5 Financing Decision

Financing Decisions 1
Financing Decision
(Capital Structure -Theories & Analysis)
Capital Structure refers to the mix of Owners Funds
(Equity) and Borrowed Funds (Debt) to meet the
financing requirements of a firm.
What should be the proportion of Debt & Equity?
Is there a Optimum mix of Debt & Equity that can
maximize the Shareholders Wealth?
Different viewpoints:
Capital Structure is relevant
Capital Structure is irrelevant
Financing Decisions
2
Capital Structure
Capital Structure is Relevant
Net Income Approach:
A firm can increase its value (or
lower its cost of Capital) by
increasing the proportion of debt
in its Capital Structure.
Traditional Approach:
A firms overall cost of Capital
may be reduced by increasing the
proportion of debt up to a certain
level only. Further increase in
debt, increases the cost of capital.
3
Capital Structure is Irrelevant
Net Operating Income:
Value of a firm is not affected by
the proportion of debt/equity in
its Capital Structure.
MM Theory:
Provides Behavioral justification
for irrelevance of Capital
Structure.
Overview on Theories on Capital Structure
Financing Decisions
Financing Decisions
4
Net Income Approach
C
o
s
t

o
f

C
a
p
i
t
a
l
Leverage
k
o
k
e
k
d
A firm can increase its value or
lower its cost of Capital by
increasing the proportion of
debt in the Capital Structure.
The optimal Capital Structure is
attained when it is totally debt
financed (or financed by debt to
the maximum possible level),
the value of the firm is
maximum and the Cost of
Capital is the minimum.
Financing Decisions
5
k
o
is a function of financial leverage.
It declines with increase in leverage and after reaching a
minimum point or stage, K
e
increases with leverage.
k
e
k
d
k
o
Stage II Stage I
Stage III
C
o
s
t

o
f

C
a
p
i
t
a
l
Leverage
Traditional Approach
k
o
is constant while k
e
increases with leverage.
As overall cost of capital (k
o
)
is constant for all levels of
leverage, all capital
structures are optimum,
hence Capital Structure is
irrelevant.
Financing Decisions
6
Leverage
k
o
k
e
k
d
C
o
s
t

