Capital Structure

CAPITAL STRUCTURE
 CAPITAL STRUCTURE AND THE PIE
• The value of the firm is defined to be the sum of the value of the
firm’s debt and equity.
• V= D+E
• If the goal of the firm’s management is to make the firm as
valuable as possible, then the firm should pick the debt to equity
ratio that makes the bie as big as possible
 CAPITAL STRUCTURE
• Capital structure refers to the relative mix of debt and equity
securities in the long term financial structure of the company.
• Capital structure usually is applied strictly to the “permanent” or
long term capital that undergirds a company’s operations.
• Does capital structure matter or not?
• If Capital structure does matters, what factors determine optimal
mix of debt and equity
 OBSERVED CAPITAL STRUCTURE
PATTERNS
• Observed Capital structure show distinct national patterns
• Capital structure have pronounced industry patterns and these are the same
• Within industries leverage is inversely related to profitability
• Taxes clearly influence capital structure
• Leverage ratios appear to be inversely related to the perceived costs of the
financial distress
 OBSERVED CAPITAL STRUCTURE
PATTERNS CONTI….
• Existing shareholders invariably consider leverage increasing events to be good
news
• Changes in the transaction costs of issuing new securities have impact on
structure
• Ownership structure clearly seems to influence capital structure
• Corporations that are forced away from a preferred capital structure tend to
return to that structure over time
 THE CAPITAL-STRUCTURE QUESTION

• There are really two important questions:

1. Why should the stockholders care about maximizing firm value?
• Perhaps they should be interested in strategies that maximize shareholder value.

2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?

As it turns out, changes in capital structure benefit the stockholders if

and only if the value of the firm
increases.
 FINANCIAL LEVERAGE, EPS, AND ROE

• Consider an all-equity firm that is considering going into

debt. (Maybe some of the original shareholders want to cash out.)
 EPS, AND ROE Current Capital Structure

• Current shares outstanding= 400 shares

 EPS, AND ROE Proposed Capital Structure

• Current shares outstanding= 240 shares

EPS, AND ROE Both Capital Structure
FINANCIAL LEVERAGE AND EPS
 ASSUMPTIONS OF THE MODIGLIANI-
MILLER MODEL
• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the same rate
– Equal access to all relevant information
– No transaction costs
– No taxes
 HOMEMADE LEVERAGE: AN EXAMPLE

14 Capital Structure
HOMEMADE (UN)LEVERAGE: AN EXAMPLE

15 Capital Structure
 MODIGLIANI AND MILLER MODEL

Modigliani and Miller, two professors in the 1950s, studied capital-structure

theory intensely. From their analysis, they developed the capital-structure
irrelevance proposition. Essentially, they hypothesized that in perfect markets, it
does not matter what capital structure a company uses to finance its operations.
They theorized that the market value of a firm is determined by its earning power
and by the risk of its underlying assets, and that its value is independent of the
way it chooses to finance its investments or distribute dividends.
 MODIGLIANI AND
MILLER'S PROPOSITION I (NO TAXES)
 We can create a levered or unlevered position by adjusting the
trading in our own account.
 This home made leverage suggests that capital structure is
irrelevant in determining the value of the firm
VL = VU
 MODIGLIANI AND
MILLER'S PROPOSITION II (NO TAXES)
 Leverage increases the risk and return to stockholders
 rs = r0 + (B / SL) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
 MODIGLIANI AND MILLER'S (II)

 MM II deals with the WACC. It says that as the proportion of debt in the
company's capital structure increases, its return on equity to shareholders
increases in a linear fashion. The existence of higher debt levels makes
investing in the company more risky, so shareholders demand a higher risk
premium on the company's stock. However, because the company's capital
structure is irrelevant, changes in the debt-equity ratio do not affect WACC.
MM II with corporate taxes acknowledges the corporate tax savings from the
interest tax deduction and thus concludes that changes in the debt-equity ratio
do affect WACC. Therefore, a greater proportion of debt lowers the company's
WACC.
THE COST OF EQUITY, THE COST OF DEBT, AND THE
WEIGHTED AVERAGE COST OF CAPITAL: MM
PROPOSITION II WITH NO CORPORATE TAXES
 TOTAL CASH FLOW TO INVESTORS UNDER
EACH CAPITAL STRUCTURE WITH CORP. TAXES
 TOTAL CASH FLOW TO INVESTORS UNDER
EACH CAPITAL STRUCTURE WITH CORP. TAXES

The levered firm pays less in taxes than does the all equity firm.

