CAPITAL STRUCTURE THEORY USE OF FINANCIAL LEVERAGE – INCREASES SHAREHOLDERS EXPECTED RETURNS ALSO IT INCREASES RISK FOR SHAREHOLDERS BECAUSE OF FINANCIAL LEVERAGE THE SHAREHOLDERS WILL ALSO HAVE TO BEAR FINANCIAL RISK ALONG WITH BUSINESS RISK
CAPITAL STRUCTURE THEORY
USE OF FINANCIAL LEVERAGE –
INCREASES SHAREHOLDERS EXPECTED RETURNS
ALSO IT INCREASES RISK FOR SHAREHOLDERS
BECAUSE OF FINANCIAL LEVERAGE THE SHAREHOLDERS
WILL ALSO HAVE TO BEAR FINANCIAL RISK ALONG WITH BUSINESS RISK
The question is:
Is the increase in expected return sufficient to compensate the risk?
TO HELP ANSWER THIS QUESTION
IT’S USEFUL TO EXAMINE CAPITAL STRUCTURE THEORY
THEORY DOES NOT PROVIDE INSIGHTS INTO THE EFFECTS OF DEBT VERSUS EQUITY FINANCING AN UNDERSTANDING OF “CAPITAL STRUCTURE THEORY”
WILL AID MANAGERS IN ESTABLISHING THEIR FIRM’S OPTIMAL CAPITAL STRUCTURE
ASSUMPTIONS OF THE THEORY
1. Firms employ only two types of capital: debt and equity
2. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debt.
3. Investors have the same subjective probability distributions of expected future operating earnings for a given firm.
4. The firm has a policy of paying 100 per cent dividends
5. The operating earnings of the firm are expected to be constant
6. The business risk is assumed to be constant and independent of capital structure and financial risk
7. The corporate and personal income taxes do not exist (Though the assumption is relaxed later)
NET INCOME APPROACH
ACCORDING TO NET INCOME APPROACH:
THE FIRM CAN INCREASE ITS VALUE
OR
LOWER THE OVERALL COST OF CAPITAL
BY
INCREASING THE PROPORTION OF DEBT
IN THE CAPITAL STRUCTURE
ASSUMPTIONS OF NET INCOME APPROACH
1. The use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, ke, and the debt capitalisation rate kd, remain constant with changes in leverage
2. The debt capitalisation rate is less than the equity capitalisation rate
3. The corporate income taxes do not exist.
Assume that a firm has an expected annual net operating income of Rs.200,000, an equity rate, ke, of 10% and Rs. 10,00,000 of 6% debt.
The value of the firm according to NET INCOME approach:Net Operating Income NOI 2,00,000
Total cost of debt Interest= KdD, (10,00,000 x .06) 60,000
Net Income Available to shareholders, NOI – I 1,40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) 14,00,000Market value of debt D (Rs. 60,000/.06) 10,00,000Total 24,00,000
The cost of equity and debt are respectively 10% and 6% and are
Assumed to be constant under the Net Income Approach
Ko= NOI/V = 200,000/24,00,000 = 0.0833
Or
Ko = Kd (D/V) + Ke (S/V)
= 0.06 (10,00,000/24,00,000) + 0.10 (14,00,000/24,00,000)
= 0.025 + 0.0583 = 0.0833 or 8.33%
If the firm employs a debt or Rs.14,00,000 instead of Rs. 10,00,000
The value of the firm under NET INCOME approach will be
The value of the firm according to NET INCOME approach:
Net Operating Income NOI 2,00,000
Total cost of debt Interest= KdD, (14,00,000 x .06) 84,000
Net Income Available to shareholders, NOI – I 1,16,000
Therefore:
Market Value of Equity (Rs. 116,000/.10) 11,60,000Market value of debt D (Rs. 60,000/.06) 14,00,000Total 25,60,000
Ko= NOI/V = 200,000/25,60,000 = 0.078125Or
Ko = Kd (D/V) + Ke (S/V)= 0.06 (14,00,000/25,60,000) + 0.10 (11,60,000/25,60,000)
= 0.03281+ 0.04531 = 0.07812 or 7.81%
NET OPERATING INCOME APPROACH
ACCORDING TO NET OPERATING APPROACH (NOI)
THE MARKET VALUE OF THE FIRM IS NOT AFFECTED
BY THE CHANGE IN CAPITAL STRUCTURE
THE WEIGHTED AVERAGE COST OF CAPITAL
IS SAID TO BE CONSTANT
ASSUMPTIONS OF NOI APPROACH
1. The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not important.
2. The market uses an overall capitalisation rate, Ko to capitalise the net operating income. Ko depends on the business risk. If the business risk is assumed to remain unchanged, Ko is a constant.