o
f

C
a
p
i
t
a
l
Net Operating Income Approach
According to MM theory, under conditions of Perfect Capital
Markets, absence of taxes and transaction costs, the value of a
firm is independent of the Capital Structure.
Value of the firm depends upon the earnings (and hence the
assets) rather than the financing mix.
Financing Decisions
7
MM Theory
Franco Modigliani
(1918-2003)
Merton H. Miller
(1923-2000)
'Dividend Policy, Growth, and the Valuation of Shares', Journal of Business, vol. XXXIV (October, 1961), 235-64
The Cost of Capital, Corporation Finance and the Theory of Investment', American Economic Review, vol. 48 (June 1958), 261-297.
(a) Perfect Capital Markets:
Investors are free to buy / sell securities;
Investors can borrow without restriction and on the same terms &
condition as a firm;
No transaction costs;
Information is perfect
Investors are rational.
(b) Homogeneous Risk class: Business risk is equal among all firms
with similar operating environment. Firms within an industry
are assumed to have same risk profile.
(c) All investors have the same expectations of firms earnings with
which to evaluate the value of any firm.
(d) Dividend Payout is 100%.
(e) No Corporate Taxes.
Financing Decisions
8
Assumptions
Proposition 1: For the firms in same risk class, the total market
value is independent of the debt-equity mix and is given by
capitalising the Operating Income (EBIT) by the Overall Cost of
Capital.
Financing mix neither changes the earnings potential (as it
depends upon the Investments in assets) nor the business
conditions and hence the business risks.
Financing mix merely changes the way in which the Operating
Income is distributed between Equity and Debt holders.
Financing Decisions
9
MM Theory
Consider two identical companies earning same EBIT, one is an all
equity financed while another uses Debt & Equity (1:1)
Financing Decisions
10
MM Theory
An investor buy 1% in an Unlevered firm
Another investor buy 1% in a Levered
firm i.e. 1% of Equity & 1% of Debt
Investment Returns
0.01D
L
0.01 Interest
0.01E
L
0.01 (EBIT-Interest)
0.01D
L
+ 0.01E
L
= 0.01V
L
0.01 EBIT
Investment Returns
0.01E
U
0.01 EBIT
= 0.01V
U
0.01 EBIT
The payoffs in both the cases is 0.01 EBIT.
The investment to get same return should also be same (Law of
One Price), hence 0.01V
U
= 0.01V
L
or
V
U
= V
L
To reach the same level of risk, the second investor borrows
amount equal to 1% of Debt of Levered firm, on his own account
and purchases 1% of Equity of the Unlevered firm.
Financing Decisions
11
MM Theory
Investment Returns
0.01V
U
- 0.01D
L
0.01 EBIT - 0.01 Interest
0.01(V
U
- D
L
) 0.01 (EBIT- Interest)
Investment Returns
0.01E
L
0.01 (EBIT Interest)
= 0.01(V
L
D
L
) 0.01 (EBIT Interest)
Alternatively, the investor buys 1% of Equity of Levered firm
which increases the risk.
Again, the payoff is same in both the cases, hence the investment
must have equal costs.
Hence, 0.01(V
L
D
L
) = 0.01( V
U
D
L
) or
V
U
= V
L
Financing Decisions
12
MM Theory
So long, an investor can borrow or lend on his own account at
the same interest rate that a firm can borrow or lend, one can
undo the changes in Capital structure.
This is Proposition 1 of the MM theorem : Market Value of a Firm
is independent of the Capital Structure.
Financing Decisions
13
MM Theory
All Equity
No. of Shares 1000
Price per Share 10
MV of Equity 10000
A B C D
EBIT 500 1000 1500 2000
EPS 0.50 1.00 1.50 2.00
ROE 5% 10% 15% 20%
Equal Equity & Debt
No. of Shares 500
Price per Share 10
MV of Equity 5000
MV of Debt 5000 @ 10%
A B C D
EBIT 500 1000 1500 2000
Interest 500 500 500 500
EPS 0.0 1.0 2.0 3.0
ROE 0% 10% 20% 30%
Earnings on 2
shares
1.00 2.00 3.00 4.00
Less Interest @10% 1.00 1.00 1.00 1.00
Net earnings 0.00 1.00 2.00 3.00
Return on Rs 10
investment (%)
0% 10% 20% 30%
An investor with Rs. 10/- of his own,
borrows Rs. 10/- @ 10% & invests in
Unlevered firm.
His payoff are exactly as the levered
firm.
Leverage does not affect the value.
As leverage increases, the EPS increases but not the share prices.
Financing Decisions
14
MM Theory
No. of Shares All Equity Equity & Debt (1:1)
EPS (Rs.) 1.50 2.00
Price per Share (Rs.) 10.00 10.00
ROE 15% 20%
Why?
Change in the earnings is exactly offset by a change in the rate at
which earnings are discounted.
ROE increases from15% to 20%.
As the two firms are identical expect for their capital structure,
the rate of return (r
A
) would be same and equal to :
Suppose an investor holds all the firms Debt & Equity.
He shall be entitled to all the firms earnings, therefore the
Return on the portfolio would be r
A
:
Rearranging the terms, we get:
Financing Decisions
15
MM Theory
A
EBIT
r =
Market Value of all Securities
A d e
D E
r = r * + r *
E+D E+D

` `
) )
Equity Risk Premium
e A A d
D
r = r + (r - r )*
E

`
)
This is Proposition 2 of the MM theorem.
When firm is unlevered, equity investors require r
A
, but when
the firm is levered, they require a premium of (r
A
-r
d
)*(D/E) to
compensate for additional risk.
Financing Decisions
16
MM Theory
Financing Decisions
17
All Equity
No. of Shares 1000
Price per Share 10
MV of Equity 10000
A B C D
Operating
Income
500 1000 1500 2000
EPS 0.50 1.00 1.50 2.00
ROE 5% 10% 15% 20%
Equal Equity & Debt
No. of Shares 500
Price per Share 10
MV of Equity 5000
MV of Debt 5000 @ 10%
A B C D
Operating
Income
500 1000 1500 2000
Interest 500 500 500 500
EPS 0.0 1.0 2.0 3.0
ROE 0% 10% 20% 30%
{ } { }
e
15%-10% * r =15%+ 1 =20%
A
Operating Income
r =
Market Value
A
1500
r = =15%
10000
MM Theory
e A A d
D
r = r + (r - r )*
E

