Capital Structure

Objectives
• Appreciate the effect of leverage on overall risk and returns
• Appreciate the impact of debt on value of the firm
• Appreciate various capital structure theories
•

Introduction

➢ Capital structure refers to the way a business finances its operations.

➢ Structure of capital is traditionally Debt and or equity.

➢ An all equity financed firm raises capital through issuing of shares only

➢ The most practical scenario is that of a mix of the two sources.

Sources of Capital

These include :

(i) Equity –ordinary and preference share capital.

(ii) Debt /borrowings

(iii) Retained earnings

(iv) Leasing

Gearing

➢ Measures the extent to which a firm uses borrowed capital

➢ It signifies the level of risk (Financial risk) inherent in a firm emanating from the type
of capital used.

➢ Borrowings carry a fixed obligation in the form of repayments whether a company

makes a profit or a loss.

➢ This makes borrowed funds more risky compared to equity.

➢ A firm which employs a high level of borrowings compared to its peers in the industry
is said to be highly geared and faces high risk.

➢ Lowly geared firms face lower risk.

➢ Measures of gearing include :

(i) Debt-to-Equity ratio = Debt capital / Equity capital

(ii) Debt ratio = debt/ Total assets

Whether a firm is highly or lowly geared depends on firm benchmarks, industry

averages and industry expectations among other factors.

Example

XYZ Ltd has a total capital of $100m divided into $75m equity and $25m borrowings.

Debt –to- equity ratio = 25/75 = 33% or 1 :3.33

This mean that every $ of borrowed funds is represented by $3.33 of equity.

Debt ratio = 25/100 = 25%= 1:4

Debt constitutes 25% of total capital

➢ If the industry average is 20%, company XYZ ltd will be said to be over borrowed.

Assessment of the impact of Leverage

Suppose XYZ Ltd has the following current and proposed capital structure.
 Current Proposed
Structure structure

Assets 8 000 000 Assets 8 000 000

Debt 0 Debt 4 000 000

Equity 8 000 000 Equity 4 000 000

Debt/equity 0 Debt/equity 1

Share Price $20 Share Price $20

Outstanding 400 000 Outstanding 200 000

Shares shares

Interest rate 10% Interest rate 10%

Note that under the proposed structure, the issued debt of $4 000 000 is used to
repurchase some of the shares @ $20 per share.

Assuming some scenarios of a possible recession, expansion and base case in the
company, we come up with the following:

Current Recession Base case Expansion

Structure

EBIT 500 000 1 000 000 1 500 000

Interest 0 0 0

Net Income 500 000 1000 000 1 500 000

ROE 6.25% 12.5% 18.75%

EPS 1.25 2.50 3.75

 Proposed Recession Base case Expansion
Structure

EBIT 500 000 1 000 000 1 500 000

Interest 400 000 400 000 400 000

Net Income 100 000 600 000 1 100 000

ROE 2.5% 15% 27.5%

EPS 0.5 3.0 5.5

➢ Debt brings about advantages during good times but is extremely detrimental should
EBIT go significantly down.

➢ When EBIT is zero, EPS is negative if there is debt in the capital structure of a firm.

➢ Debt however also brings about advantages to a firm but the question is: What
minimal levels of EBIT should be maintained for this benefit to accrue to the
company.

➢ From a strategic perspective, managers should therefore ensure that EBIT does not
fall to a level that erodes shareholder value. This can be done by undertaking
projects which generate higher cash inflows or profits.

Weighted Average cost Of Capital

➢ Since a firm will employ more than one source of capital, the cost of capital for
decision making purposes becomes the average cost of the individual sources of
capital.
➢ The weight of each source determines the contribution of each source to overall cost
of capital (WACC).

NB: Debt carries a tax shield advantage, ie interest paid on borrowings is tax-
deductible. Before tax is levied, interest expenses are deducted resulting in a lower tax
bill.

Example

ABC ltd is considering raising capital to finance the $500million dollar Hydro electric
project in Kariba. They are considering borrowing at,9% $300million, issue 10 000 000
ordinary shares at $10 each and the balance will be from available retained earnings
from previous years. The required rate of return by shareholders is 8%. Corporation tax
(T) is 25%.

Analysis and WACC

Debt = $300m at a cost of 9%, Equity =$100m at a cost of 8% and Retained

funds=$100m at a cost of 8%

Cost of Debt = Kd = 9%

After-tax cost of debt = Kd(1-T)=9%(75%)

Cost of Equity =Ke =8%

Cost of retained earnings=Ks = Ke =8%

WACC= Weight Debt * Kd(1-T) +Weight Equity*Ke +Weight Retained Earnings * Ks

WACC = 3/5 * 9%(75%) + 1/5* 8% + 1/5* 8% =

➢ The determination of the required rate of return may be derived from CAPM. The
Expected rate of return = required rate of return, where the beta of the firm can be
determined.

Expected Return = Required Rate of return= Risk Free rate +Beta( Market return – Risk Free rate)

Theories of Capital Structure : To what extent should firms borrow?

Traditionalists/ Traditional theory (Capitalisation of Income)

- The value of a firm is arrived at by discounting the future cash inflows or future
Net Income at the WACC rate.

