CAPITAL STRUCTURE: THEORY AND POLICY

LEARNING OBJECTIVES
2

Understand the theories of the relationship between capital structure and the value of the firm
Highlight the differences between the Modigliani-Miller view and the traditional view on the relationship between capitalstructure and the cost of capital and the value of the firm Focus on the interest tax shield advantage of debt as well as its disadvantage in terms of costs of financial distress Explain the impact of agency costs on capital structure

Discuss the information asymmetry and the pecking order theory of capital structure
Study the determinants of capital structure in practice

INTRODUCTION
3

The

objective of a firm should be directed towards the maximization of the firms value.

The

capital structure or financial leverage decision should be examined from the point of its impact on the value of the firm. If the capital structure decision can affect the firms value, then it would like to have capital structure which maximizes its market value

Capital Structure Theories:

4

Traditional approach and Net income (NI) approach. Net operating income (NOI) approach. MM hypothesis with and without corporate tax. Millers hypothesis with corporate and personal taxes. Trade-off theory: costs and benefits of leverage.

Net Income (NI) Approach

5

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
The effect of leverage on the cost of capital under NI approach

Suppose firm L is a levered firm and its has financed its assets by equity and debt. It has perpetual expected EBIT or NOI of Rs 1000 and interest payment of Rs 300. The firm cost of equity (ke) is 9.33 percent and cost of debt is (kd) is 6 %. What is the firm value. The value is sum of values of all of its securities. Value of L will be sum of E and D. The value of firms shares (equity), E, is discounted value of shareholders earnings, called net income, NI. Firm Ls net income is 1000-300= 700 Hence, value of equity E is: 700/0.0933 = Rs 7500 Similarly, Value of D will be 300/0.06 = Rs 5000 Total value (V) = E+D = 7500+5000 = Rs 12,500

Firms Ls value is Rs 12500 and its expected net operating income is Rs 1,000.Therefore, the firm overall expected rate of return is or cost of capital is: NOI/value of firm = 1,000/12500 = 0.08 = 8% Or alternatively, WACC can be calculated as:

WACC= cost of equity x equity weight + cost of debt x debt weigh

Suppose firm Ls substitutes debt for equity and raises the debt to 90 percent. Its WACC will be = 0.0933*.10+.006*0.90 = 0.0633 or 6.33%

Value of firm (NI approach)

8

Given Cost of equity is 10%, coat of debt is 5%

Zero debt NOI Total cost of debt, INT = kd*D Net Income Market value of equity E: NI/Ke Market value of Debt, D: INT/kd Market value of firm V WACC, NOI/V = Ke x E/V+Kd x D/V 100,000 0 100,000 1,000,000 0 1,000,000 0.100 5% Rs 300,000 debt 100,000 15,000 85,000 850,000 300,000 1,150,000 0.087 5% Rs 900,00 debt 100,000 45,000 55,000 550,000 900,000 1,450,000 0.081

Traditional Approach
9

The traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

Cost ke

ko

kd

Debt

10

The traditional theory on the relationship between capital structure and the firm value has three stages:
First

stage: Increasing value Second stage: Optimum value Third stage: Declining value

Effect of leverage on Value Traditional approach

11

firm has Total Assets of 1500 crore and net operating income of Rs 150 crore The firms equity capitalization rate ( cost of equity) is 10 percent . It is considering substituting equity by issuing perpetual debentures of Rs 300 crore at 6% interest rate. The cost of equity is expected to increase to 10.56%. The firm is also considering the alternative of raising perpetual debentures of Rs 600 crore at 7% interest rate and replace equity and cost of equity will increase to12.5%. Show the effect on value of firm under three plans. Also calculate WACC.

Value of firm (Traditional approach)

12

No debt (Rs in crore) NOI Total cost of debt, INT = kd*D Net Income Cost of equity (ke) Market value of equity E: NI/Ke Market value of Debt, D: INT/kd Market value of firm V Equity to total value, We = E/V Debt to Total value WACC, NOI/V = Ke x E/V+Kd x D/V 150 0 150 0.01000 1,500 0 1500 1.00 0.00 0.100

6% debt (Rs in crore) 150 18 132 0.1056 1,250 300 1,550 0.806 0.194 0.0970

7% debt (Rs in crore) 150 42 108 0.1250 864 600 1464 0.590 0.410 0.1030

13

Criticism of the Traditional View

The

contention of the traditional theory, that moderate amount of debt in sound firms does not really add very much to the riskiness of the shares, is not defensible.

There

does not exist sufficient justification for the assumption that investors perception about risk of leverage is different at different levels of leverage.

