Capital Structure

CAPITAL STRUCTURE

Capital Structure

Capital StructureThis is concerned with the question as

to whether there is an optimal capital mix of debt and capital which a company should try to achieve.

There are three major theories: Net Income (NI) approach Traditional view Modigliani and Miller

Net Income Approach

Suggested by David Durand Capital structure affect the value of the

firm Change in the capital structure causes a

corresponding change in the overall cost of capital and the total value of the firm

Higher financial leverage will result in the decline in the WACC Causing the increase in the value of the

firm And the increase in the value of the firm

Net Income Approach

Assumptions of the NI Approachi. There are no corporate taxes

ii. The cost of debt is less than the cost of equity

iii. The debt content does not change the risk perception of the investors

The value of the firmV = Ve + Vd

Where Ve = Market value of equity

Vd = market value of debt

Ve= NI/re

Traditional View

The traditional view of Capital structure There is an optimal capital structure The company can increase its total value by a

suitable debt finance in its capital structure. Assumptions:a) The company pays out all its earnings as

dividendsb) The leverage of the company can be

changed immediately by issuing debt to purchase shares, or by issuing shares to repurchase debt

Traditional View

Assumptions:a) The company pays out all its earnings as

dividendsb) The leverage of the company can be changed

immediately by issuing debt to purchase shares, or by issuing shares to repurchase debt

c) The earnings of the company are expected to remain constant in perpetuity

and all investors share the same expectations

d) Business risk is also constant, regardless of how the company invests its funds

e) Taxation, for the time being, is ignored

Traditional View

a) As the level of leverage increase, the cost of debt remains unchanged up to a certain level.

Beyond this level the cost of debt will increase

b) The cost of equity rises as the level of leverage increases and financial risk increases.

There is a non-linear relationship between the cost of equity and leverage

c) The WACC does not remain constant falls initially as the proportion of debt capital

increases Then begins to increase as the rising cost of

equity becomes significant

Traditional View

d) The optimum level of leverage is where the company WACC is minimized.

Modigliani-Miller (MM) View

Assumptions of MM viewa) A perfect capital market exists in which

investors have the same information Upon which they act rationally To arrive to the same expectations about

future earnings and risks

b) There are no taxes or transaction costsc) Debt is risk-free and freely available at

the same cost to investors and companies alike.

Modigliani-Miller (MM) View

In 1958 Modigliani and Miller proposed MM Proposition I The total market value of a company, in the

absence of tax will be determined by two factors1. Total earnings of the company2. The level of operating risk attached to those

earnings(The total market value would be computed by

discounting the total earnings at a rate that is appropriate to the level of operating risk. The WACC)

Thus the capital structure has no effect on the WACC.

Modigliani-Miller (MM) view

MM justified their approach by the use of arbitrage.

MM Proposition II1. The cost of debt remains

unchanged as the level of leverage increases

2. The cost of equity rises in such a way as to keep the WACC constant.

Graphical MM view

The MM view would be represented on a graph as shown below

Cost of equity

WACC

Cost of Debt

Cost of capital

D/E ratio

Modigliani-Miller (MM) view

Summing up MM view: MM hypothesis is based on the idea that

No matter how you divide up the capital structure of a firm among debt, equity and other claims, there is a conservation of investment value

Since total investment value of a corporation depends on its underlying profitability and risk.

Total investment value is invariant w.r.t. relative changes in the firm’s financial capitalization.

Market imperfections

In 1963 MM modified their theory Admitted the effect of tax relief on interest

payment to the WACC Interest on debt is tax deductible

Saving from tax relief on debt is called tax shield. They claimed that the WACC will continue to fall

up to 100% gearing. This suggests that companies should have a

capital structure made up entirely of debt. This does not happen because of market

imperfections

Market imperfections

Value of the interest tax shield = (T x rd x Vd )/rd

= T x Vd

VL = VU + (TxVd) Vu = EBIT (1-T)/rU

Taxes, WACC and Proposition II

WACC(rA) =

rV

V Vr

V

V Vee

e dd

d

e d

Market imperfection

re = rA + (rA –rd) (Vd/Ve) MM demonstrates that in the world with

corporate taxes re = ru + (ru –rd) (Vd/Ve)x (1-T) This results indicates a positive

relationship between the expected return on equity and debt equity ratio

It implies that the rA decreases as the amount of debt increases

Market Imperfections

1. Bankruptcy costs One assumption of MM theory is perfect

capital market But in reality, at higher levels of leverage

there is an increasing risk of the company being unable to meet its interest payment and being declared bankrupt

At these higher levels of leverage the bankruptcy risk means that required rate of return will be higher.

Market Imperfections

2. Agency Costs At Higher levels of leverage, there are

also agency costs Due to actions taken by concerned debt

holders Restrictive covenants: limit to dividends

and minimum level of liquidity, by debt providers to protect investments.

Higher levels of monitoring

Market Imperfections

3. Tax Exhaustion As the companies increase their level of

leverage they may reach a point where there are

not enough profits from which to obtain all available tax benefits

Bankruptcy and agency costs will rise, but benefits of tax shield will not rise sufficiently.

So market imperfections undermine the tax advantage of debt finance.

Optimal Capital Structure

Financial distress costs are insignificant for a firm with little or no debt.

so if an unlevered firm adds a small amount of debt It benefits from the tax shield on debt Without incurring significant costs of

financial distress As a firm uses more and more debt

The tax savings are eventually offset by the higher likelihood of financial distress

Optimal Capital Structure

The point where these two factors offset each other is where the firm value is maximized.

STATIC THEORY OF CAPITAL STRCUTURE A Firm uses debt financing up to the point

where tax benefits from additional debt exactly offsets the cost associated with an increased likelihood of financial distress. That is the optimal capital structure

Optimal capital structure Minimum WACC Maximizes the firm value

Optimal Capital Structure

Recommendations From The Static Theory of Capital

1. Firms with higher tax rates should borrow more as long as they don’t have other tax shields

2. Firms with higher risk of distress (due to higher operating risks) should borrow less

3. Firms for which the cost of financial distress is higher should borrow less