`
)
When firm is unlevered, equity investors require r
A
, but
when the firm is levered, they require a premium of
(r
A
-r
d
)*(D/E) to compensate for additional risk.
Financing Decisions
18
Proposition 1 says that market value of a firm is not affected by
the capital structure, while Proposition 2 says that as leverage
increases, equity shareholders expect higher rate of return.
MM Theory
if EBIT falls from Rs. 1500 Rs. 500 Change
All Equity:
EPS 1.50 0.50 -1.00
ROE 15% 5% -10%
Debt & Equity (1:1):
EPS 2.00 0 -2.00
ROE 20% 0 -20%
Debt-Equity choices amplify the spread of returns
Financing Decisions
19
At low levels of debt, the firms debt is
considered risk-free which implies that
r
d
is independent of D/E.
As D/E crosses a threshold level, risk of
default increases and the expected
return on debt r
d
increases.
To compensate for this, the rate of
increase in r
e
decreases i.e. at higher
levels of debt, r
e
becomes less
sensitive to further borrowings.
This is because as D/E increases
beyond the threshold level, a portion
of firms business risk is borne by the
suppliers of debt capital.
As the firm borrows more, more of its
business risk is shifted from
shareholders to creditors.
MM Theory
r
e
R
a
t
e

o
f

r
e
t
u
r
n
Leverage
r
d
r
A
Risky Debt Risk-free Debt
Similarly, beta of a firm is the weighted average of the betas of its
securities.
Financing Decisions
20
A d e
D E
= * + *
E+D E+D

` `
) )
e A A e
D
= + ( - )*
E

`
)
MM Theory
At higher levels of D/E, investors require higher returns to match
the increased risk (beta).
Limitations of MM Hypothesis:
Lending and borrowing at same rates
Substitutability of personal and corporate leverage
Transaction costs
Corporate Taxes
MM Theory
In a world without taxes, MM concluded that the value of a firm
is independent of its capital structure.
In reality, however, firms pay taxes and interest cost is tax
deductible.
In 1963, MM revised their contention by relaxing the
assumption of absence of taxes and showed that the value of
the firm increases with debt due to tax deductibility of interest
cost.
MM Theory Under Taxes
Corporate Income Taxes and the Cost of Capital : A Correction', American Economic Review, vol. 53 (June 1963),
433 - 443.
Financing Decisions
22
Particulars Levered Firm Unlevered Firm
Net Operating Income (EBIT) 2,500 2,500
Less Interest (Rs 5,000/- Debt @10%) 500 --
Income before Taxes 2,000 2,500
Corporate Tax @50% 1,000 1,250
Income after Taxes 1,000 1,250
Total Income to Investors after Corporate Taxes
Dividends to Shareholders 1,000 1,250
Interest to debt holders 500 --
Total Income to Investors 1,500 1,250
Interest Tax Shield 250
Assume 100% Dividend payout
For Levered firm, the tax saving is due to Interest Cost.
Interest Tax Shield = Interest Cost * Corporate Taxes
d
Interest Tax Shield = T INT = Tk D
Total income to investors in case of Levered firm is greater than
unlevered firm by the amount of Interest Tax Shield.
After Tax Income of Levered firm - After Tax income of Unlevered firm = Interest Tax Shield
Present Value of Tax Shield:
Assume that the debt is perpetual, so will be the Interest tax shield
d
d
Tk D
Present Value of Interest Tax Shield = =TD
k
Thus, Present Value of Interest Tax Shield is independent of cost
of debt.
= 50%*5000=2500
MM Theory (Contd.)
V
a
l
u
e