- As the WACC increases, the value of the firm decreases.

- As WACC decreases, the value of the firm increases because of the lower
discount rate used in discounting the Net Income.

Value of firm = N.O.I/WACC

- The traditional theories therefore argue that the value of the firm does not
depend on capital structure but on the earnings capacity of the firm.

- According to traditional theorists, the increase in debt (which carries a tax shield
advantage) is offset by the increase in cost of equity ie, as debt is increased,
equity holders see more risk in the firm and hence their RRR (Cost of equity)
increases thereby offsetting the cheapness of debt.

- Value of firm will therefore not change with an increase in debt.

M&M Proposition I – world with no taxes

Modern capital structure theory began in 1958, when Professors Franco Modigliani and
Merton Miller (hereafter MM) published what has been called the most influential finance
article ever written. MM’s study was based on some strong assumptions, including the
following:
1.There are no brokerage costs.
2.There are no taxes.
3.There are no bankruptcy costs.
4.Investors can borrow at the same rate as corporations.
5.All investors have the same information as management about the firm’s future
investment opportunities.
6.EBIT is not affected by the use of debt.
If these assumptions hold true, MM proved that a firm’s value is unaffected by its capital
structure, hence the following situation must exist: VL = VU;

Here VL is the value of a levered firm, which is equal to VU, the value of an identical but
unlevered firm. SL is the value of the levered firm’s stock, and D is the value of its debt.
Recall that the WACC is a combination of the cost of debt and the relatively higher cost
of equity, rs. As leverage increases, more weight is given to low-cost debt, but equity gets
riskier, driving up rs. Under MM’s assumptions, rs increases by exactly enough to keep
the WACC constant. Put another way, if MM’s assumptions are correct, it does not matter
how a firm finances its operations, so capital structure decisions would be irrelevant.

Despite the fact that some of these assumptions are obviously unrealistic, MM’s
irrelevance result is extremely important. By indicating the conditions under which capital
structure is irrelevant, MM also provided us with clues about what is required for capital
structure to be relevant and hence to affect a firm’s value. MM’s work marked the
beginning of modern capital structure research, and subsequent research has focused
on relaxing the MM assumptions in order to develop a more realistic theory of capital
structure.
Another extremely important aspect of MM’s work was their thought process. To make a
long story short, they imagined two portfolios. The first contained all the equity of the
unlevered firm, and it generated cash flows in the form of dividends. The second portfolio
contained all the levered firm’s stock and debt, so its cash flows were the levered firm’s
dividends and interest payments. Under MM’s assumptions, the cash flows of the two
portfolios would be identical. They then concluded that if two portfolios produce the same
cash flows, then they must have the same value.

M&M Proposition I states that the value of a firm does NOT depend on its capital
structure. For example, think of 2 firms that have the same business operations, and
same kind of assets. Thus, the left side of their Balance Sheets look exactly the same.
The only thing different between the 2 firms is the right side of the balance sheet, i.e the
liabilities and how they finance their business activities.

In the first diagram, stocks make up 70% of the capital structure while bonds (debt)
make up for 30%. In the second diagram, it is the exact opposite. This is the case
because the assets of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation
is irrelevant. The value of the firm is determined by Real Assets and not its capital
structure.
NB: Two firms with equal balance sheets should trade at the same price even if they
have different capital structures. If their prices are different, there is an arbitrage
opportunity which investors can exploit.

M & M proposition II - world with no taxes

➢ Any increase in debt increases risk and therefore increases the RRR by equity
holders.
➢ the cheapness of debt is therefore eroded by increase in cost of equity hence WACC
will remain unchanged. Value of firm remains unchanged under leveraged or
unleveraged position.
➢ Earnings power and not capital structure affects the value of a firm.

M&M Proposition II states that the value of the firm depends on three things:

1) Required rate of return on the firm's assets (Ra)

2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for
WACC is:

WACC = [Rd x D/V x (1-t)] + [Re x E/V]

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x Rd

The above formula can also be rewritten as:

Re = Ra + (Ra - Rd) x (D/E)

This formula #3 is what M&M Proposition II is all about.

Analysis of M&M Proposition II Graph

- The above graph tells us that the Required Rate of Return on the firm (Re) is a linear
straight line with a slope of (Ra - Rd)

- Why is Re linear curved and upwards sloping? This is because as a company borrows
more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more
higher. Since adding more debt is risky, the shareholders demand a higher rate of
return (Re) from the firm's business operations. This is why Re is upwards sloping:

- As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

- Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight
line with NO slope. It therefore does not have any relationship with the Debt/Equity ratio.
This is the basic identity of M&M Proposition I and II, that the capital structure of the firm
does not affect its total value.

- WACC therefore remains the same even if the company borrows more debt (and
increases its Debt/Equity ratio).

