Capital Structure Theory and Policy

It is better if the company raises the fund required for financing the new project by issue of debentures in place of equity shares. This will push up the EPS as well as Market Price per Share. MP= EPS X P/E Ratio

Points of Indifference:The EBIT level at which EPS remains the same irrespective of the D?E mix(Break even of EBIT for alternative Financial Plans). (X-I1) (1-T)-PD S1 = (X-I2) (I-T) S22

It helps in ascertaining the level of Operating Profit beyond which the debt alternative is beneficial because of its favourable effects on EPS. *If expected EBIT is likely to be going high - Debt financing *If expected EBIT is likely to be going low - Equity Financing

Financial Break Even PointThe level of EBIT at which a firm will be in a position to satisfy all fixed Financial Charges i. e. Interest & Pref. Dividend I+ PD/(1-T) So, the profit available for Equity Shareholders would be ZERO at this point, and therefore EPS would also be ZERO. Any increase beyond this point will result in increase in EPS more than the proportionate to increase in EBIT.

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Optimum Capital Structure(To maintain Financial Stability) (Market Value per Equity Share is Maximum) Optimum Capital structure is expressed by the proportion of D/E securities which maximise the value of a companys share in stock market. Maximisation in the value of firm Optimum Leverage can be defined as that mix of debt & equity which will maximise the market value of a company. Advantages: It minimises the companys Cost of Capital which in turns increases its ability to find new wealth creating investment opportunities(Rate of Investment) By increasing the firms opportunity to engage in future wealth creating investments(Wealth)EZRA SOLOMON:4

Considerations:4.Take advantage of favourable financial leverage while raising funds 2. Income tax leverage

3. Avoid perceived high risk capital structure (Human Sentiments)

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Capital Structure TheoriesIn order to achieve the goal of identifying an Optimum D/E mix, it is necessary to be conversant with basic theories underlying the capital structure of corporate enterprise. Existence of Optimum Capital Structure is not accepted by all. There exist extreme views: View point I:- The financing or D/E mix has a major impact on Shareholders wealth View point II:- The decision about financial structure is irrelevant as regards maximisation of Shareholders wealth6

Capital structure theories:

Net income (NI) approach. Net operating income (NOI) approach. Modigiliani-Miller hypothesis with and without corporate tax.

Traditional Approach

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Assumptions: 3.Only two types of capital(D & E) No Pref. Shares 4.No Corporate Tax(Removed later) 5.100% earning is distributed as Dividend- No R.E. 6.Investment Decisions are constant- No change in assets 7.Total financing remains the same- No change in Capital volume 8.EBIT are not expected to grow 9.Business risk is constant- not dependant on capital structure or, financing risk 10.All investors have the same probability distribution of the future expected EBIT for a given firm 11.Firm is having a perpetual life.8

Net Income (NI) Approach Suggested by Durand David Supports View point I According to NI approach

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. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.9

Higher debt in capital structure will result in decline in the overall/ weighted average cost of capital i.e. increase in the value of firm, & consequently increase in EPS Assumptions: 4.No Corporate Tax 5.Cost of Debt is less than cost of Equity 6.Debt doesnt change the risk perception of the investors V= S+B; S = NI/ Ke

V= Value of firm S= Market value of Equity B= Market value of Debt NI= Earning available for Equity Shareholders Ke= Equity Capitalisation rate

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Cost

ke, ko

ke

kd

ko kd

Debt

11

Net Operating Income (NOI) Approach Opposite of NI Approach According to NOI approach the value of the firm

and the weighted average cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.12

Market Value of a firm is not affected by Capital Structure changes. Market Value of the firm is ascertained by Capitalising the net operating income at the overall cost of capital, which is considered to be constant. V = EBIT K

(Value of equity would be the residual value) S= V- B

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Assumption:2.K is constant for all degrees of D/E mix 3.Market capitalises the value of the firm as a whole 4.Use of debt increases the risk of equity shareholders. This results in increase in equity capitalisation rate 5.No corporate tax V is constant irrespective of leverage mix Market price

will also not change No existence of optimum capital structure Tax Leverage (Maximum possible debt content) Ke = (EBIT-I) / (V-B) ; K= Kd (B/V) + Ke(S/V) Increase in debt proportion Ke would also increase Market Price remain unchanged

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Cost ke

ko kd

Debt

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Modigiliani-Miller ApproachSimilar to NOI Approach Value of the firm is independent to its capital structure i.e. Independence of total valuation and the cost of capital of the firm from its capital structure NOI is purely conceptual, Doesnt provide operational justification Supports NOI and provides behavioural justifications Prepositions: 2.K & V are constant for all level of D/E mix. Total market value of the firm is given by capitalising the expected net operating income by the rate appropriate for that risk class.