o
f

F
i
r
m
Leverage
V
L
V
U
Value of
Interest Tax
Shield
Implications of MM Hypothesis with Corporate Taxes:
Due to Tax deductibility of interest cost, a firm can increase its
value by increasing the level of debt in its Capital Structure.
Hence, Optimal Capital Structure is attained when firms employ
100% debt.
In reality, however, firms neither employ large amounts of debt
nor lenders are willing to lend beyond a certain limit.
MM suggest that firms adopt a target debt ratio.
Why firms do not borrow 100%?
Impact of Corporate and Personal Taxes
Besides Interest Costs, borrowing also involves other costs.
Corporate & Personal Taxes
Firms pay taxes on the profits earned by them.
Investors also pay Personal Taxes on their income.
From the investors viewpoint, effect of both Corporate &
Personal Income Taxes should be considered, while considering
the Capital Structure of a firm.
A firm should aim to minimize the total tax (Corporate &
Personal Income Tax)
Net Operating Income (EBIT) 100 100
Less Interest 100 0
Income before Taxes 0 100
Corporate Tax @ 50% 0 50
Income after Taxes 0 50
Dividends to Shareholders 0 50
Less Tax on Dividends @ 30% 0 15
Net Income to Shareholders 0 35
Interest to debt holders 100 0
Less Tax on Interest @ 40% 40 0
Net Income to Debt holders 60 0
Total Taxes (Corporate + Personal) 40 65
Borrowing is better as total taxes are lower & larger part of firms income
goes to the investors
Net Operating Income (EBIT) 100 100
Less Interest 100 0
Income before Taxes 0 100
Corporate Tax @ 40% 0 40
Income after Taxes 0 60
Dividends to Shareholders 0 60
Less Tax on Dividends @ 20% 0 12
Net Income to Shareholders 0 48
Interest to debt holders 100 0
Less Tax on Interest @ 40% 40 0
Net Income to Debt holders 60 0
Total Taxes (Corporate + Personal) 40 52
As Corporate Tax rate & Equity Income Tax reduces, the advantage of borrowing
also reduces.
Unlevered Firms Income after all taxes:
Appropriate discount rate is k
o
(1-T
pe
)
Value of Unlevered firm with Corporate & Personal taxes:
c pe
X(1-T )(1-T )
c pe
o pe
X(1-T )(1-T )
k (1-T )
Levered Firms Income Equity income after all taxes:
Levered firms debt-holders income after taxes:
Combined income to all investors after taxes:
First Term = Unlevered Firms income after taxes
Second Term = Interest Tax Shield after Corporate & Personal
Taxes
d c pe
(X-k D)(1-T )(1-T )
c pe d c pe
X(1-T )(1-T )-k D(1-T )(1-T )
d pd
k D(1-T )
c pe d c pe d pd
X(1-T )(1-T )-k D(1-T )(1-T )+k D(1-T )
c pe d pd c pe
First Term
Second Term
X(1-T )(1-T )+k D (1-T ) - (1-T )(1-T ) (

Value of First Term:

Value of Second Term:
Value of Levered Firm:
Value of Levered Firm = Value of Unlevered Firm + PV of Interest Tax
c pe
L U
pd
(1-T )(1-T )
V =V +D 1-
(1-T )
(
(
(

c pe
o pe
X(1-T )(1-T )
k (1-T )
d pd c pe
d pd
k D (1-T ) - (1-T )(1-T )
k (1-T )
(

d pd c pe
c pe
o pe d pd
k D (1-T ) - (1-T )(1-T )
X(1-T )(1-T )
+
k (1-T ) k (1-T )
(

Thus, attractiveness of borrowing depends upon:
Corporate Tax rate
Personal Tax rate on Interest Income
Personal Tax rate on Equity Income
Advantage of borrowing reduces when:
Corporate Tax rate reduces ,or
Personal Tax rate on Interest Income increases, or
Personal Tax rate on Equity Income decreases.
Financial Distress arises when the firm is unable to pay interest
and repay the principal to the lenders.
For a given level of Operating risk, financial distress will increase
with financial leverage.
Financial Distress
Direct Costs:
Insolvency proceedings
Delay in liquidation due to conflicting
interest of creditors & Other
stakeholders
Physical condition of Assets, may
have to be sold at distress prices
Indirect Costs:
Employees may be demoralized
Customers-Quality issues, Fear poor after
sales service, Reduced demand
Suppliers may discontinue supplies
Investors unwilling to lend further
Shareholders take higher risks
Managers - expropriate firms resources
Financial Distress reduces value of the firm.
Value of Levered firm = Value of Unlevered Firm
+ Present Value of Interest Tax Shield
Present Value of Financial Distress
As leverage increases, Interest Tax Shield also increases, so does
the cost of Financial Distress
Leverage
M
a
r
k
e
t

