Capital Structure Theories

Capital Structure Theories

Traditional Approach Modern Approach

Traditional Theories

Net Income Approach

Suggested by Durand Assumptions
No corporate taxes Kd<ke Increase in Debt doesnt increase risk perception

Net Income Approach

Financial leverage decreases WACC (ko) Increase in debt weight decreases weight of equity (we) Cost of debt (kd) and cost equity (ke) remains constant ko comes down due to decreasing (we)

Financial leverage increases value of firm

Net Income Approach

Wd 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Kd 12.0 12.0 12.0 12.0 12.0 12.0 12.0 12.0 Ke 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 We 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 Ko 20.0 19.2 18.4 17.6 16.8 16.0 15.2 14.4

0.8
0.9 1.0

12.0
12.0 12.0

20.0
20.0 20.0

0.2
0.1 0.0

13.6
12.8 12.0

Net Income Approach

22.0 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Debt Ratio

Cost of capital

Ke Ko Kd

Net Operating Income Approach

Proposed by Durand There is no optimal capital structure and any combination is good Assumptions
No corporate taxes ko remains constant for all degrees of capital mix Market capitalizes the value of a firm as a whole and split between debt and equity is not important kd remains constant Debt increases equity share holders risk further increasing ke

Net Operating Income Approach

Increase in debt enhances equity risk
Debt increases cost of equity ke Increased debt weight keeps ko constant

Financial Leverage doesnt influence the value of the firm

Net Operating Income Approach

32.0 30.0 28.0 26.0 24.0 22.0 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Debt Ratio
Cost of capital

Ke Ko Kd

Traditional Approach
An intermediate approach between NI and NOI approaches Optimal capital structure lies where Ko is minimum

Traditional Approach
kd remains constant till appoint of leverage and rises after that ke rises constantly till a point of leverage and rises sharply after that

ko decreases till some extent, remains constant till a point and rises beyond that

Traditional Approach
32.0 30.0 28.0 26.0 24.0 22.0 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Debt Ratio

Cost of capital

Ke Ko Kd

Modern Capital Structure Theories

Modern Capital Structure Theories

MM theory
Zero taxes
Corporate taxes Corporate and personal taxes

Trade-off theory Signaling theory Debt financing as a managerial constraint

MM Theory
Assumptions

Perfect capital markets

No brokerage

No bankruptcy costs
Personal and corporate borrowing rates are same

Investors have all company information

MM Theory: Zero Taxes

Propositions
Proposition I : VL = VU = EBIT/WACC Proposition II :keL= keU + Risk Premium = keU +(keU-kd)(D/E)

MM prove, under a very restrictive set of assumptions, that a firms value is unaffected by its financing mix: VL = VU. Therefore, capital structure is irrelevant. Any increase in ROE resulting from financial leverage is exactly offset by the increase in weight of debt so WACC is constant.

MM Theory: Corporate Taxes

Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. Propositions
Proposition 1 : VL = VU + Present value of tax shields = VU + TD. Proposition 2 : KeL = KeU +(KeU-kd)(1-T)(D/E)

Optimum capital structure is virtually 100% debt Ke increases as leverage increases but not at a pace without taxes WACC falls as debt is added.

MM Theory and Hamadas Equation

Increase in debt increases risk faced by shareholders Hence keL increases Beta of companies with equity and mix of debt are different
L = U [ 1 + (1-T)(D/E) ] U = L / [ 1 + (1-T)(D/E) ]

CAPM can be expressed as keL = kf + (km - kf) U[ 1 + (1-T)(D/E)]

Firm value and debt with corporate taxes

Value of Firm, V VL TD VU Debt 0
Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.

MM relationship between capital costs and leverage when corporate taxes are considered.

Cost of Capital (%)

ke

20

40

60

80

WACC kd(1 - T) Debt/Value 100 Ratio (%)

Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage bankruptcy costs. levels, tax benefits outweigh

At high levels, bankruptcy costs outweigh tax benefits.

An optimal capital structure exists that balances these costs and benefits.

Signaling Theory
MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued. Sell bonds if stock is undervalued.

Investors understand this, so view new stock sales as a negative signal.

Implications for managers?
Issue of debt sends positive or at least neutral signal to share holders. Companies would try to avoid issue stock to avoid negative signal and maintain reserve borrowing capacity

Optimum Capital Structure

Features of an optimum capital structure

Low cost of capital Maximize value of the firm
Maximize market price of the stock

Market price of the stock

Debt raises equity risk Equity risk makes stocks price to come down Higher ROE raises stock price

Optimum Capital Structure and Market price of the stock

Stock prices fall to a given increase in debt Stock prices go up as ke goes up due increase in financial risk It is difficult to measure optimum mix of debt and equity as it is difficult to measure the fall/gain of market price of the stock to a given increase in debt component

Process of Estimating Optimum Capital Structure

Estimating Cost of Debt Estimating Cost of Equity

Estimating WACC
Estimating Firms Value Estimating Share holders wealth and stock price

Optimum Capital Structure

Debt in % 0 10 20 D/E 0 11.11 25.00 After Tax Kd 4.80 4.80 4.86 Estimated 1.00 1.07 1.15 Ke 12.0 12.4 12.9 WACC 12.00 11.64 11.29 Firm Value 200,000 206,186 212,540

30

42.86

5.10

1.26

13.5

11.01

217,984

40
50 60

66.67
100 150

5.40
6.60 8.40

1.40
1.60 1.90

14.4
15.6 17.4

10.80 222,222
11.10 12.00 216,216 200,000

Thank You
Questions???