3. The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate to increase. Thus the advantage of debt is offset exactly by the increase in the equity capitalisation rate, Ke.
4. The debt – capitalisation rate, Kd is a constant.
5. The corporate income taxes do not exist.
PROBLEM ON NOI APPROACH
Assume that a firm has annual net operating income of Rs. 2,00,000, an average cost of capital Ko, of 10 % and initial debt of Rs.10,00,000 at 6%
Net Operating Income, 2,00,000Therefore:
Market value of the Firm, V = S + D = 2,00,000/0.10 = 20,00,000
Market value of the Debt, D -10,00,000
Market value of the Equity S = V – D 10,00,000
Ko= NOI/V = 200,000/0.10 = 20,00,000Here, Ke is not a constant as that in NI approach
It is computed by using the formulaKe = Ko + (Ko-Kd)D/S
= 0.10 + (0.10 – 0.06) 10,00,000/10,00,000= 0.10 + 0.04 (1) = 0.14
To verify that the weighted average cost of capital is a constant:
Ko = Kd (D/V) + Ke (S/V)
= 0.06 (10,00,000/20,00,000) + 0.14 (10,00,000/20,00,000)
= 0.06 (0.50) + 0.14 (0.5)
= 0.03 + 0.07 = 0.10
IF DEBT IS INCREASED FROM 10,00,000 TO 14,00,000
Ke is not a constant in NOI approachIt has to be computed by using the formula
With the increase in leverage the cost of equity tends to go up
Ke = Ko + (Ko-Kd)D/S= 0.10 + (0.10 – 0.06) 14,00,000/6,00,000= 0.10 + 0.04 (2.33) = 0.1933 or 19.33%
To verify that the weighted average cost of capital is a constant:Ko = Kd (D/V) + Ke (S/V)
= 0.06 (14,00,000/20,00,000) + 0.1933 (6,00,000/20,00,000) = 0.06 (0.70) + 0.1933 (0.3)
= 0.042 + 0.05799 = 0.9999 or 10%
THE TRADITIONAL VIEWTHIS IS ALSO KNOWN AS INTERMEDIATE APPROACH
IT IS A COMPROMISE BETWEEN THE NI & NOI APPROACHACCORDING TO THIS VIEW
THE VALUE OF THE FIRM CAN BE INCREASED OR THE COST OF CAPITAL CAN BE REDUCED BY A JUDICIOUS MIX OF
DEBT AND EQUITY CAPITAL
THIS APPROACH IMPLIES THAT THE COST OF CAPITAL DECREASES WITHIN THE REASONABLE LIMIT OF DEBT
AND THEN INCREASES THE WITH LEVERAGE
TRADITIONAL VIEW
FIRST STAGE
In the first stage, the cost of equity rises less than proportionate to cost of debt ie
It does not increase fast enough to offset the advantage of low cost debt
During this stage the cost of debt, Kd, remains constant or rises negligibly
on the assumption that the market views use of debt as a reasonable policy
SECOND STAGE
Once the firm has reached a certain degree of leverage,
A further increase in leverage will have a negligible effect on the value, or the cost of the capital of the firm.
B’cause
The increase in the cost of equity due to the added financial risk offsets the advantage of low cost debt.
At a specific point, the value of the firm will be maximum or the cost of capital will be minimum
THIRD STAGE
Beyond the acceptable limit of leverage, the value of the firm decreases with leverage or the cost of the capital increases with
leverage
B’cause the investors perceive a high degree of financial risk and increase equity capitalisation rate by more than to offset the
advantage of low cost debt.
