Capital Structure Theory l15 2

8/10/2019 Capital Structure Theory l15 2

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Capital Structure

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CAPITAL STRUCTURE THEORY

Net Icome ApproachMM Theory

Asymmetric information - Agency Cost


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Capital structure decision is one of the key decisions

that focuses on finding the capital structure with the

objective of maximization of value of the firm.

It is perhaps the key strategic decision that has

occupied much of the time and attention of

academicians and managers alike

The issue revolves around the question of an optimal

capital structure, if there is any


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COMMON ASSUMPTIONS FOR THE ANALYSIS

Following assumptions are required to arrive at

optimal capital structure

To analyse effects of capital structure one form ofcapital needs to be replaced with another form

Maximization of value of the firm is consistent with

maximization of shareholderswealthOptimal capital structure is one that minimizes WACC

Earning levels remain constant


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TARGET CAPITAL STRUCTURE

Target capital structure Concept

Target capital structure is determined by

several factors (Determinants of Target Capital

Structure)


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NET INCOME APPROACH

NI assumes that capitalization of the firm is based on

the net income derived by each supplier of capital

discounted at fixed rates irrespective of levels of debt


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Net Income approach assumes that capitalizationrates are constant and increasing debt would reduceoverall capitalization rate (WACC) and increase thevalue of the firm

Optimal capital structure under net income approachis 100% debt.


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NOI assumes that value of the firm remains constant

because overall capitalization rate remains constant

Net operating income approach states that value of the

firm is determined by the earning capacities of the

assets and not by how are they acquired.

Net Operating Income (NOI) approach


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Under net operating income approach the cost ofequity rises so as to compensate the reduced cost ofdebt keeping the overall capitalization rate constant.


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TRADITIONAL APPROACH

Traditional approach recognizes the advantage of debt

only up to certain level. Any increase in debt beyond a

point causes cost of equity to rise.

Initially the cost of capital for the firm will fall as

cheaper debt replaces expensive equity.

Even though the cost of equity rises with increased

debt the advantages of debt would outweigh the

increased cost of equity.


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Beyond a certain level of leverage the cost of equity

starts rising disproportionately, more than offsetting

the advantage of debt, raising the overall cost of capital

for the firm.

Since cost of capital falls initially and then starts

rising there exists a point where cost of capital would

be least.

This point of least cost of capital would maximise the

value of the firm and is the optimal capital structure.


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MODIGLIANI AND MILLER (MM) THEORY

Who are Modigliani and Miller (MM)?

They published theoretical papers that changed

the way people thought about financial leverage. They won Nobel prizes in economics because of

their work.

MMs papers were published in 1958 and 1963.

Miller had a separate paper in 1977. The papersdiffered in their assumptions about taxes.


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What assumptions underlie the MMand Miller models?

Firms can be grouped into homogeneousclasses based on business risk.

Investors have identical expectationsabout firms future earnings.

There are no transactions costs.


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All debt is riskless, and both individualsand corporations can borrow unlimitedamounts of money at the risk-free rate.

All cash flows are perpetuities. Thisimplies perpetual debt is issued, firmshave zero growth, and expected EBIT isconstant over time.


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MMs first paper (1958) assumed zerotaxes. Later papers added taxes.

No agency or financial distress costs.

These assumptions were necessary forMM to prove their propositions on thebasis of investor arbitrage.


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Proposition I:

VL= VU.

Proposition II:

rsL

= rsU

+ (rsU

- rd)(D/S).

MM with Zero Taxes (1958)


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Given the following data, find V, S, rs, and WACC for Firms

U and L.

Firms U and L are in same risk class.

EBITU,L= $500,000.

Firm U has no debt; rsU= 14%.

Firm L has $1,000,000 debt at rd= 8%.

The basic MM assumptions hold.

There are no corporate or personal taxes.


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1. Find VUand VL.


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Trade-off Theory

According to this, a firm has to trade offbetween the benefits of debt financing (which istax shield) and the costs of debt in terms of

bankruptcy costs in case of excessive debtfinancing.

The bankruptcy costs, also referred to asfinancial distress cost, can be seen as the

product of two factors i.e. the probability ofentering in a distressed situation and the costsof resolving such a situation.


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According to Stewart C. Myers, when a firmissues debt to finance its future investments,there occurs a suboptimal investment futureinvestment strategy due to which the presentvalue of firmsfuture investments gets reduced.

The shareholders of the firm bear this loss ofreduction in value of the firm. Thus, in case of

no corporate taxes, the firm should not issue anydebt.


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But, since corporate taxes are present in theactual market which provides additional benefitof tax shield on interest payments on the debt

issued, the firms need to make a trade-offbetween the benefits of tax shield and the costsof the suboptimal investment strategy.

The suboptimal investment strategy is nothingbut the agency costs induces by risky debt.


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This transfer of wealth towards the debtholders causes the shareholders to turn downgood investment opportunities.