Modigliani and Miller: Taxes

Proposition I
MM published a follow-up paper in 1963 in which they relaxed the assumption that there
are no corporate taxes. Our tax law allows corporations to deduct interest payments as
an expense, but dividend payments to stockholders are not deductible. This differential
treatment encourages corporations to use debt in their capital structures. This means that
interest payments reduce the taxes paid by a corporation, and if a corporation pays less
to the government, more of its cash flow is available for its investors. In other words, the
tax deductibility of the interest payments shields the firm’s pre-tax income. As in their
earlier paper, MM introduced a second important way of looking at the effect of capital
structure: The value of a levered firm is the value of an otherwise identical unlevered firm
plus the value of any “side effects.” While others expanded on this idea, the only side
effect MM considered was the tax shield:

VL = VU + Value of side effects = VU + PV of tax shield

Under their assumptions, they showed that the present value of the tax shield is equal to
the corporate tax rate, T, multiplied by the amount of debt, D: PV of Tax Shield = VdT

MM also showed that the cost of equity, rs, increases as leverage increases, but that it
doesn’t increase quite as fast as it would if there were no taxes. As a result, under MM
with corporate taxes the WACC falls as debt is added.

Signaling Theory
- MM assumed that investors have the same information about a firm’s prospects
as its managers—this is called symmetric information.
- However, in fact managers often have better information than outside investors.
This is called asymmetric information, and it has an important effect on the
optimal capital structure.
- To see why, consider two situations, one in which the company’s managers know
that its prospects are extremely positive (Firm P) and one in which the managers
know that the future looks negative (Firm N).
- Suppose, for example, that Firm P’s R&D labs have just discovered a non-
patentable cure for the common cold. They want to keep the new product a secret
as long as possible to delay competitors’ entry into the market.
- New plants must be built to make the new product, so capital must be raised. How
should Firm P’s management raise the needed capital? If it sells stock, then, when
profits from the new product start flowing in, the price of the stock would rise
sharply, and the purchasers of the new stock would make a bonanza.
- The current stockholders (including the managers) would also do well, but not as
well as they would have done if the company had not sold stock before the price
increased, because then they would not have had to share the benefits of the new
product with the new stockholders.
- Therefore, one would expect a firm with very positive prospects to try to avoid
selling stock and, rather, to raise any required new capital by other means,
including using debt beyond the normal target capital structure.
- A firm with negative prospects would want to sell stock, which would mean bringing
in new investors to share the losses!

- The conclusion from all this is that firms with extremely bright prospects prefer not
to finance through new stock offerings, whereas firms with poor prospects like to
finance with outside equity.
- How should you, as an investor, react to this conclusion? You ought to say, “If I
see that a company plans to issue new stock, this should worry me because I know
that management would not want to issue stock if future prospects looked good.
- However, management would want to issue stock if things looked bad. Therefore,
I should lower my estimate of the firm’s value, other things held constant, if it plans
to issue new stock.” If you gave the above answer, your views would be consistent
with those of sophisticated portfolio managers.
 - In a nutshell, the announcement of a stock offering is generally taken as a signal
that the firm’s prospects as seen by its management are not bright.
- Conversely a debt offering is taken as a positive signal. Notice that Firm N’s
managers cannot make a false signal to investors by mimicking Firm P and issuing
debt. With its unfavorable future prospects, issuing debt could soon force Firm N
into bankruptcy. Given the resulting damage to the personal wealth and
reputations of N’s managers, they cannot afford to mimic Firm P. All of this
suggests that when a firm announces a new stock offering, more often than not
the price of its stock will decline. Empirical studies have shown that this situation
does indeed exist.

The Trade-Off Theory of Capital Structure

➢ refers to the idea that a company chooses how much debt finance and how much
equity finance to use by balancing the costs and benefits.
➢ The classical version of the hypothesis goes back to Kraus and Litzenberger
who considered a balance between the dead-weight costs of bankruptcy and the
tax saving benefits of debt.
➢ Often agency costs are also included in the balance.
➢ An important purpose of the theory is to explain the fact that corporations usually
are financed partly with debt and partly with equity. It states that there is an
advantage to financing with debt, the tax benefits of debt and there is a cost of
financing with debt, the costs of financial distress including bankruptcy costs of
debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding
disadvantageous payment terms, bondholder/stockholder infighting, etc).
➢ The marginal benefit of further increases in debt declines as debt increases,
while the marginal cost increases, so that a firm that is optimizing its overall value
will focus on this trade-off when choosing how much debt and equity to use for
financing.
Pecking-Order theory
➢ A theory stating that, all other things being equal, companies seeking to finance a
new project or product have a hierarchy of preferred financing options.
➢ This hierarchy (or pecking-order) goes from the most preferred to the least
preferred: The sources in order of preference are as follows :

1. internal funding (or simply financing a project or product out-of-pocket),

2. debt issuance,
3. debt-equity hybrid issuance,
4. equity issuance.
➢ The pecking-order view states that the hierarchy is structured this way
because of the transaction costs involved in each form of financing. That is,
internal funding has a lower transaction cost that debt issuance and so forth.

Research on the Hamada Theory

 Determinants of Financing-the-growt Financial Growth of
Capital Structure in Emerging Markets.pdf
h-of-SMEs-in-Africa--What-are-the-c_2017_Review-of-Develo.pdf
SMEs in African 2017.pdf

Impact of Financial
Markets Developent on Capital Structure of Firms on Vietenamese Exchange.pdf