V
a
l
u
e

o
f

F
i
r
m
Value of
unlevered
firm
PV of Interest
tax shields
PV of Costs of
financial distress
Value of
levered firm
Optimal amount
of debt
Maximum value of firm
According to Stewart Myers (1984) managers have more
information about their firms than investors.
Because of asymmetric information, managers issue debt when
they are positive about the firms future prospects and issue
equity when they are unsure.
The manner in which managers raise funds gives signal of their
belief about the firms future prospects.
1
st
Choice: Internal Financing Avoids outside scrutiny by
suppliers of capital; No Floatation costs associated with
retained earnings
When cash flow is insufficient and a sticky dividend policy
precludes a cut in dividends, company may resort to external
financing.
2
nd
Choice: Straight Debt Little scope for mis-pricing;
prevents dilution of control.(Secured Debt, Unsecured debt,
hybrid securities)
Pecking Order of Financing
Last Choice: External Equity Viewed as bad news, Investors
generally believe that the firm issues external equity when it
considers its stock overpriced in relation to its future
prospects.
Pecking order theory is able to explain the inverse relationship
between profitability and debt ratio within an industry, but does
not fully explain differences in capital structure between
industries.
Given the Pecking order, there is no well-defined target Debt-
Equity ratio, as there are two kinds of Equity External &
Internal.
While Internal Equity is most preferred and is at the top of the
pecking order, External Equity is the least preferred and hence at
the bottom of the pecking order.
Pecking Order of Financing (Contd.)
Highly profitable firms generally use less debt, as they do not
need much external funds and not because they have low target
debt-equity ratio.
Less profitable firms borrow more as their borrowing needs
exceed retained earnings and debt finance comes before external
equity in the pecking order.
Pecking Order of Financing (Contd.)
Evaluates the impact of Leverage on the relationship
between EBIT & EPS.
Compares different financing alternatives under various
assumptions of EBIT levels.
EBIT- EPS Analysis
ABC Limited currently has 200,000 Equity shares (MV of Rs
100 Lacs) & generates EBIT of Rs 20 Lacs. The co. intends to
raise additional Rs. 50 Lacs for its expansion project, either
through:
Plan 1: Issue of 100,000 Equity @ Rs 50/- per Share; or
Plan 2: Issue of 12% Debentures.
After the completion of the project, the expected EBIT
would be Rs.24 Lacs. Tax Rate is 40%.
Particulars Plan 1 Plan 2
EBIT 24,00,000 24,00,000
Interest - 6,00,000
EBT 24,00,000 18,00,000
Taxes 9,60,000 7,20,000
PAT 14,40,000 10,80,000
Preference Div. - -
Earnings for Equity 14,40,000 10,80,000
No. of Shares 3,00,000 2,00,000
Earnings per Share 4.80 5.40
Financing Decisions
40
EBIT-EPS Analysis (Contd.)
Financing Decisions
41
Particulars Plan 1 Plan 2
EBIT 0 6,00,000
Interest 0 6,00,000
EBT 0 0
Taxes 0 0
PAT 0 0
Preference Div. 0 0
Earnings for Equity 0 0
No. of Shares 3,00,000 2,00,000
Earnings per Share 0 0
Financing Decisions
42
EBIT (Rs Lacs)
E
P
S