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2. Ke = Capitalisation of pure equity stream plus a premium for the financial risk 3. The cutoff rate for investment purpose is completely independent of the way in which investment is financed Assumptions: 2.Capital market is perfect (i) Investors are free to bye and sell (ii) Well informed market (iii) Firm & investors can borrow on the same terms (iv) Rational behaviour of investors (v) No transaction cost 8.Homogeneous risk class 9.All investors have the same expectations of the firms EBIT 10.No R.E. 17 11.No Corporate Tax(removed later)

In brief, MM hypothesis based on the idea that no matter how the capital structure is been divided among D & E and other claims, there is a conservation of investment value. Because the total investment depends upon its underlying profitability and risk. Arbitrage Process( An operational justification of MM Approach With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.18

Cost

ko

Debt MM's Proposition I

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* Arbitrage restores equilibrium in value of securitiesConsequence: Market price of the securities of the two firms(exactly similar in all respect except in their capital structure) can't for a long time remain different in different markets. Example: Two firm A & B are identical in all respect except that the firm A has 10% Rs. 50,000 debentures. Both the firm have the same EBIT amounting to Rs. 10,000. The equity capitalisation rate of the firm A is 16% while that firm B is 12.5%. You are required to calculate the total market value of each of the firms and explain with an example the working of the arbitrage process20

Particulars EBIT Less: Interest Earning available for equity share holders Equity capitalization rate(Ke) Total market value of equity(s) Firm A : (5,000X100)/16 Firm B : 10,000X100)/12.5 Total market value of debt(B) Total value of Firm(V) Overall cost of capital(K): EBIT/V Firm A : (10,000X100)/81,250 Firm B: (10,000X100)/80,000 D/E Ratio: (B/S)Firm A: 50,000/81,250

Firm A 10,000 5,000 5,000 16% 31,250 50,000 81,250 12.3%

Firm B 10,000 NIL 10,000 12.5%

80,000 NIL 80,000

12.5% 0.6 21

Working of the Arbitrage Process: The example shows that firm A s market value is higher than the firm B due to the debt financing. According to MM hypothesis this situation is not going to continue for a longer time due to arbitrage process. The investors in firm B can earn a higher return on their investment with a lower financial risk. Hence, the investors in firm A will start selling their shares and they buy shares in firm B. This process continue till firm As shares decline in price and firm Bs shares increase in price enough to make the total value of two firms identical.Note: The investors sell the shares of overvalued firm, borrow additional fund( Personal leverage/Home made) on personal account and invest in the undervalued firm in order to obtain the same return on a smaller investment outlay22

Example: Mr. X holds 10% shares of firm A. His share in the earning would amount to rs.500(i.e. 10% of 5000.Mr. X will sale his holding in firm A and invest money in firm B. Financial risk in firm b is less than firm A, so to have the same degree of financial risk Mr. X will borrow home made loan i.e. Rs. 5000(10% of 50000) at 10% interest. The proportionate holding of Mr. X in firm B is now amounting to Rs. 8000(10% of 80000) .What will be the position of Mr. X in these varied situations.

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A. Mr. X position in firm A with 10% equity holding: (i) Investment outlays Rs. 3125(i.e. 10% of 31250) (ii) Dividend income 10% of Rs. 5000 Return on own fund = (500X100)/3125

Rs. 500 16%

B. Mr. X position in firm B with 10% equity holding: (i)Investment Outlay(Own fund Rs. 3000+Borrowed fund Rs. 5000) (ii)Dividend Income Total income 10% of Rs 10000 1000 less: Interest payable on borrowed fund 500 Return on owned fund = (500X100) /3000

8000 500 16.67%

C. Mr. X position in firm B, if he invests the total available funds: (ii)Total investment outlay: (owned fund Rs. 3125+borrowed fund Rs. 5000) (ii) Total Income( 1000X8125)/ 80000 1016 Less: Interset 500 Return on owned fund = (516X100)/3125 *Point of equilibrium

8125 516 16.5124

MM Hypothesis With Corporate Tax

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.25

MM Hypothesis with Corporate TaxAfter-tax earnings of Unlevered Firm: Value of Unlevered Firm: X X (1 T ) Vu T T

X (1 T ) ku After-tax earnings of Levered Firm: X Value of Levered Firm: Vl X (1 T ) T k d D ku kd ( X k d D )(1 T ) k d D X (1 T ) Tk d D

