Capital structure

The term capital structure is used to represent the

proportionate relationship between debt and equity.
Capital structure can be defined as the mix of owned
capital (equity, reserves & surplus) and borrowed capital
(debentures, loans from banks, financial institutions)
Maximization of shareholders wealth is prime objective
of a financial manager. The same may be achieved if an
optimal capital structure is designed for the company.
Use of long term fixed interest bearing debt and share
capital is called financial leverage or trading on equity.
Optimal Capital Structure
It means the capital structure or the combination of
equity & debt that leads to the maximum value of the
firm and minimizes the cost of capital.
Capital Structure theories
Net Income Approach
Net Operating Income Approach
Traditional Approach
Modigliani Miller Approach
Trade-off theory
Signaling theory
Debt financing as a managerial constraint
A) Net Income Approach (NI)
Durand David suggested this approach
Net Income approach proposes that there is a definite
relationship between capital structure and value of the
firm.
The theory propounds that a company can increase its
value and reduce the overall cost of capital by increasing
the proportion of debt in its capital
In other words, a changing the financial leverage will
lead to a corresponding change in the cost of capital as
well as the total value of the firm
Assumption-
1.The cost of debt is less than the cost of equity.
2.There are no taxes.
3.The risk perception of investors is not changed by the use
of debt.
V=S+D
V=Total market value of firm
S=Market value of equity shares
D=Market value of debt
Overall cost of capital(ko)=EBIT/V






ke
ko
kd
Debt
Cost
kd
ke, ko
Example A companys expected annual net operating income
(EBIT) is Rs.50000. The company has Rs.200000 @ 10%
debentures. The equity capitalization rate (ke) 12.5

Example Rs.
Net Operating Income (EBIT) 50000
(Less) Interest on 20000
PBT ( no tax so) PAT (NI) 30000
K
e
0.125
Value of equity (S) [ NI/Ke) 240000
Value of debt (D) 200000
Value of the firm [S+D] 440000
Overall cost of capital Ko = EBIT/V 11.36%
Suppose, the company raise debt by 100000 i.e.., Rs.300000
Net Operating Income (EBIT) 50000
(Less) Interest on 30000
PBT ( no tax so) PAT (NI) 20000
Ke 0.125
Value of equity (S) [ NI/Ke) 160000
Value of debt (D) 300000
Value of the firm [S+D] 460000
Overall cost of capital Ko = EBIT/V 10.9%
Thus the Ko is differ when Debt differ
B) Net Operating Income (NOI)
According to NOI approach the value of the firm and the
weighted average cost of capital are independent of the
firms capital structure., Therefore value of the company is
the same.
Net Operating Income (NOI) approach is the exact
opposite of the Net Income (NI) approach.
As per NOI approach, value of a firm is not dependent
upon its capital structure.
Assumptions
o The market capitalizes the value of the firm as a
whole
o The business risk is constant at every level of debt
equity mix
o The cost of debt (K
d
) is constant.
o Corporate income taxes do not exist.
V=EBIT/Ko
S=V-D
S= market value of equity shares
D= market value of debt
V=total market value of a firm
Ko=overall cost of capital



ke
ko
kd
Debt
Cost
Example A companys expected annual net operating income
(EBIT) is Rs.50000. The company has Rs.200000 @ 10%
debentures. The equity capitalization rate (ke) 12.5%.
Example Rs.
Net Operating Income (EBIT) 50000
Overall cost of capital (Ko) 0.125
Value of the firm [ EBIT/ Ko ] 400000
Value of the debt (D) 200000
Value of the equity (S) = V-D 200000
Ke = Eps / Value of Equity shares
Eps = EBIT I = 50000 20000 = 30000
30000/200000 = 0.15
Ko = K [B/V ]+ Ke [S/V]
=0.10 [ 200000/400000]+ .15[200000/400000]
= 0.125