Thus, the sum of the debt plus the equity of the levered firm is greater than the equity
of the unlevered firm
This is how cutting the pie differently can make the pie “larger”. The government
takes a smaller slice of the pie
 APPROACHES OF CAPITAL
STRUCTURE
The main contributors to the theories are Durand,
Ezra, Solomon, Modigliani and Miller.
The important theories are:
1.Net Income Approach.
2.Net Operating Income Approach.
3.The Traditional Approach.
4.Modigliani and Miller Approach.
1. Net Income Approach:
This approach has been developed by Durand. The main
findings are:
 Capital structure decisions are relevant to the valuation of the firm:
 if a firm makes any change in its capital structure, it will cause a corresponding change in
the overall cost of capital as well as the total value of the firm.
 Thus, the capital structure decisions are relevant to the valuation of the firm.

 Increased use of debt will increase the shareholders’ earning:

 A firm can increase its total value(V) and lower the overall cost of capital (Ko) by
increasing the proportion of debt in its capital structure.
 As a result, the market value of equity shares of the company will also increase.
 THREE BASIC SITUATIONS

• Un-geared / No Debt:
• Cost of Debt Zero %, Cost of Equity say
12%, WACC will be 12%.
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 1*12% + 0*0 =
12%

25 Capital Structure
 THREE BASIC SITUATIONS

• Low Debt / Gearing:

• Say 20% debt at 10%, 80% Equity at 12%, WACC
will be 11.6% (lower than un-geared)
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 80%*12% + 20%*10% = 11.6%

26 Capital Structure
 THREE BASIC SITUATIONS

• High debt / Gearing:

• Say 80% debt at 10%, 20% Equity at 12%, WACC will
be 10.04% (higher than both previous cases)
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 20%*12% + 80%*10%= 10.04%

27 Capital Structure
 ASSUMPTIONS
(a) Capital structure consists of debt and equity.
(b) Cost of debt is less than cost of equity
(i.e. Kd<Ke).
(c) Cost of debt remains constant for all levels of debt to
equity.
(d) The use of debt content does not change the risk
perception of investors.
 CALCULATION OF THE
VALUE OF THE FIRM

According to Net Income Approach the value of the firm can be

ascertained as follows:
V = S+ D
where,

V= Value of the firm

S= Market value of equity=Earnings available for equity shareholders/ Equity
capitalisation rate.

D= Market value of debt.

 CALCULATION OF OVERALL
COST OF CAPITAL
According to Net Income Approach the overall cost of
capital can be calculated as follows:

(Ko) = EBIT X 100

v
where, (Ko)= Overall cost of capital
EBIT= Earnings before interest and tax
V= Value of firm
 2. NET OPERATING INCOME (NOI) APPROACH
Net Operating Income approach is suggested by Durand. This approach is simply opposite to the Net Income
approach.

The main findings are:

Capital structure decisions are irrelevant to the valuation of the firm:

 The capital structure decisions are irrelevant to the valuation of the firm. Thus, if a firm makes any
change in its capital structure, it will not affect the total value of firm.

Increased use of debt will increase the financial risk of the shareholders:
 The increased use of debt in the capital structure would lead to an increase in the financial risk of the
equity shareholders.
 To compensate for the increased risk, the shareholders would expect a higher rate of return and hence
the cost of equity will increase.
 Thus the advantage of use of debt is offset exactly by the increase in the cost of equity.
 THREE BASIC SITUATIONS

• Un-geared / No Debt:
• Cost of Debt Zero %, Cost of Equity say
12%, WACC will be 12%.
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 1*12% + 0*0 =
12%

32 Capital Structure
 THREE BASIC SITUATIONS

• Low Debt / Gearing:

• Say 20% debt at 10%, 80% Equity at 12.5%, WACC
will be 12% (lower than un-geared)
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 80%*12.5% + 20%*10% = 12%

33 Capital Structure
 THREE BASIC SITUATIONS

• High debt / Gearing:

• Say 80% debt at 10%, 20% Equity at 20%, WACC will
be 12% (higher than both previous cases)
• WACC= WeKe + WpKp + WdKd(1-t)
• WACC= WeKe + WdKd(1-t)
• WACC= 20%*20% + 80%*10%= 12%

34 Capital Structure
 ASSUMPTIONS

(a) The market capitalises the value of firm as a whole.

(b) Cost of debt (Kd) is constant.
(c) Increases use of debt increases the financial risk of equity
shareholders which, in turn, raises the cost of equity (Ke).
(d) Overall cost of capital (Ko) remains constant for all levels of debt
equity mix.
(e) There is no corporate income tax.
 Various calculation under Net Operating Income approach are explained below:

1. Value of Firm (V):

V = EBIT
Ko
where, V = Value of firm, EBIT= Earnings before interest ant tax (Ko)= Overall cost of capital

2. Market Value of Equity (S):

S =V–D
where, S= Market value of equity, V= Value of firm, D = Market value of debt.

3. Cost of Equity Capitalisation Rate:

 the increased use of debt in the capital structure would lead to an increase in the financial risk of the equity shareholders.