Vu TD26

Millers Approach WITH Corporate and Personal Taxes

To establish an optimum capital structure both corporate and personal taxes paid on operating income should be minimised. The personal tax rate is difficult to determine because of the differing tax status of investors, and that capital gains are only taxed when shares are sold. Merton miller proposed that the original MM proposition I holds in a world with both corporate and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At this point, there will be no net tax advantage to companies from issuing additional debt. It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest tax shield.27

Traditional Approach The traditional approach argues that moderate degree

of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.28

Cost ke

ko

kd

Debt

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Financial Distress Financial distress arises when a firm is not able to

meet its obligations to debt-holders. For a given level of debt, financial distress occurs because of the business (operating) risk . with higher business risk, the probability of financial distress becomes greater. Determinants of business risk are: Operating leverage (fixed and variable costs) Cyclical variations Intensity of competition Price fluctuations Firm size and diversification Stages in the industry life cycle

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Consequences of Financial Distress

Bankruptcy costs

Specific bankruptcy costs include legal and administrative costs along with the sale of assets at distress prices to meet creditor claims. Lenders build into their required interest rate the expected costs of bankruptcy which reduces the market value of equity by a corresponding amount. Indirect costs Investing in risky projects. Reluctance to undertake profitable projects. Premature liquidation. Short-term orientation.31

Debt Policy and Shareholders Conflicts

Shareholdermanager conflicts Managers have a tendency to consume some of the firms resources in the form of various perquisites. Managers have a tendency to become unduly risk averse and shirk their responsibilities as they have no equity interest or when their equity interest falls. They may be passing up profitable opportunities. Shareholderbondholder conflicts Shareholder value is created either by increasing the value of the firm or by reducing the the value of its bonds. Increasing the risk of the firm or issuing substantial new debt are ways to redistribute wealth from bondholders to shareholders. Shareholders do not like excessive debt.32

Monitoring

Outside investors will discount the prices they are willing to pay for the firms securities realising that managers may not operate in their best interests. Firms agree for monitoring and restrictive covenants to assure the suppliers of capital that they will not operate contrary to their interests. Agency costs are the costs of the monitoring and control mechanisms. Agency costs of debt include the recognition of the possibility of wealth expropriation by shareholders. Agency costs of equity include the incentive that management has to expand the firm beyond the point at which shareholder wealth is maximised.

Agency Costs

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Optimum Capital Structure: Trade-off Theory The optimum capital structure is a function of:

Agency costs associated with debt The costs of financial distress Interest tax shield

The value of a levered firm is:Value of unlevered firm + PV of tax shield PV of financial distress34

Features of an Appropriate Capital Structure Return Risk Flexibility Capacity Control

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Approaches to Establish Appropriate Capital Structure EBITEPS approach for analyzing the

impact of debt on EPS. Valuation approach for determining the

impact of debt on the shareholders value. Cash flow approach for analyzing the firms

ability to service debt.36

Cash Flow Approach to Target Capital Structure Cash adequacy and solvency

In determining a firms target capital structure, a key issue is the firms ability to service its debt. The focus of this analysis is also on the risk of cash insolvencythe probability of running out of the cashgiven a particular amount of debt in the capital structure. This analysis is based on a thorough cash flow analysis and not on rules of thumb based on various coverage ratios. Operating cash flows Non-operating cash flows Financial cash flows

Components of cash flow analysis

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Reserve financial capacity

Reduction in operating and financial flexibility is costly to firms competing in charging product and factor markets. Thus firms need to maintain reserve financial resources in the form of unused debt capacity, large quantities of liquid assets, excess lines of credit, access to a broad range of fund sources. Focus on liquidity and solvency Identifies discretionary cash flows Lists reserve financial flows Goes beyond financial statement analysis Relates debt policy to the firm value

Focus of cash flow analysis

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Cash Flow Analysis Versus EBITEPS Analysis The cash flow analysis has the following advantages over

EBITEPS analysis: It focuses on the liquidity and solvency of the firm over a long-period of time, even encompassing adverse circumstances. Thus, it evaluates the firms ability to meet fixed obligations. It goes beyond the analysis of profit and loss statement and also considers changes in the balance sheet items. It identifies discretionary cash flows. The firm can thus prepare an action plan to face adverse situations. It provides a list of potential financial flows which can be utilized under emergency. It is a long-term dynamic analysis and does not remain confined to a single period analysis.39

Practical Considerations in Determining Capital Structure

Control Widely-held Companies Closely-held Companies Flexibility Loan Covenants Early Repay ability Reserve Capacity Marketability Market Conditions Flotation Costs Capacity of Raising Funds Agency Costs40