Capital Structure

Amity Business School

• Module III: Financing Decisions• Capital Structure and Cost of Capital, Marginal Cost of Capital.


CAPITAL STRUCTURE

“Capital Structure refers to the composition of capital, i.e., the mix of long term funds such as debentures, long term borrowings, preference share capital, equity share capital and retained earnings”Capital structure is the proportion of debt and preference and equity shares on a firm’s balance sheet.


OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the

weighted average cost of capital is minimum and thereby value

of the firm is maximum.


PATTERNS / FORMS OF CAPITAL STRUCTURE

a) Complete equity share capital

b) Different proportions of equity share capital and preference

share capital

c) Different proportions of equity share capital and debentures

d) Different proportions of equity share capital, preference share

capital and debentures

Amity Business SchoolILLUSTRATION

Very Right International Ltd. has a capital structure (all equity) comprising of Rs 5,00,000 each share of Rs 10. the firm wants to raise an additional Rs 2,50,000 for expansion project. The firm has the following four alternative financial plans. The firm is able to earn an operating profit at Rs 80,000 after additional investment and 50% tax rate. Calculate EPS for all four alternatives and select the preferable financial plan.

a)Raise the entire amount in the form of equity capitalb)Raise 50% as equity capital and 50% as 10% debt capitalc)Raise the entire amount as 12% debenturesd)Raise 50% equity capital and 50% preference share capital at

10%


FACTORS DETERMINING CAPITAL STRUCTURE

Financial Risk

Trading on Equity (EBIT-EPS Analysis)

Cost of Capital

Cash Flow

Control

Flexibility

Size of the company


Contd..

Nature of Business

Market conditions

Floatation costs

Corporate taxation

Government policies

Purpose and Period of financing


CAPITAL STRUCTURE THEORIES

Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital (k0) and valuation (V ). The four important theories are:

Major theories Net Income (NI) theory Net Operating Income (NOI) Approach Modigliani and Miller (MM)theory Traditional Theory


ASSUMPTIONS OF CAPITAL STRUCTURE THEORIES

1. There are only two sources of funds used by a firm: debt and ordinary shares.

2. There are no corporate taxes. This assumption is removed later.3. 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.4. The total assets are given and do not change. The investment decisions

are, in other words, assumed to be constant.5. 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.


Contd..

6. The operating profits (EBIT) are not expected to grow.7. Business risk is constant over time and is assumed to be independent of

its capital structure and financial risk.8. Perpetual life of the firm.


NET INCOME APPROACH

According to Net Income (NI) Approach, suggested by David

Durand, the capital structure decision is relevant to the

valuation of the firm.

According to the NI approach, capital structure is relevant as

it affects the k0 and V of the firm.


NET INCOME APPROACH - Assumptions

1) There are no taxes

2) Cost of debt is less than the cost of equity

3) Use of debt does not change the risk perception of investors. With change in leverage, cost of equity or cost of debt will not change


As the degree of financial leverage increases, the proportion of a cheaper source of funds, that is, debt in the capital structure increase. As a result, the weighted average cost of capital tends to decline, leading to an increase in the total value of the firm and vice versa

In other words, when degree of financial leverage is

increased, the weighted average cost of capital will decline and market price of ordinary shares as well as value of firm will increase.


5.0

10.0

15.0

0 0.5 1.0

Degree of Leverage

Leverage and Cost of Capital (NI Approach)

X

Y

Ke,

kd a

nd

k0 (%

)

k0

kd

ke


Value of firm = Value of equity + Value of debt

Value of equity = Net Income Cost of equity (Ke)

Value of debt = Interest Cost of Debt (Kd)

Firm’s cost of capital = EBIT Value of firm

= D x Kd + E x KeD+E D+E


ILLUSTRATION

A company’s expected annual net operating income (EBIT) is Rs 50,000. The company has Rs 2,00,000, 10% debentures. The equity capitalization rate (ke) of the company is 12.5 per cent.

Calculate value of firm and cost of capital


Increase in Value

In order to examine the effect of a change in financing-mix on the firm’s overall (weighted average) cost of capital and its total value, let us suppose that the firm has decided to raise the amount of debenture by Rs 1,00,000 and use the proceeds to retire the equity shares.

The kd and ke would remain unaffected as per the assumptions of the NI Approach.


Decrease in Value

Let us suppose that the amount of debt has been reduced by Rs 1,00,000 to Rs 1,00,000 and a fresh issue of equity shares is made to retire the debentures.