The value of the forgone opportunities and thecosts of contractual payments constitute theagency cost of debt.

Si ifi f C it l


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Significance of CapitalStructure

Since the objective of financial management is tomaximize the shareholders wealth, they key issue inthe capital structure decision is: what is the

relationship between capital structure and firm value? Alternatively, what is the relation between capital

structure and cost of capital?

It is so because valuation of a firm is determined bydiscounting its future cash flows by a discounting ratewhich is the cost of capital.


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Thus, the valuation and cost of capital areinversely related. Hence, maximizing the

value of the firm means minimizing the costof capital for a given level of earnings.


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2. The firms capital structure reflects itsability to repay its debts as per their

maturity and its future cash flows.Since non repayment causes bankruptcy,which should be avoided, capital structure

shows the financial health or soundness ofthe firm.


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3. Financing future investments throughdebt is more economical than financing itthrough equity.

The cost of capital is influenced by thefinancial leverage.


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The presence of corporate taxes reduces thecost of capital due to financial leverage. Thisleads to increase in value of the firm.

Imperfections like bankruptcy costs and agencycosts tend to increase the cost of capital asfinancial leverage increases.

Thus the value of the firm decreases due tothe presence of these costs.


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4.It shows the leverage which has animpact over future expected

earnings and the risks faced bycreditors and shareholders.


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5. There is effect of taxation, bankruptcy costsand agency costs on the relationshipbetween cost of capital and financial

leverage; value of the firm and financialleverage.

As the cost of Bankruptcy and monitoring

costs are added to the cost of capital, thecost capital increases and the value of thefirm decreases simultaneously.

P h i l i l (F


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1.Optimal debt ratio is one which minimizes thecost of capital. Value of firm is PV of CFdiscounted at cost of capital.

2.Optimal debt ratio is one that maximizes theoverall value of the firm.

Path to optimal capital structure (Fourapproaches) (Given by Damodaran):


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Cost and Benefits

of Debt Financing


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Benefits:

Tax, Increase in EPS and AddDiscipline to Management


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Bankruptcy Costs

Agency Cost

Loss of Future Financial

Flexibility

Cost of Debt:


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1: The cost of going for bankruptcy: DirectCost and Indirect Costs

2: The probability of bankruptcy, whichwill depend upon how uncertain companyis about future cash flows.

Bankruptcy Cost: is afunction of two variables :-


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Direct Costs: Rusts machinery,obsolete inventories, lawyers fees,

court fees


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Managers and other employees generally losetheir jobs when a firm fails.

Knowing this, the management may take actions

which keep it alive in the short-run but whichalso dilute long-term value.

Indirect Cost: Cost arising because peopleperceive that company will be in financialtrouble.


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Example: The firm may defer maintenanceof machinery, sell off valuable assets to

bargain prices, cuts costs so much that thequality of the products is impaired and thefirmslong-run market position is eroded.

Determinants of Capital


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How Much Debt a Company

can carry in its CapitalStructure?

Determinants of CapitalStructure:


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The firms asset composition or thecollateralizable assets influence the capitalstructure with a positive correlation betweenthe total assets and the amount of debt in the

capital structure.

Firms with higher tangible assets will havegreater capacity of raising debts and also willbear lower interest costs.

Assets Structure


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One indicator to determine the levelof collateralizable assets is average ratio

of accounts receivable, inventory plusnet fixed assets over total assets.


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Debt financing has biggest advantage of Taxbenefits since the interest payments overdebts are tax deductible. Thus, other non debtrelated expenses that provide tax shield caninfluence the amount of debt raised.

Firms having large non-debt tax shield willtend to have lower debt because tax

deductions for depreciation and investmenttax credits are substitutes for the tax benefitsof debt financing.

Non-Debt Tax Shield


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Thus there is negative correlation betweenthe non-debt tax shield and leverage. Fewexamples of non-debt tax shield are

depreciation, Amortization, pension funds,tax loss carry forward, and investment taxcredits.

C Si


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Size of the firm has a positive relation withamount of leverage in capital structure which isdetermined by the total assets of the firm.According to Warner and McConnell, large firmsare more diversified and also less prone tofinancial distress or bankruptcy due to interestburden.

Hence, they can raise greater amount of debtfinancing. Also, the cost of issuing debt orequity is also related to the firm size.

Company Size


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Issue costs for small firms is greater whileissuing equity or long term debt as compared tolarge firms. This forces small firms to issue shortmaturity debts (through bank loans) due to

lower costs.The Size can be measured by average totalsales, average total assets and logarithm ofaverage assets.But according to the findings of Titman andWessels smaller firms tend to use significantlymore short term debt than the large firms.


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Debt financing involves periodic interestpayments and thus it creates a financialdistress cost for highly leveraged firms.

Firms with a high volatility in their income anda high degree of operating leverage tend tokeep low on debt financing.