 To compensate for the increased risk, the shareholders would expect a higher rate of return and hence the cost of equity will
increase.

Cost of Equity (Ke) or Equity Capitalisation Rate =

Earnings available for equity shareholders Market value of equity (S)/ Total value of equity.
 3. THE TRADITIONAL APPROACH
 Traditional approach also known as intermediate approach.
 It is a mix of both the net income approach and the net operating income
approach.
 According to this approach, the prudent use of debt equity mix can lower
the firm’s overall cost of capital and thereby increase its market value.
 This approach states that initially a firm can increase its value of reduce the
overall cost of capital by using more debt. However, the increase in the
value of firm or reduction in the overall cost of capital is possible only up to
a particular level of debt equity mix.
 Beyond that level, the value of firm start declining and the cost of capital
start increasing.
 Thus, the manner in which the value of firm and the cost of capital reacts to
change in capital structure can be divided into 3 stages as follow:
Stage 1: Increase in the value of firm and decrease in the cost of capital

In the first stage, both the cost of debt and cost of equity remain constant. As a result, the
increased use of debt in the capital structure will cause increase in the value of firm and
decrease in the overall cost of capital. This is based on the assumption that cost of debt is less
than cost of equity (i.e. Kd< Ke).

Stage 2: Optimal debt equity mix

In the second stage, the firm reaches at an optimal level. Optimal level means the ideal debt
equity mix, which minimises the cost of capital and maximises the value of the firm.

Stage 3: Decrease in the value of firm and increase in the cost of capital

In the third stage the value of firm start declining and the cost of capital start increasing. This
happens because use of debt beyond optimal level will increase the risk of investors, so both Kd
and Ke will rise sharply.
 EXAMPLE 1
• Equity: 40 million shares of Rs 10 each (Rs 400 M)

• Debt: 60 million bonds, also of Rs 10 each, carrying 12% interest. (Rs 600M)

• Capital structure/Capital Employed: Rs 1,000 million

• Profit: Rs 136 million

• ROE: Rs 64 million (136 – 72 million) = 16%

• WACC = 13.6%

• If the company earns a profit of Rs 136 million, its share and bond will sell at par.

• Hence, market value of company’s equity and debt will be Rs 1,000 million.

40 Capital Structure
 EXAMPLE 2 (SAME PROFIT)
• WACC = 13.6%,We= 40%, Wd= 60%
• Ke = 16%, Kd= 12%
• now
• Equity: 20 million shares of Rs 10 each
• Debt: 80 million bonds, also of Rs 10 each, carrying 12% interest.
• Capital Employed: Rs 1,000 million
• Profit: Rs 136 million
• EPS: Rs 40 million (136 – 96)/20 million = Re 2
• Due to increase in debt level, the equity holders will demand a higher return. Let us assume
that the return now demanded by them is 20%. Since, the new EPS is Rs 2, the market value of
equity shares will stay at Rs 10. (Rs 2 is 20% of Rs 10)
• This will give EYR of 20% and debt cost of 12% and WACC of 13.6%.
• Hence, market value of company’s equity and debt will remain Rs 1,000 million.

41 Capital Structure
 EXAMPLE 3 (HIGHER PROFIT)

• Assume capital structure as Example 1, but profit of Rs 152 million.

• EPS = Rs 80m (152 – 72)/40m = Rs 2
• This will lead to higher market value of equity shares (around Rs 13) since
equity holders will accept slightly less than 16% return on safer investment. EPS
Rs 2 is 15.4% of Rs 13.
• Total MV = Equity Rs 520m + Debt 600m= 1,120m
• Total Profit 152m as % of Rs 1,120m = 13.6%
• Hence, WACC remains 13.6%

42 Capital Structure
 FINANCIAL CHOICES

Trade-off Theory - Theory that capital

structure is based on a trade-off between tax
savings and distress costs of debt.

Pecking Order Theory - Theory stating that

firms prefer to issue debt rather than equity if
internal finance is insufficient.
 TRADE-OFF THEORY
• MM theory ignores financial distress costs, which increase as
more leverage is used:
• Higher debt costs, including negotiation and monitoring by
creditors (MM assume constant cost)
• Feedback to Free Cash Flow
• Rejection of high risk but +NPV investments (under-investment)
• Lost customers, suppliers, and employees
• Loan covenants, which constrain growth
• ‘Fire sales’ of assets to raise cash
• Contradicts assumption of MM that capital structure doesn’t
effect operating cash flows
 TRADE-OFF THEORY (CONT.)

