INTRODUCTION:

In theory, capital structure can affect the value of a company by affecting either its
expected earnings or the cost of capital, or both. While it is true that financing-mix
cannot affect the total operating earnings of a firm, as they are determined by the
investment decisions, it can affect the share of earnings belonging to the ordinary
shareholders. The capital structure decision can influence the value of the firm
through the earnings available to the shareholders. But the leverage can largely
influence the value of the firm through the cost of capital. In exploring the
relationship between leverage and value of a firm in this chapter we are concerned
with the relationship between leverage and cost of capital from the standpoint of
valuation. While section one deals with the assumptions, definition and symbols
relating to capital structure theories, the next four sections of the chapter explain
the major capital structure theories, namely: (i) Net Income Approach, (ii) Net
Operating Income Approach, (iii) Modigliani-Miller (MM) Approach, and (iv)
Traditional Approach. The last section summarizes the main points.
There are only two sources of funds used by a firm: perpetual riskless debt and
ordinary shares.

There are no corporate taxes. This assumption is removed later.

The dividend-payout ratio is 100. That is, the total earnings are paid out
as dividend to the shareholders and there are no retained earnings.
The total assets are given and do not change. The investment decisions
are, in other words, assumed to be constant.
The total financing remains constant. The firm can change its degree of
leverage (capital structure) either by selling shares and use the proceeds to
retire debentures or by raising more debt and reduce the equity capital.
The operating profits (EBIT) are not expected to grow.
All investors are assumed to have the same subjective probability
distribution of the future expected EBIT for a given firm.
Business risk is constant over time and is assumed to be independent of
its capital structure and financial risk.
Perpetual life of the firm.
The objective of the firm should be directed towards the maximization of the value
of the firm the capital structure, or average, decision should be examined from the
point of view of its impact on the value of the firm.

If the value of the firm can be affected by capital structure or financing decision a
firm would like to have a capital structure which maximizes the market value of
the firm. The capital structure decision can affect the value of the firm either by
changing the expected earnings or the cost of capital or both.

If average affects the cost of capital and the value of the firm, an optimum capital
structure would be obtained at that combination of debt and equity that maximizes
the total value of the firm (value of shares plus value of debt) or minimizes the
weighted average cost of capital. For a better understanding of the relationship
between financial average and the value of the firm, assumptions, features and
implications of the capital structure theories are given below.

Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital controversy
property, the following assumptions are made:
Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of average can be changed by
selling debt to purchase shares or selling shares to retire debt.

The firm has a policy of paying 100 per cent dividends.

The operating earnings of the firm are not expected to grow.

The business risk is assumed to be constant and independent of capital structure
and financial risk. The corporate income taxes do not exist. This assumption is
relaxed later on.

The following are the basic definitions:

The above assumptions and definitions described above are valid under any of the
capital structure theories. David Durand views, Traditional view and MM
Hypothesis are tine important theories on capital structure.

1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There exist
two extreme views and a middle position. David Durand identified the two extreme
views the Net income and net operating approaches.

a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are
assumed to be independent of the capital structure. The weighted average cost of
capital declines and the total value of the firm rise with increased use of average.

b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is assumed to
increase linearly with average. As a result, the weighted average cost of capital
remains constant and the total of the firm also remains constant as average
changed.

Thus, if the Nl approach is valid, average is a significant variable and financing

decisions have an important effect on the value of the firm, on the other hand, if
the NOI approach is correct, then the financing decision should not be of greater
concern to the financial manager, as it does not matter in the valuation of the firm.

2. Traditional view:
The traditional view is a compromise between the net income approach and the net
operating approach. According to this view, the value of the firm can be increased
or the cost, of capital can be reduced by the judicious mix of debt and equity
capital.

This approach very clearly implies that the cost of capital decreases within the
reasonable limit of debt and then increases with average. Thus an optimum capital
structure exists and occurs when the cost of capital is minimum or the value of the
firm is maximum.

The cost of capital declines with leverage because debt capital is chipper than
equity capital within reasonable, or acceptable, limit of debt. The weighted average
cost of capital will decrease with the use of debt. According to the traditional
position, the manner in which the overall cost of capital reacts to changes in capital
structure can be divided into three stages and this can be seen in the following
figure.

Criticism:
1. The traditional view is criticised because it implies that totality of risk incurred
by all security-holders of a firm can be altered by changing the way in which this
totality of risk is distributed among the various classes of securities.

2. Modigliani and Miller also do not agree with the traditional view. They criticise
the assumption that the cost of equity remains unaffected by leverage up to some
reasonable limit.

3. MM Hypothesis:
The Modigliani Miller Hypothesis is identical with the net operating income
approach, Modigliani and Miller (M.M) argue that, in the absence of taxes, a firms
market value and the cost of capital remain invariant to the capital structure
changes.

Assumptions:
The M.M. hypothesis can be best explained in terms of two propositions.

It should however, be noticed that their propositions are based on the

following assumptions:
1. The securities are traded in the perfect market situation.

2. Firms can be grouped into homogeneous risk classes.

3. The expected NOI is a random variable

4. Firm distribute all net earnings to the shareholders.

5. No corporate income taxes exist.

Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same risk
class, the total market value is independent of the debt equity combination and is
given by capitalizing the expected net operating income by the rate appropriate to
that risk class.

This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not
affected by leverage.
Arbitrary-process:
M-M opinion is that if two identical firms, except for the degree of leverage, have
different market values or the costs of capital, arbitrary will take place to enable
investors to engage in personal leverage as against the corporate leverage to
restore equilibrium in the market.