D) Traditional Approach
The NI approach and NOI approach hold extreme views
on the relationship between capital structure, cost of
capital and the value of a firm.
Traditional approach (intermediate approach) is a
compromise between these two extreme approaches.
Traditional approach confirms the existence of an
optimal capital structure; where Weghited average Cost
of capital (WACC) is minimum and value is the firm is
maximum.
As per this approach, a best possible mix of debt and
equity will maximize the value of the firm.
Traditional Approach is midway between NI approach
and NOI approach
It is also known as Intermediate approach
It argues that Ko will not change upto certain level of
change in debt equity proportion.
Example: Assume a firm has EBIT of Rs. 40000. the
firm has 10 % debentures of Rs. 100000 and its current
equity capitalisation rate is 16 %.
Particulars Amount (Rs)
EBIT 40000
Less : Interest (10% on Debt) 10000
EAT [NI] 30000
Equity Capitalisation rate 0.16
Total MV of Equity (S) [NI/Ke] 187500
Total MV of Debt (B) 100000
Total Value of the Firm [V=S+B] 287500
Ko [EBIT/V] 0.139
Therefore the Ko is approx 14%

Suppose debentures increase by Rs. 50000 i.e.
Rs.150000 and Interest Is increase by 11% and Ke 17%
Ensure whenever Debt increase interest will also increase

EBIT 40000
Less : Interest 16500
NI 23500
Ke 0.17
S = NI / Ke 138235
D= 150000
Then V = (S+D) 288235
Ko = [ EBIT / V ] 0.138
Therefore the Ko is approx 14%
Thus we can understand that there is no relevant of the
Ko with the proportion of S: D
At the same time suppose if the firm issue additional debt
Rs.100000 i.e. Rs.200000 then interest is 12.5% and Ke
20 % then Ko will differ from past capital structure

EBIT 40000
Less : interest 25000
NI 15000
Ke 0.20
Value of the Equity (S) [NI / Ke] 75000
Value of the Debt (D) 200000
Value of the firm V = [S+D] 275000
Ko = EBIT / V 0.145

C) Modigliani Miller Model (MM)
Modigliani and Miller (1958) show that financing
decisions dont matter in perfect capital markets.
The Modigliani Miller Approach is relating to the
relationship between the capital structure, Cost of capital.
MM Approach maintains that the Weghited average Cost
of capital (WACC) does not change, with a change in the
proportion of debt to equity in the capital structure.
M&M Proposition 1:
Firms cannot change the total value of their
securities by splitting cash flows into two different
stream.
Capital structure is irrelevant
MM approach supports the NOI approach, i.e. the
capital structure (debt-equity mix) has no effect on
value of a firm.
Assumptions
o Capital markets are perfect and investors are free to
buy, sell, & switch between securities. Securities are
infinitely divisible.
o Investors can borrow without restrictions at par with
the firms.
o Investors are rational & informed of risk-return of
all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits
retention.
MM Model proposition
o Value of a firm is independent of the capital
structure.
o Firms total market value=EBIT/Ke
o Firms market value of equity(S)=V-D
o Firms leverage cost of equity=Cost of equity
o MM prove, under a very restrictive set of
assumptions, that a firms value is unaffected by its
financing mix:
V
L
= V
U

V
u
is the value of an unlevered firm = price of buying a firm
composed only of equity, and V
L
is the value of a levered
firm = price of buying a firm that is composed of some mix of
debt and equity.