14

IRRELEVANCE OF CAPITAL STRUCTURE:

NOI APPROACH AND THE MM HYPOTHESIS WITHOUT TAXES

MM Approach
15

Modigilani and

Miller (MM)do not agree with the traditional view. They argue that, in perfect capital market, without taxes and transaction costs, a firms market value and the CoC remains invariant to the capital structure changes. The value of the firm depends on the earnings and risk of its assets ( business risk ) rather than the way in which assets have been financed

16

MM Approach Without Tax: Proposition I

MMs Proposition I is that, for firms in the same risk class, the total market value is independent of the debtequity mix and is given by capitalizing the expected net operating income by the capitalization rate (i.e., the opportunity cost of capital) appropriate to that risk class.

Value of Levered firm = Value of Unlevered firm VL=Vu Value of Firm= NOI/Firms opportunity cost of capital

V= V l = Vu = NOI/K a

17

Financing changes the way in which the earnings are distributed between equity and debt holders. Firms with identical NOI and business (operating risk),but different CS, should have same total value.

18

MMs Proposition I: Key Assumptions

Perfect

capital markets

Investor can freely buy and sell securities Investor behave rationally They can borrow without any restriction and the same terms as the firms do. No cost of buying and selling securities

Homogeneous

risk classes Risk- operating risk is variability of NOI No taxes- Implies no debt ta shield Full payout- 100% payout ratio

19

The cost of capital under MM proposition I

20

Net Operating Approach

Income

(NOI)

According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same. MMs approach is a net operating income approach.

Arbitrage Process
21

Suppose

two identical firms, except for their capital structures, have different market values. In this situation, arbitrage (or switching) will take place to enable investors to engage in the personal or homemade leverage as against the corporate leverage, to restore equilibrium in the market. the basis of the arbitrage process, MM conclude that the market value of a firm is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does not help in creating any wealth for shareholders. Hence one capital structure is as much desirable (or undesirable) as the other.

On

22

Example :The MM Proposition I and Arbitrage

Suppose

two firms, Firm U and unlevered firm and Firm L, a levered firm- have identical assets and expected NOI of Rs 10,000. The value firm U is Rs 100,000 assuming cost of equity is 10 % under the traditional view. Since Firm U has no debt, the value of firm is equal to value of equity (Eu= Vu). Firm L employ 6 percent Rs 50,000 debt. Suppose its cost of equity under traditional view is 11.7 percent. The value of equity shares of L is Rs 60,000 ( 7000/0.117) and its total value is Rs 110,000.

23

Value of Levered and Unlevered Firms

Firm U (Unlevered) Net operationg income 10,000 Firm L (Levered) 10,000

Interest, INT

3000
0.117 60,000 50,000 110,000

Cost of equity , Ke (Traditional 0.100 view) Market Value of equity, E Market Value of debt, D Market Value of Firm, U 100,000 0 100,000

WACC, Ko (traditional view)

0.10

0.091

24

MM

argue that the difference in the value of U and L cannot for long, as arbitrage will bring two prices into equilibrium. How does arbitrage work? Assume that you hold 10 percnet shares of the levered firm, L. What is your return from investment in the shares of firm L? Since you own 10 percent of Ls shares, your equity investment is 0.10 x (110,000-50,000) = Rs 6000. You also own 10 percent of Ls corporate debt: 0.10 * 50,000 = Rs 5000. You are entitled 10 percent of equity income Return = 0.10 (NOI- INT) = 0.10 (10,000-3000) = Rs 700.

25

You can earn same return at lesser investment through an alternative strategy. This you can do by switching your investment from firm L to firm U as follows:

Selling your investment in firm Ls shares for Rs 6000. Borrowing on your personal account an amount equal to your share of firm Ls corporate debt at 6% of interest : 0.10 (50,000) Rs 5000. Buying 10 % of the unlevered firm Us shares investing 0.10 * (100,000)= Rs 10,000.

You have Rs. 11,000 with you; that is Rs 6000 from sale of Ls share and Rs 5000 borrowed funds. Your investment in Us shares is Rs 10,000. This you have a surplus of Rs 1000. Your return from U is:

Return from investment in Us share = 0.10*10,000 = Rs 1000 Hence you have borrowed Rs @6% you have to pay an interest of Rs 300. Thus your net return is Rs 700 (Rs 1000-Rs 300)

You earn the same return from an alternate strategy. But you now have Rs 1000 that you can invest to enhance your return. Your risk in both the cases is same.

26

While shifting your investment from firm L to firm, U you replaced your share of Ls debt by personal debt. You have created personal or homogenous leverage instead of corporate leverage. Due to the advantage of the alternate investment strategy, a number of investor will be induced towards it. They will sell their share in firm L and buy shares and debt of firm U. This arbitrage will tend to increase the price of firms U shares and to decline that of firm L shares. It will continue until the equilibrium price of the shares of firm U and firm L is reached.