• Trade-off theory suggests optimal capital

structure is reached at point where marginal
distress costs exceed the marginal tax benefit
from adding debt in the MM model.
• Since these costs are only significant at high
levels of debt, WACC could be relatively
unaffected for many capital structures
TRADE-OFF THEORY SUGGESTS THESE
TYPES OF FIRMS WILL USE MORE DEBT
• Strong cash flow
• Low variability in cash flow
• Low growth opportunities (predictable funds needs and less
risk of jeopardizing growth investments)
• Large size (safety and lower growth)
• Profitable enough to benefit from tax shelter
 DEBT CAN REDUCE EQUITY AGENCY
COSTS
• Equity agency problem is that managers might:
• use corporate funds for non-value maximizing purposes
(perks, acquisitions, value-destroying growth)
• or seek low risk due to undiversified interest in firm

• Problem is most significant in large firms with

diffuse stockholders where management ownership
is low
 DEBT CAN REDUCE EQUITY
AGENCY COSTS (CONT.)
• The use of financial leverage:
• Bonds free cash flow for firms generating more cash than required
to fund +NPV opportunities, reducing perk consumption and value-
destroying growth.
• Increases free cash flow by forcing efficiencies: failure risk gets
managers’ attention
• Substitute for other strategies: outside board members, stock
ownership, large outside blockholders, takeover threat
 DEBT CAN REDUCE EQUITY AGENCY
COSTS (CONT.)
• Debtholders can serve as monitors for diffuse free-riding stockholders
• However, debt agency costs will increase: negotiation, monitoring,
covenants, under-investment
 SIGNALING THEORY
• MM assumed that investors and managers have the same
information.
• Where significant information asymmetries exist,
stockholders assume:
• Company issues new stock when it is overvalued
• Bonds are issued when stock is undervalued
• Stock issues indicate lower expected FCF, unwilling to
commit to increased debt service
• Leverage-decreasing events signal overvalued stock, and vice
versa, supported by empirical data
 MM relationship between value and debt
with taxes
Value of Firm, V (%)

VL
TD
VU VU

Debt
 SIGNALING THEORY RESULTS IN
PECKING ORDER HYPOTHESIS
• Firms will choose the following sequence of funding sources to maintain
financial flexibility and avoid negative signals
• Retained earnings Maintain
• Excess cash borrowing
• Debt issuance capacity
• Stock issuance
• Evidence: profitable firms use less debt (surprise) because they can build
more equity internally. Contradicts Trade-off theory which suggests high
debt due to low default risk and need for tax shelters.
 PECKING ORDER THEORY

• Pecking order theory has been developed as an alternative to traditional theory. It

states that firms will prefer retained earnings to any other source of finance, and then
will choose debt, and last of all equity. The order of preference will be:
• Retained earnings
• Straight debt => e.g, bank loan, common bonds
• Convertible debt
• Preference shares
• Equity shares
 PECKING ORDER THEORY

Internally-generated funds – i.e. retained earnings

Already have the funds.
Do not have to spend any time persuading outside investors of the merits of the
project.
No issue costs.

Debt
The degree of questioning and publicity associated with debt is usually
significantly less than that associated with a share issue.
Moderate issue costs.
 PECKING ORDER THEORY

New issue of equity

Perception by stock markets that it is a possible sign of problems.

Extensive questioning and publicity associated with a share issue.

Expensive issue costs.

 PECKING ORDER THEORY

Some Implications:

Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is

less room for difference in opinions about what debt is
worth).
 FACTORS INFLUENCING CAPITAL
STRUCTURE DECISION
• The factors can be described as follows:
• Taxes, especially the corporate tax rate – Since interest expenses are tax-
deductible, the company would gain a greater advantage from using debt if
the corporate profit tax rate were higher.

• Sales and earnings stability – As interest payments and principal

repayments are mandatory, firms with more fluctuating sales and earnings
will have less capacity to take on debt.

• Asset structure – Firms with more tangible, general-purpose assets will

have a higher debt capacity. Intangible or specific-purpose assets usually do
not make good collateral.
 FACTORS INFLUENCING CAPITAL
STRUCTURE DECISION
• Management attitudes – Some management tend to be more conservative
and use less debt compared with more aggressive management.

• Corporate control – In order to maintain control over the company, existing

shareholders, especially majority shareholders, may prefer to issue debt to
raise additional financing. After all, creditors usually do not have any voting
rights.

• Capital market conditions – Companies tend to issue more equity during

bull markets and more debt when interest rates are low.
FACTORS INFLUENCING CAPITAL
STRUCTURE DECISION
• Operating leverage – Firms with high operating leverage are less likely
to employ more debt, as it will make the firm even riskier.

• Profitability – Companies with very high returns on assets use very little
debt, mainly because they can generate enough internal cash flows to
finance their business expansion. On the other hand, if these firms need
external capital, they tend to issue debt in order to minimize earnings
dilution associated with additional equity financing.
 Other factors in setting the target
capital structure
• Effect on sustainable growth: willingness to
increase debt allows for higher growth rate now.

• Debt ratios of other firms in the industry.

• Lender and rating agency attitudes

(impact on bond ratings).