The volatility can be measured by the standarddeviation of percentage change in operatingincome.

Financial Distress


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Firms with more future growthopportunities will have several

investment options and will oftenoutrun their internally generatedfunds. Hence, they will require

external financing in the form ofdebt.

Growth


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The agency costs among the shareholdersand bondholders are expected to behigher in case of firms in growingindustries because they have moreflexibility in their choice of futureinvestments.


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Thus, there occurs a negativerelationship between the Long term Debt

and the future growth of a firm. Instead,they can use short term debt financing toavoid the agency costs associated with

long term debt.


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The higher the profitability of a firm,higher will be the tax advantages ofusing debt and less will be the

probability of failing the interestpayments i.e. the financial distress costs.

Since there might be higher cash flows,

more debt would be raised to cater theagency costs of management.

Profitability


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Firms with high profitability will follow thepecking order theory according to which they

will use internal financing i.e. retainedearnings first to fund their operations andlater go for outside debt and then equity ifrequired. This may be due to the costs of

issuing equity due to asymmetric informationor the transaction costs.


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Thus, highly profitable firms will be

less leveraged making it a negativecorrelation. It may be determined bystudying ratio of cash flow over salesand ratio of cash flow over total

assets.

A


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Age

Older firms will tend to have abetter credit history of repaying

debts and hence will have lowerborrowing costs charged bycreditors. Also, there will be lessdifficulty in raising debts for olderfirms.


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It is difficult for young firms to raiseequity as compared to the older & wellestablished firms due to the problem of

asymmetric information.Hence, they more often go for debt

financing. Thus, Age of the firm is

negative correlated with debt financing.

Si li


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This factor refers to the firmsability totransfer information to the marketeffectively regarding its financial health,

deployment of funds, investments andcapital expenditures.

If it can effectively flow this informationto outside market, it can access thefunds through raising equity.

Signaling


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The variable that can indicate signaling isratio of Dividend to net operating incomesince companies use dividends to signal

their credibility to the market.

Thus, there is an inverse relationshipbetween leverage and Dividend payments(representing Signaling).

U i


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Firms with unique products find it difficult toraise debt since they spend more on Researchand Development to create that uniqueproduct and R&D expenditure is long termcapital expenditure which is generally financedthrough equity.

Also, they incur significant selling expenses

such as advertisements, promotions to selltheir unique product.

Uniqueness


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Hence, Uniqueness is related to less leveragedfirms which can be reflected through variables

like ratio of R&D to sales, ratio of sellingexpenses to sales and the rate at whichemployees voluntarily leave their job i.e. thequit rates (% of total workforce that voluntarily

leaves their job).


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Firms that have high quite rates willbe expected to be less unique since

producing unique goods or servicesrequire highly skilled labor or jobspecific professionals who will find it

difficult to leave their jobs.


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Also, expenses on Research and developmentand selling expenses can be considered capitalgoods which are immediately expensed but

cannot be used as collateral.

Thus, the uniqueness attribute may benegatively related to debt given its positive

correlation which non debt tax shield andnegative correlation with collateral value.

Stability of Sales, Profits andO i C h Fl h E i


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Higher the variation in sales or earnings greaterwill be the bankruptcy risks and thus lower willbe the amount of debt raised. Hence, Stability ofsales, earnings and cash flow is positively relatedto leverage.

Coefficient of variation on return on capital

employed and coefficient of variation on returnon assets can measure the earnings risk.

Operating Cash Flows or the EarningsRisk

Corporate Tax


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Since interest payments of debt financingprovide tax shield, higher corporate taxrate will attract more debt financing

making it effectively cheaper than equityfinancing. Thus, there is a positiverelation with Corporate Tax rate and debt

financing.

Corporate Tax


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Net Exports: In India, exporting firms areprovided credit benefits and other sopswhich imply that they will require less debt

in their capital structure.

Thus, net exports level can be a

determinant of debt in the capitalstructure. Average net exports to salesratio can be an indicator of the net exportslevel of the firm.


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Regulation: Managers in regulatedfirms have less discretion over

future investment than that ofunregulated firms. Thus,regulated firms will have more

long term debt than unregulatedfirms.


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Corporate Strategy: Diversified firms are atan advantage of borrowing more. Thecombination of various assets provides less

than perfectly correlated returns. Firmswith diversified business will havediversified cash flows and thus reduced

bankruptcy risks. This will allow raisingmore debt financing for diversified firms.


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Liquidity: Firms with ample liquidresources of funds will not prefer issuingdebt and rather use the internallygenerated funds. Hence, greater theliquidity less will be the debts raised.


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Industry classification: according toTitman, firms that produce productsrequiring the availability of specialized

servicing and spare parts will tend to haveliquidation costly. Hence, they should tendto have low debt levels to finance their

machines and equipments.


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Management Control

Degree of Financial Distress:DOL and DFL


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Thank You

Capital Structure Theory l15 2

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