MMs Proposition II
27

Financial

leverage causes two opposing effects: it increases the shareholders return (EPS ROE) but it also increases their financial risk. Shareholders will increase the required rate of return (i.e., the cost of equity) on their investment to compensate for the financial risk. The higher the financial risk, the higher the shareholders required rate of return or the cost of equity. The cost of equity for a levered firm should be higher than the opportunity cost of capital, ka; that is, the levered firms ke > ka. It should be equal to constant ka, plus a financial risk premium.

Cont
28

To determine the levered firm's cost of equity, ke:

Cost of equity under the MM

29

Criticism of the MM Hypothesis

Lending

and borrowing rates discrepancy Non-substitutability of personal and corporate leverages Transaction costs Institutional restrictions Existence of corporate tax

30

RELEVANCE OF CAPITAL STRUCTURE:

THE MM HYPOTHESIS UNDER CORPORATE TAXES

31

MM

show that the value of the firm will increase with debt due to the deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm.

Example: Debt Advantage: Interest Tax Shields Suppose two firms L and U are identical in all respects except that firm L
32

is levered and firm U is unlevered. Firm U is an all-equity financed firm while firm L employs equity and Rs 5,000 debt at 10 per cent rate of interest. Both firms have an expected earning before interest and taxes (or net operating income) of Rs 2,500, pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends to shareholders.


33

You may notice that the total income after corporate tax is Rs 1,250 for the unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered firm Ls investors are ahead of the unlevered firm Us investors by Rs 250. You may also note that the tax liability of the levered firm L is Rs 250 less than the tax liability of the unlevered firm U. For firm L the tax savings has occurred on account of payment of interest to debt holders. Hence, this amount is the interest tax shield or tax advantage of debt of firm L: 0.5 (0.10 5,000) = 0.5 500 = Rs 250. Thus,

Value of Interest Tax Shield

34

Interest tax shield is a cash inflow to the firm and therefore, it is valuable.

The cash flows arising on account of interest tax shield are less risky than the firms operating income that is subject to business risk. Interest tax shield depends on the corporate tax rate and the firms ability to earn enough profit to cover the interest payments. The corporate tax rates do not change very frequently.
Under the assumption of permanent debt, the present value of the present value of interest tax shield can be determined as follows:

35

Value of the Levered and Unlevered Firm

Value of the levered firm

36

37

Implications of the MM Hypothesis with Corporate Taxes

The

MMs tax-corrected view suggests that, because of the tax deductibility of interest charges, a firm can increase its value with leverage. Thus, the optimum capital structure is reached when the firm employs almost 100 per cent debt.

In

practice, firms do not employ large amounts of debt, nor are lenders ready to lend beyond certain limits, which they decide.

38

Why do companies not employ extreme level of debt in practice?

First,

we need to consider the impact of both corporate and personal taxes for corporate borrowing. Personal income tax may offset the advantage of the interest tax shield. borrowing may involve extra costs (in addition to contractual interest cost)costs of financial distress that may also offset the advantage of the interest shield.

Second,

FINANCIAL LEVERAGE AND CORPORATE AND PERSONAL TAXES Companies everywhere pay corporate tax on their earnings. Hence,
39

the earnings available to investors are reduced by the corporate tax.

Further, investors are required to pay personal taxes on the income earned by them. Therefore, from investors point of view, the effect of taxes will include both corporate and personal taxes. A firm should thus aim at minimizing the total taxes (both corporate and personal) to investors while deciding about borrowing.

How do personal income taxes change investors return and value?

It depends on the corporate tax rate and the difference in the personal income tax rates of investors.

Limits to Borrowings
40

The attractiveness of borrowing depends on corporate tax rate, personal tax rate on interest income and personal tax rate on equity income. The advantage of borrowing reduces when corporate tax rate decreases, or when the personal tax rate on interest income increases, or when the personal tax rate on equity income decreases.

Corporate and Personal Tax Rates in India

41

In

India, investors are required to pay tax at a marginal rate, which can be as high as 30 per cent. Dividends in the hands of shareholders are taxexempt. Capital gains on shares are treated favourably. In India, companies are required to pay dividend tax at 16.22 per cent (as in 2013) on the amount distributed as dividend.

Millers Model
42

To establish an optimum capital structure both corporate and personal taxes paid on operating income should be minimised. The personal tax rate is difficult to determine because of the differing tax status of investors, and that capital gains are only taxed when shares are sold. Merton miller proposed that the original MM proposition I holds in a world with both corporate and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At this point, there will be no net tax advantage to companies from issuing additional debt. It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest tax shield.

43

THE TRADE-OFF THEORY: COSTS OF FINANCIAL DISTRESS AND AGENCY COSTS

Financial Distress
44

Financial

distress arises when a firm is not able to meet its obligations to debt-holders. For a given level of debt, financial distress occurs because of the business (operating) risk . with higher business risk, the probability of financial distress becomes greater. Determinants of business risk are:

Operating leverage (fixed and variable costs) Cyclical variations Intensity of competition Price fluctuations Firm size and diversification Stages in the industry life cycle

Costs of Financial Distress

45

Financial

distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of insolvency.