NET OPERATING INCOME APPROACH

Net Operating Income Approach was suggested by David

Durand. The NOI approach is diametrically opposite to the NI

approach. The essence of this approach is that capital

structure decision of a corporate does not affect its cost of

capital and valuation, and, hence, irrelevant.


ASSUMPTIONS

1. Investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole.

2. The overall cost of capital of the firm is constant and depends upon the business risk, which also is assumed to be unchanged.

3. The cost of debt is also taken as constant.

4. The use of more and more debt in the capital structure increases the risk of shareholders and thus results in the increase in the cost of equity capital i.e., the increase in cost of equity is such, as to completely offset the benefits of employing cheaper debt, and

5. There is no tax.


According to NOI approach the value of the firm and the weighted average

cost of capital are independent of the firm’s capital structure.

For the given value of EBIT, value of the firm remains constant irrespective of

the capital structure. Overall Cost of Capital / Capitalization Rate (k0) is also

constant

The increase in the proportion of debt in the capital structure would lead to

increase in the financial risk of the equity shareholders. To compensate

increased financial risk, the shareholders would expect a higher rate of

return on investment. Hence Ke would increase.


Value of firm = Net Operating IncomeKe

Value of debt = Interest Cost of Debt (Kd)

Value of equity = Value of firm – Value of debt

Ke = Net IncomeValue of equity


5.0

10.0

15.0

0 0.5 1.0

Degree of Leverage

Figure 2: Leverage and Cost of Capital (NOI Approach)

X

Y

Ke,

ki a

nd

k0 (%

)

k0

kd

ke

20.0

25.0


Optimum Capital Structure

The total value of firm will remain unaffected by its capital structure. The

market price of shares will also not change with the change in debt-equity

ratio. There is nothing such as Optimum Capital Structure. Any Capital

Structure is optimum, according to NOI Approach.


ILLUSTRATION

Assume operating income Rs 50,000; cost of debt, 10 per cent; and outstanding debt, Rs 2,00,000. If the overall capitalisation rate (overall cost of capital) is 12.5 per cent, what would be the total value of the firm and the equity-capitalisation rate?


INCREASE IN DEBT

In order to examine the effect of leverage, let us assume that the firm increases the amount of debt from Rs 2,00,000 to Rs 3,00,000 and uses the proceeds of the debt to repurchase equity shares. Calculate cost of equity capitalisation.


DECREASE IN DEBT

Let us further suppose that the firm retires debt by Rs 1,00,000

by issuing fresh equity shares of the same amount. Calculate

cost of equity capitalisation


QUESTION

A firm has an EBIT of Rs 2,00,000 and belongs to a risk class of 10%. What is the value of cost of equity capital if it employees 6% debt to the extent of 30%, 40% or 50% of the total capital funds of Rs 10,00,000.


TRADITIONAL APPROACH

The traditional approach is mid-way between the two extreme (the NI and

NOI) approaches.

According to this approach, a firm can increase its value (V) and reduce its

cost of capital (k0) up to a point through a judicious combination of debt

and equity. However, beyond that point, the use of additional debt will

increase the financial risk of the investors as well as of the lenders and as a

result will cause a rise in the k0.


MODIGLIANI AND MILLER APPROACH

Modigliani and Miller Approach is similar to NOI approach.

According to this approach capital structure decision is irrelevant to the

valuation of the firm

However, MM approach provides the behavioural justification for constant

overall cost of capital and constant value of the firm.


ASSUMPTIONS OF MM APPROACH

1.Perfect Capital Market – This means that:a. Investors are free to buy and sell securitiesb. They can borrow without restrictionsc. The investors behave rationallyd. There are no transaction costse. Investors are well informed about the risk-return on all types of

securities2. Homogeneous Risk Class –All firms within the same class have same

degree of risk3.No taxes4. Same expectations - All investors have same expectations from a firm’s

operating income5.Dividend pay-out ratio is 100%


MM APPROACH –Proposition 1

As per the 1st proposition of MM theory on capital structure

“ The market value of any firm is independent of its capital structure”

i.e the total value of firm must be constant irrespective of degree of leverage. Similarly the cost of capital as well as the market price of the shares must be same regardless of the financing-mix.

The operational justification of this process is explained through ARBITRAGE process.


