Capital Structure Theories

In this chapter… Net income and net operating income

approaches… Optimal capital structure… Factors affecting capital structure… EBIT/EPS and ROI & ROCE Analysis Capital Structure Policies in practice…

Capital Structure… Capital structure includes only long term

debt and total stockholder investment. Capital Structure = Long Term Debt +

Preferred Stock + Net Worth

OR Capital Structure = Total Assets – Current

Liabilities.

Optimal Capital Structure… It is that capital structure at that level of debt –

equity proportion where the market value per share is maximum and the cost of capital is minimum.

Features: Profitability solvency Flexibility Conservation control

Determinants / Factors affecting Capital Structure… The benefit of debt. Flexibility Control Industry leverage

ratios Seasonal variations Degree of competition Industry life cycle. Agency cost Company characteristics Timing of public issue Requirement of investors Period of finance Purpose of finance Legal requirements.

Patterns of Capital Structure…

1. Complete equity share capital;

2. Different proportions of equity and preference share capital;

3. Different proportions of equity and debenture (debt) capital an

4. Different proportions of equity, preference and debenture (debt) capital.

EBIT – EPS Approach… In this approach, it is analyzed that how

sensitive is EPS to the changes in EBIT under different capital structure.

ROI – ROE Approach… This approach analyses the relationship

between the ROI and ROE for different levels of financial leverage.

Theories of Capital Structure… Net Income Approach Net Operating Income Approach Modigliani and Miller Approach [MM

Hypothesis] Traditional Approach.

Assumptions of Capital Structure Theories…

Firm uses only two sources of funds: perceptual riskless debt and equity;

There are no corporate or income: or personal tax;The dividend payout ratio is 100% [There are no retained earnings];The firm’s total assets are given and do not change [Investment decision

is assumed to be constant].The firm’s total financing remains constant. [Total capital is same, but

proportion of debt and equity may be changed];The firm’s operating profits (EBIT) are not expected to grow; The business risk is remained constant and is independent of capital

structure and financial risk;All investors have the same subject probability distribution of the

expected EBIT for a given firm; andThe firm has perpetual life;

Definitions used in Capital Structure… E = Total Market Value of Equity. D = Total Market Value of Debt. V = Total Market Value of the Firm. I = Annual Interest payment. NI = Net Income. NOI = Net Operating Income. Ee = Earning Available to Equity Shareholder.

Net Income Approach… A change in the proportion in capital structure will lead

to a corresponding change in Ko and V. Assumptions:

(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change the risk

perception of investors.

(iv) Cost of debt and cost of equity remains constant;

Net Income Approach…

Formula used for NI Approach… Net Income [NI] = EBIT – Debenture

Interest. Value of the Firm [V] = Market Value of

Equity [E] + Market Value of Debt [D] Market Value of Equity [E] = Net Income

[NI] / Cost of Equity [Ke] Cost of Capital [Ko] = EBIT / V * 100

Net Operating Income Approach… There is no relation between capital structure and Ko and V. Assumptions:

(i) Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. (ii) The market capitalises the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity;(iii) The market value of equity is residue [i.e., Total value of the firm minus market value of debt)(iv) The use of debt funds increases the received risk of equity investors, there by ke increases (v) The debt advantage is set off exactly by increase in cost of equity.(vi) Cost of debt (Ki) remains constant(vii) There are no corporate taxes.

Net Operating Income Approach…

Formula used for NOI Approach… Value of the Firm [V] = EBIT / Ko Market Value of Equity [E] = V – D Cost of Equity/ Equity Capitalization Rate

[Ke] = Ee / E or EBIT – I / V - D

MM Hypothesis… This approach was developed by Prof.

Franco Modigliani and Mertan Miller. According to this approach, total value of

the firm is independent of its capital structure.

Assumptions…a. Information is available at free of costb. The same information is available for all investorsc. Securities are infinitely divisibled. Investors are free to buy or sell securitiese. There is no transaction costf. There are no bankruptcy costsg. Investors can borrow without restrictions as the same

terms on which a firm can borrowh. Dividend payout ratio is 100 percenti. EBIT is not affected by the use of debt

Propositions:I. Ko and V are independent of capital structureII.Ke = to capitalisation rate of the pure equity plus a

premium for financial risk.Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt)

III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.

MM Approach [Proposition I]arbitrage Progress:

Refers to an act of buying an asset or security in one market at lower price and selling it is an other market at higher price.

Steps in working out Arbitrage Process:Step 1: Investors Current Position: In this step there is a need to find

out the current investment and income (return).Step 2: Calculation of Savings in Investment by moving from levered

firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of

investment. Here the income will be same which was earning in previous firm.

Step 3: Calculation of Increased Income, by investing total funds available.

Limitations of MM Approach… Investors cannot borrow on the same terms and

conditions of a firm Personal leverage is not substitute for corporate

leverage Existence of transaction cost Institutional restriction on personal leverage Asymmetric information Existence of corporate tax

Traditional Approach… This approach was given by Soloman. This approach is the midway between NI

Approach and NOI Approach. Traditional approach says judicious use of debt

helps increase value of firm and reduce cost of capital

Main Prepositions…1. The pretax cost of debt (Ki) remains more or less constant up to a certain

degree of leverage and /but rises thereafter of an increasing rate2. The cost of equity capital (Ke) remains more or less constant rises slightly

up to a certain degree of leverage and rises sharper there after, due to increased perceived risk.

3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It(a)Decreases up to a certain point level of degree of leverage [stage I increasing

firm value];(b) Remains more or less unchanged for moderate increase in leverage

thereafter [stage II optimum value of firm], and (c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].