Financial

distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers and shareholders.

Cont
46

47

Value of levered firm under corporate taxes and financial distress

With more and more debt, the costs of financial distress increases and therefore, the tax benefit shrinks. The optimum point is reached when the marginal present values of the tax benefit and the financial distress cost are equal. The value of the firm is maximum at this point.

Agency Costs
48

In

practice, there may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, which involve agency costs. Agency costs have their influence on a firms capital structure. ShareholdersDebt-holders conflict ShareholdersManagers conflict Monitoring and agency costs

PECKING ORDER THEORY

49

The pecking order theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information. The manner in which managers raise capital gives a signal of their belief in their firms prospects to investors. If they are raising money by debt they are giving signal of good performance of the company. If using equity, it is otherwise. This also implies that firms always use internal finance when available, and choose debt over new issue of equity when external financing is required.

The pecking order theory is able to explain the negative inverse relationship between profitability and debt ratio within an industry.
However, it does not fully explain the capital structure differences between industries.

Implications:
50

Internal equity may be better than external equity. Financial slack( sufficient level of cash) is valuable. If external capital is required, debt is better.

CAPITAL STRUCTURE PLANNING AND POLICY

51

Theoretically,

the financial manager should plan an optimum capital structure for the company. The optimum capital structure is one that maximizes the market value of the firm. The capital structure should be planned generally, keeping in view the interests of the equity shareholders and the financial requirements of a company. While developing an appropriate capital structure for its company, the financial manager should inter alia aim at maximizing the long-term market price per share.

Elements of Capital Structure

52

1.

2.
3. 4. 5. 6.

Capital mix- how much mix of debt and equity. Maturity and priority Terms and conditions Currency Financial innovations-convertible securities. Financial market segments

53

Framework for Capital Structure: The FRICT Analysis

Flexibility-debt capacity

should not be exceeded. Risk- excessive use of debt. Income CS should be advantageous to the shareholders. Control Timing- should be feasible for current and future conditions of capital market.

APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE

54

1. 2. 3.

EBITEPS approach for analyzing the impact of debt on EPS. Valuation approach for determining the impact of debt on the shareholders value. Cash flow approach for analyzing the firms ability to service debt.

EBIT-EPS Analysis
55

The EBIT-EPS analysis is a first step in deciding about a firms capital structure. It suffers from certain limitations and does not provide unambiguous guide in determining the level of debt in practice.

The

major shortcomings of the EPS as a financing-decision criterion are:

It is based on arbitrary accounting assumptions and does not reflect the economic profits. It does not consider the time value of money. It ignores the variability about the expected value of EPS, and hence, ignores risk.

Valuation Approach
56

The

firm should employ debt to the point where the marginal benefits and costs are equal. This will be the point of maximum value of the firm and minimum weighted average cost of capital. The difficulty with the valuation framework is that managers find it difficult to put into practice. The most desirable capital structure is the one that creates the maximum value.

Cash Flow Analysis

57

Cash

adequacy and solvency

In determining a firms target capital structure, a key issue is the firms ability to service its debt. The focus of this analysis is also on the risk of cash insolvency the probability of running out of the cashgiven a particular amount of debt in the capital structure. This analysis is based on a thorough cash flow analysis and not on rules of thumb based on various coverage ratios.

Components

of cash flow analysis

Operating cash flows- arising out of operations of business. Non-operating cash flows-capital expenditure and WCM. Financial cash flows- interest, dividend, lease rental, repayment of debt.

58

Cash Flow Analysis Versus EBIT EPS Analysis

The
1.

cash flow analysis has the following advantages over EBITEPS analysis:
It focuses on the liquidity and solvency of the firm over a longperiod of time, even encompassing adverse circumstances. Thus, it evaluates the firms ability to meet fixed obligations. It goes beyond the analysis of profit and loss statement and also considers changes in the balance sheet items. It identifies discretionary cash flows. The firm can thus prepare an action plan to face adverse situations. It provides a list of potential financial flows which can be utilized under emergency. It is a long-term dynamic analysis and does not remain confined to a single period analysis.

2.

3.

4.

5.

Practical Considerations in Determining Capital Structure

59

Assets 2. Growth Opportunities- firm with high M/B ratio have more opportunities. 3. Debt and Non-debt Tax Shields 4. Financial Flexibility and Operating Strategy 5. Loan Covenants 6. Financial Slack 7. Sustainability and Feasibility 8. Control 9. Marketability and Timing 10. Issue Costs 11. Capacity of Raising Funds
1.