PROPOSITION II

MM’s proposition II states

“ The rate of return required by shareholders increases linearly as the

debt/equity ratio is increased”

i.e that with increasing leverage the cost of equity rises exactly to offset the

advantage of reduced cost of debt to keep the value of the firm constant


34

x

(in Rs)

v

k 0 (

%)

Degree of Leverage

Leverage and Cost of Capital (MM Approach)

V0

k0

MM APPROACH


Illustration

Consider two firms that are identical in every respect EXCEPT:

Company U -- no financial leverage

Company L – Rs. 5,00,000 of 10% debt

Required return on equity/ equity capitalisation rate

-- Ke of Company U is 12.5%

-- Ke of Company L is 16%

NOI for each firm is Rs. 1,00,000


Particulars FirmsL U

EBIT Rs 1,00,000 Rs 1,00,000Less: Interest 50,000 —Earnings available to equity-holders 50,000 1,00,000Equity-capitalisation rate (ke) 0.16 0.125

Total market value of equity 3,12,500 8,00,000Total market value of debt 5,00,000 —Total market value (V) 8,12,500 8,00,000Implied overall capitalization rate/cost of capital (k0) = EBIT/V 0.123 0.125

Thus, the total market value of the firm which employs debt in the capital structure (L) is more than that of the unlevered firm (U). According to the MM hypothesis, this situation cannot continue as the arbitrage process, based on the substitutability of personal leverage for corporate leverage, will operate and the values of the two firms will be brought to an identical level.


Arbitrage ProcessSuppose an investor, Mr X, holds 10 per cent of the outstanding shares of the levered firm (L). His holdings = Rs 31,250 (i.e. 0.10 × Rs 3,12,500) and His share in the earnings (Net Profit) = Rs 5,000 (0.10 × Rs 50,000).

As the value of firm L and share price of firm L is higher than that of Firm U, he will sell his holdings in firm L and invest in the unlevered firm (U).

Since firm U has no debt in its capital structure, the financial risk to Mr X would be less than in firm L. To reach the level of financial risk of firm L, he will borrow additional funds equal to his proportionate share in the levered firm’s debt on his personal account. That is, he will substitute personal leverage (or home-made leverage) for corporate leverage.


Instead of the firm using debt, Mr X will borrow money. The effect, in essence, of this is that he is able to introduce leverage in the capital structure of the unlevered firm by borrowing on his personal account.

Mr X in our example will borrow Rs 50,000 at 10 per cent rate of interest. His proportionate holding (10 per cent) in firm U = Rs. 80,000Dividend income received on 10% holding = Rs. 10,000Interest paid on personal borrowings = Rs. 5,000Profit left with Mr. X = Rs. 10,000 – Rs. 5,000= Rs. 5,000

But his investment outlay in firm U is less (Rs 30,000) as compared with that in firm L (Rs 31,250). At the same time, his risk is identical in both the situations.


Effect of Arbitrage

(A) Mr X’s position in firm L (levered) with 10 per cent equity-holding

(i) Investment outlay Rs 31,250

(ii) Dividend Income 5,000

(B) Mr X’s position in firm U (unlevered) with 10 per cent equity holding

(i) Total funds available (own funds, Rs 31,250 + borrowed funds, Rs 50,000) 81,250

(ii) Investment outlay (own funds, Rs 30,000 + borrowed funds, Rs 50,000) 80,000

(iii) Dividend Income:

Total Income (0.10 × Rs 1,00,000) Rs 10,000

Less: Interest payable on borrowed funds 5,000 5,000

(C) Mr X’s position in firm U if he invests the total funds available

(i) Investment costs 81,250.00

(ii) Total income 10,156.25

(iii) Dividend income (net) (Rs 10,156.25 – Rs 5,000) 5,156.25


LIMITATIONS OF MM APPROACH

1.Risk perception – MM approach assumes that corporate leverage and home-made leverage are perfect substitutes. However, the risk exposure to the investor is greater in personal leverage as compared to corporate leverage

2.Convenience- Apart from higher risk exposure, the investors would find personal leverage as inconvinient.

3.Cost High cost of borrowing in personal leverage4.Institutional Restrictions5.Double leverage6.Transaction costs7.Corporate Taxes


x

Y

0Degree of Leverage

Ke,

ki a

nd

k0 (%

)

Leverage and Cost of Capital (Traditional Approach)

ke

k0

kd









Capital Structure

Documents

mr xs position

amity business

capital structure

weighted average

optimum capital

preference

net income

equity share