Proposition II: It defines the cost of equity, follows from their proposition, and
derived a formula as follows:

Ke = Ko + (Ko-Kd) D/S

The above equation states that, for any firm in a given risk class, the cost of equity
(Ke) is equal to the constant average cost of capital (Ko) plus a premium for the
financial, risk, which, is equal to debt-equity ratio times the spread between the
constant average of capita and the cost of debt, (Ko-Kd) D/S.

The crucial part of the M-M hypothesis is that Ke will not rise even if very
excessive raise of leverage is made. This conclusion could be valid if the cost of
borrowings, Kd remains constant for any degree of leverage. But in practice Kd
increases with leverage beyond a certain acceptable, or reasonable, level of debt.

However, M-M maintain that even if the cost of debt, Kd, is increasing, the
weighted average cost of capital, Ko, will remain constant. They argue that when
Kd increases, Ke will increase at a decreasing rate and may even turn down
eventually. This is illustrated in the following figure.
Criticism:
The shortcoming of the M-M hypothesis lies in the assumption of perfect capital
market in which arbitrage is expected to work. Due to the existence of
imperfections in the capital market/arbitrage will fail to work and will give rise to
discrepancy between the market values of levered and unlevered firms.

The Trade-Off Theory

Frydenberg (2004) explained that, the theory shows how a firms optimal debt ratio
is determined by a trade-off between the benefits and obligations of borrowing,
holding the firms assets and investment plans constant. The firm can use debt in
place of equity, or equity for debt until the firm ultimately maximised the value of
the firm. The benefit of debt according to Frydenberg (2004) is primarily the tax-
shield effect, which emanates from the fact that interest on debt is deductible on
the profit and loss account.

The costs of debt is directly and indirectly associated to bankruptcy costs such that
as the firm increase its gearing level the inability to pay the obligations attached to
the debt also increases enhancing the probability of bankruptcy of firm. In the
more general trade - off theory several other arguments are used for why firms
might try to adjust their capital structure to some target. Leverage also depends on
restrictive covenants in the debt-contracts, takeover possibilities and the reputation
of management. In view of this, Harris and Raviv (1990) proposed a negative
correlation between debt and monitoring costs.

The theory according to Ross et al (2011), states that firms borrow up to the point
where the tax benefit from an extra dollar in debt is exactly equal to the cost that
comes from the increased profitability of financial distress. Ross et al (2011)
further noted that the static theory is called static theory because it assumes that the
firm is fixed in terms of its assets and operations and it only considers possible
chances in the debt equity ratio. They also stated that the model is not capable of
identifying a precise optimal capital structure, but it does point out two of the more
relevant factors, namely taxes and financial distress.

The trade off theory indicates the exposure of the firm to bankruptcy and agency
cost against tax benefits associated with debt use. Bankruptcy cost is a cost directly
incurred when the perceived probability that the firm will default on financing is
greater than zero. One of the bankruptcy costs is liquidation cost, which represents
the loss of value as a result of liquidating the net assets of the firm. Another
bankruptcy cost is distress cost, which is the cost a firm incurs if stakeholders
believe that the firm will discontinue.

The static trade off theory has been critised by many authors, including Miller
(1977), who argued that the static trade off model implies that firms should be
highly leveraged than they really are, as the tax savings of debt seem large while
the costs of financial distress seem minor.
Signaling Theory:

The signaling theory is based on the conception that managers have more superior
information than outside investors when it comes to the financial performance and
non financial performance of the firm, and would thus send some form of message
through this potential information to investors by increasing leverage. Barclay and
Smith (2005) in a contrast view to the market timing theory mentioned that,
securities often are seen as an attempt to raise capital with the minimum cost, the
signalling model assumes that financing decisions are designed basically to convey
future prospects to outside investors. This is usually done to raise the value of
shares when managers think they are undervalued.

Gatsi (2012), argued that debt obligates firms to make a fixed cash payment to
debt-holders over the term of the debt security. They also mentioned that firms
could be forced into bankruptcy and liquidity, if they default in honouring their
debt obligations, and would ultimately affect the managers as they could lose their
jobs. Managers may be aware of this and do everything possible to maintain their
positions, all things being equal.

Barclay and Smith (2005) contend that, dividend payments are not obligatory and
managers have more judgment over their payments and can omit them in times of
financial difficulty. Ross et al (2011) indicated that adding more debt to the
companys capital structure can show as a credible signal of higher expected future
cash flows as it shows that the firm has a credible reputation been able to redeem
their credit responsibilities on time. In view of this, increasing gearing has been
suggested one of the potentially effective signalling tools.

Two other signalling models are described by Heinkel in 1982 and Blazenko in
1987. The Heinkel model is focused on debt signalling information to the investors
about the average and variability of the returns. In that model he assumed that
positive relationship between the average and the degree of variability facilitates
signalling equilibrium in which higher value firms signals their quality with higher
debt levels while the Blazenko model observes that managers that are prone to the
mean variance criterion would shift risky positive net present value investments
opportunities thus reducing the value of the firm.

From the fore-going discussion, it evident that higher value firms would use
more debt in their capital structure to signal this value relative to their low value
counterpart and this is based on the premise that inefficient firms cannot manage
debt and any attempt to use more debt would jeopardize the financial health of the
firm due to bankruptcy and its associated costs.