(
R
s
)
Plan 1- All
Equity
Plan 2 All Debt
EBIT- EPS Analysis
24 18
(6,0)
(24,5.4)
(24,4.8)
(0,0)
Indifference Point
Use Debt
Use Equity
Financing Decisions
43
=
Option 1 Option 2
Equity vs. Debt Plan:
Break Even EBIT* = 18,00,000
P
1
(EBIT*- Interest)(1-t)-D
No. of Shares (S )
P
2
(EBIT*- Interest)(1-t)-D
No. of Shares (S )
(EBIT*- 0)(1-0.40)-0
3,00,000
(EBIT*- 6,00,000)(1-0.40)-0
2,00,000
=
EBIT-EPS Analysis shows the impact of different
financing alternatives on the EPS.
EBIT-EPS does not provide a clear-cut answer regarding
choice of one financing alternative but provides a
broad indication by way of:
Comparing the Expected Level of EBIT with the indifference
point and
Assessing the probability of EBIT falling below the indifference
point.
Financing Decisions
44
Capital Structuring involves a complex trade-off among various
factors Profitability, Risk, Flexibility, Control etc.
Ensure Total Risk is reasonable:
Total risk consists of :
a) Business Riskrefers to the variability of EBIT. Depends
upon : Demand Variability; Price Variability; Variability in
Input prices; % age of Fixed Cost to total costs.
b) Financial Riskresults from financial leverage.
Total Risk borne by shareholders should not be high. If Business
risk is high, then reduce financial risk , while if Business risk is low,
firm may assume higher leverage.
Financing Decisions
45
Guidelines for Capital Structuring
Avail the tax advantage of debt:
Interest on debt is tax deductible, hence the effective
cost of debt funds is lower than equity funds.
Hence, avail the benefit of debt funds.
Preserve flexibility:
Though debt is advantageous, the firm should not
exploit its debt capacity fully.
By doing so, the firm losses its flexibility.
Flexibility refers to the reserve borrowing capacity to
enable it to raise debt funds to meet unforeseen
situations.
Lenders attach various conditions, which may restrict
smooth functioning.
Financing Decisions
46
Guidelines for Capital Structuring (Contd.)
Control vs. Financing alternatives:
Raising additional equity requires promoters to either
bring in more funds or dilute their equity holding. Control
issue is critical at three levels:
When the equity holding falls below 100%:More of a psychological
problem for the promoters. Their control cannot be challenged so
long shareholding is above 50%, though they become answerable to
outsiders. Necessity arises from the requirement of funds for
expansion purposes.
When the equity holding falls below 50%: May be difficult for
promoters to cross this level, but is required to support growth.
When the equity holding falls below 26%: Effective control may be
exercised by smaller holding also. Dilution the only way to facilitate
expansion & growth.
Financing Decisions
47
Issue Innovative Securities: Corporates in India are now free
to issue securities with innovative features. While evaluating
various alternatives, firms must consider:
(a) Does the financial instrument reallocate the risk from
those less inclined to bear it to those who are willing to
assume it;
(b) Does it enhances liquidity;
(c) Does it diminishes agency costs;
(d) Does it lowers the tax burden for issuer and investors;
(e) Does it bypasses ingeniously some regulatory
restriction.
Financing Decisions
48
Widen the range of Financing source:
In a dynamically evolving financial market, traditional
sources of financing are loosing their importance.
Firms should explore newer modes of financing, tap
different markets and instruments.
This would help firms to be familiar with the nuances
of various markets and instruments, establish as a
player in these markets besides increasing the options
available to cope with uncertain future.
CPs, Factoring, Securitisation, ADRs/GDRs etc.
Financing Decisions
49
Understand the Signalling value of Financing choices:
In order to mitigate Informational Asymmetry,
management should send out signals to the market.
If mgt is confident of the stability of future cash flows,
they will issue debt.
Issue of equity sends negative signals.
Financing Decisions
50
Know the norms of lenders & rating agencies:
Lenders look for borrowers with stable & tangible assets.
Therefore, firms with risky, intangible assets will be able
to borrow less.
Rating Agencies look for earning power, business &
financial risks, asset protection, cash flow adequacy,
financial flexibility and quality of accounting.
Loan Covenants
Financing Decisions
51

5 Financing Decision

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

5 Financing Decision

Transféré par

Droits d'auteur :

Formats disponibles

Financing Decisions 1

Value of First Term:

Vous aimerez peut-être aussi