value of the equity 10000 8500

Kd .05Value of the debt 3000

Value of the firm 10000 11500

WACC .10 .087


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. 5

Net Income (NI) Approach

Assumptions:o No taxeso No financial risko Kd < Ke

o

The optimum capitalstructure would be100 per cent debtfinancing under NIapproach.

Criticism This approach has no

basis in reality.

k e

k ok d

D e b t

C o s t

k d

k e , k o


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TRADITIONAL APPROACHFinancial Plan

DEBT INCR

1. Earnings before interest and taxes, EBIT 1000

2. Less: interest, INT 450

3. Profit before taxes, PBT = EBIT INT 550

Ke .15

Value of the equity ?

Kd .07

Value of the debt ?

Value of the firm ?

WACC .095


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TRADITIONAL APPROACHFinancial Plan

DEBT INCR

1. Earnings before interest and taxes, EBIT 1000

2. Less: interest, INT 450

3. Profit before taxes, PBT = EBIT INT 550

Ke .15

Value of the equity 3667

Kd .07

Value of the debt 6248

Value of the firm 9910

WACC .095


8/17

8

Traditional Approach

Assumptions:

o Same as Net IncomeApproach except that thereis a financial risk.

Initial rise in Ke is less thangain by issuing debt withlower Kdbut at higherstages Ke rises more.

So there is an Optimumcapital structure where Kois the lowest.

k e

k o

k d

D e b t

C o s t


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NET OPERATING INCOME APPROACHFinancial Plan

Unlevered Levered




Ke


KdValue of the debt


WACC/ OPPURTUNITY COST OF CAPITAL .010 .010


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10

Net Operating Income (NOI)Approach Assumptions

o Perfect capitalmarket

o No taxes

o NOI and Opportunitycost is constantfor all levels.

o

o No optimum capitalstructure exists.

o

o

k e

k o

k d

D e b t

C o s t


11/17

11

MM Approach Without Tax:Proposition I Assumptions

o Perfect capital market

o Investors can borrow atthe same rate

corporate can.o Same expectations

about operatingprofits.

o Same Business Risk

o No taxes.

No optimum capitalstructure explainedthrough operation alarbitrage processusing home made

k o

D e b t

C o s t

M M ' s P r o p o s i t i o n I


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M&M- operational ArbitrageFinancial Plan

Unlevered Levered




Ke .10 .10

Value of the equity 10000 8500

Kd.05



WACC .10 .087


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M&M PROPOSITION IIFinancial Plan

Levered Unlevered


2. Less: Interest, INT 0 150


Ke .10 ?


Kd - .05



WACC/ OPPURTUNITY COST OF CAPITAL .010 .010


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14

M&Ms Proposition II

Assumptions : same

But Rise is Ke= Fall inWACC due to lowerrate debt.

k e

k o

k d

D e b t

C o s t

M M ' s P r o p o s i t i o n I I


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M&M WITH TAXESUnlevered levered

1. Earnings before interest and taxes, EBIT 1000 10002. Less: Interest, INT 0 150


Taxes @ 50 % 500 425

Profit after tax 500 425

Amount to EQ and Debt holders 500 425+150=575

Value of the equity and Firm (u) 10000

Value of firm (L)= V (u) + P V of tax shield (TD) - 11500

, % .S o 1 0 0 d e b t Fa vo u rab le b u t for tap p in g op p ortu n ities

%a n d re m a in in g fle xib le it sho u ld n o t b e 1 0 0 a s su g g e ste d

&b y M M


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Optimum capital struture100% Debt

Mark

etValu

eofTheFir

m

Value ofunlevered

firm

PV of interesttax shields

Maximum value of firm

M & M (WITH TAXES)


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Then why is there not aninclination of firm towards

DEBT?

Capital Struct Theories

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