GRAPHIC PRESENTATION
XX
Y
Threshold Debt Level Where bankruptcy
costs become material
Optimal capital structure Marginal tax shelter benefits = marginal Bankruptcy related costs
VALEU OF STOCK
LEVERAGE
Some considerations in the Capital Structure Decision:
1. Managerial conservatism
2. Lender and Rating Agency Attitudes
3. Reserve Borrowing capacity and Financing Flexibility
4. Control
5. Business Risk
6. Asset Structure
7. Growth Rate
8. Profitability
9. Taxes
10. Market conditions
MM HYPOTHESIS1. Securities are traded in the perfect capital market situation.
2. Investors are free to buy and sell securities
3. They can borrow without restriction at the same terms as the firms do;
4. Investors behave rationally
5. There is no transaction cost
6. Firms can be grouped into homogeneous risk classes
7. The expected NOI is a random variable, with a constant mean probability distribution and a finite variance
8. Firms distribute all net earnings to the shareholders, which means the dividend payout ratio is 100%
9. No corporate income taxes (later they relaxed)
Assignment ProblemCapital Structure Debt (Rs.) Kd% Ke%
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
SOLUTIONParticulars Plan I II III IV V
EBIT 300000 300000 300000 300000 300000
Less Interest 30,000 40,000 55,000 72,000 98,000
Net Profit 270,000 260,000 245,000 228,000 202,000
Ke 0.12 0.125 0.135 0.15 0.18
MV of Eq.
MV of Debt
Total Mkt. Value
Ko
22,50,000
300,000
25,50,000
11.76
20,80,000
400,000
24,80,000
12.10
18,14,815
500,000
23,14,815
12.95
15,20,000
600,000
21,20,000
14.15
11,22,222
7,00,000
18,22,222
16.46
CASE – SOFT DRINK COMPANY
A SOFT DRINK MANUFACTURING COMPANY IS PREPARING TO MAKE CAPITAL STRUTURE DECISION.
IT HAS OBTAINED ESTIMATE OF SALES AND THE ASSOCIATED LEVELS OF EARNINGS BEFORE INTEREST AND TAXES FROM ITS FORECASTING GROUP.
THE PROJECTED SALES ACCORDING TO THE GROUP ARE AS FOLLOWS:
PROJECTED SALES
SALES (25% CHANCE) 400,000
SALES (50% CHANCE) 600,000
SALES (25% CHANCE) 800,000
FIXED OPERATING COSTS
200,000
VARIABLE OPERATING COSTS
50% OF SALES
Further . . . . . . . . . . . . . .
COMPANIES CURRENT CAPITAL STRUCTURE
ASSUME THAT THE SHARE VALUE IS Rs. 20
LIABILITIES AMOUNT ASSETS AMOUNT
EQUITY 500,000 FIXED AND CURRENT
500,000
LONG TERM DEBT
000,000 MISC. EXPENSES
000,000
TOTAL 500,000 TOTAL 500,000
ASSUMPTIONS UNDERLYING THE CASE
1. THE FIRM HAS NO CURRENT LIABILITIES2. ITS CAPITAL STRUCTURE CURRENTLY
CONTAINS ALL EQUITY AS IN THE B/S.3. THE TOTAL AMOUNT OF CAPITAL
REMAINS CONSTANT.
THAT THE FIRM IS CONSIDERING SEVEN ALTER-NATIVE CAPITAL STRUCTURES WITH A DEBT OF 0, 10, 20, 30,40,50 AND 60 PER CENTS AND THE RATE OF INTEREST WILL BE 9.0%, 9.5%, 10.0%, 11.0%, 13.5%, AND 16.5% RESPECTIVELY.
WHAT TO DO?
AS A FINANCE MANAGER – USING THE DATA – DECIDE UP ON A CHOICE OF THE CAPITAL STRUCTURE THAT YOU WOULD ADVISE THE FIRM.
THE REASONS FOR THE SPECIFIC PROPORTION OF USAGE OF DEBT i.e. LEVERAGE
WHAT CAN BE THE BEST OPTION FOR THE FIRM;
WHY YOUR OPTION IS THE BEST BET – REASONS TO SUBSTANTIATE THE SAME.