MM Theory:Corporate Taxes
Corporate tax laws favor debt financing over equity
financing.
With corporate taxes, the benefits of financial leverage
exceed the risks: More EBIT goes to investors and less
to taxes when leverage is used.
MM show that: V
L
= V
U
+ TD.
If T=40%, then every dollar of debt adds 40 cents of
extra value to firm.
Millers Theory:Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
o Corporate taxes favor debt financing since
corporations can deduct interest expenses.
o Personal taxes favor equity financing, since no gain
is reported until stock is sold, and long-term gains
are taxed at a lower rate.
V
L
= V
U
+ [1 - (1 - T
c
)(1 - T
s
)]D
( 1- T
d
)
T
c
= corporate tax rate.
T
d
= personal tax rate on debt income.
T
s
= personal tax rate on stock income.
T
c
= 40%, T
d
= 30%, and T
s
= 12%.
V
L
= V
U
+ [1 - (1 - 0.40)(1 - 0.12) ]D
(1 0.30)
= V
U
+ (1 - 0.75)D
= V
U
+ 0.25D.
Value rises with debt; each $1 increase in debt raises Ls
value by $0.25
Effects of Bankruptcy Cost
Another important imperfection affecting CS decision is the
presence of bankruptcy cost. When a firm is unable to meet its
obligations it results in financial distress that can lead to
bankruptcy because a major contributor to financial distress is
debt. The greater the level of debt, the larger the debt
servicing burden associated with it, the higher the probability
of financial distress. If there is a possibility of bankruptcy, and
if administrative and other costs associated with bankruptcy
are significant, the levered firm may be less attractive to
investors than that of the unlevered one. As a result, the
investors are likely to penalize the price of the stock as
Leverage increases.
Expected bankruptcy cost rise when Price declines, and the
threat of this cost pushes less profitable firms toward lower
Leverage targets. Similarly, expected bankruptcy cost is
higher for firms with more volatile earnings, which should
drive smaller, less-diversified firms toward fewer targets
Leverage. Taxes have two offsetting effects on optimal
Capital structure. The deductibility of corporate interest
payments pushes firms toward more target Leverage, while
the higher personal tax rate on debt,relative to equity, pushes
them toward less Leverage. Baxter (1967)35 used the concept
of bankruptcy costs to argue for the existence of an optimal
capital structure. Expected bankruptcy cost depends on the
cost of bankruptcy (eg., legal fees, loss of sales, employees
and suppliers) and the probability of occurrence. Increased
debt financing will increase the probability of bankruptcy and
will in turn increase expected bankruptcy costs. The optimal
debt ratio is reached when the marginal tax savings from debt
financing is equal to the marginal loss from expected
bankruptcy costs.
Trade-off Theory
The term trade-off theory is used by different authors to
describe a family of related theories. Management
running a firm evaluates the various costs and benefits
of alternative Leverage plans and strives to bring a trade-
off between them. Often it is assumed that an interior
solution is obtained so that marginal costs and marginal
benefits are balanced. Thus, trade-off theory, implies that
companys Capital structure decision involves a trade-off
between the tax benefits of debt financing and the costs
of financial distress. When firms adjust their Capital
structure, they tend to move toward a target debt ratio
that is consistent with theories based on tradeoffs
between the costs and benefits of debt.
MM theory ignores bankruptcy (financial distress) costs,
which increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy
costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these
costs and benefits.
Signaling Theory
MM assumed that investors and managers have the
same information.
But, managers often have better information. Thus, they
would
o Sell stock if stock is overvalued.
o Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a
negative signal.
The pioneering study of Donaldson (1961)41 examined
how companies actually establish their Capital structure
Firms prefer to rely on internal accruals, that is, on
retained earnings and depreciation cash flow.
Expected future investment opportunities and expected
future cash flows influence target dividend payout ratios.
Firms set the target payout ratios at such a level that
capital expenditures, under normal circumstances are
covered by internal accruals.
Dividends tend to be sticky in the short run. Dividends
are raised only when the firm is confident that the higher
dividend can be maintained;dividends are not lowered
unless things are very bad.
If a firms internal accruals exceed its capital expenditure
requirements, it will invest in marketable securities,
retire debt, raise dividend, and resort to acquisitions or
buyback its shares.
If a firms internal accruals are less than its non-
postponable capital expenditures, it will first draw down
its marketable securities portfolio and then seek external
finance. When it resorts to external finance, it will first
issue debt, then convertible debt, and finally equity
stock, thus, there is a pecking order of financing.
Debt Financing and Agency Costs
One agency problem is that managers can use corporate
funds for non-value maximizing purposes.
The use of financial leverage:
o Bonds free cash flow.
o Forces discipline on managers to avoid perks and
non-value adding acquisitions.
o A second agency problem is the potential for
underinvestment.
o Debt increases risk of financial distress.
o Therefore, managers may avoid risky projects even
if they have positive NPV