CAPITAL STRUCTURE: THEORY AND POLICY

INTRODUCTION
2

The

objective of a firm should be directed towards the maximization of the firms value. capital structure or financial leverage decision should be examined from the point of its impact on the value of the firm(shares)

The

Capital Structure Theories:

3

Net operating income (NOI) approach. Traditional approach and Net income (NI) approach. MM hypothesis with and without corporate tax.

Net Income (NI) Approach

4

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

Traditional Approach
5

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

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

There

A firm has no debt and its net operating income is Rs 1,00,000 and equity capitalization rate is 10%.calculate value of the firm.
7

A firm has Rs 3,00,000@ 5% debt and its net operating income is Rs 1,00,000 and equity capitalization rate is 10%.calculate value of the firm.
8

A firm has Rs 3,00,000@ 5% debt and its net operating income is Rs 1,00,000 and equity capitalization rate is 10%.calculate value of the firm.
9

Value

of company = value of Eq shares + Value of Debt Value of Company = 8,50,000 + 3,00,000=11,50,000 =0.10 x (8,50,000) + 0.05 x (3,50,000) 11,50,000 11,50,000 =0.087 = 8.7%
WACOC

A firm has 1500 crores of Assets,NOI = Rs Rs 150 crores 1: 100% Equity (cost 10%) 2: Rs.300 crores debt (6%), Rs 1200 crores Eq (10.56%) 3; Rs.600 crores debt (7%), Rs 900 crores Eq (12.5%) calculate value of company and WACOC Rs Crores
EQ= 1500 EQ = 1200 no Debt 6% debt= 300
NOI Cost of Debt = Interest Net Income = NOI - Int Cost of Equity Mkt Value of Eq = E= (NOI-int)/Ke Mkt Value of Debt= D Value of Firm V = E + D W of EQ W of debt WACOC 150 0 150 0.10 1500 0 1500 1.0 0 0.10 150 18 132 0.1056 1250 300 1550 1250/1550 300/1550 0.970

10

EQ = 900 7% debt= 600

150 42 108 0.1250 864 600 1464 864/1464 600/1464 0.1030

11

IRRELEVANCE OF CAPITAL STRUCTURE:

NOI APPROACH AND THE MM HYPOTHESIS WITHOUT TAXES

12

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 debt-equity 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.

13

MMs Proposition I: Key Assumptions

Capitalizes

value of firm as a whole Market uses overall coc at a level of business risk Adv of low cost debt is offset by high Eq Capitalization rate. so overall COC is constant Perfect capital mkts (buy/borrow/sell/rational) Homogeneous risk classes (similar operating risk/same industry) Risks = variability of NOI.

expected v/s actual

No

taxes/No transaction cost Full payout

NOI Approach /MM approach

14

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.

15

Eq 1000 no Debt
NOI Cost of Debt = Interest Net Income NI = NOI - Int 100 0 100 0.05 0.10 1000 1000 0.10

Eq =800 debt =200

100 10 90 0.05 0.10 1000 200 800 0.1125

Eq = 600 debt= 400

100 20 80 0.05 0.10 1000 400 600 0.1333

E=V-D

Arbitrage Process
16

Suppose

two identical firms, same asset value and diff. 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. On 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.

Two firms have identical assets and NOI

17

NOI Cost of Debt = Interest Net Income=NI = NOI - Int Cost of Equity - given Mkt Value of Eq = E= (NOI-int)/Ke Mkt Value of Debt= D Value of Firm V = E + D W of EQ W of debt WACOC

Eq = Rs1,00,000 unlevereged 10,000 0 10,000 0.10 1,00,000 0 1,00,000 1.0 0 0.10

6% debt of 50,000 Eq = Rs 60,000 leveraged 10,000 3,000 7,000 0.117 60,000 50,000 1,10,000 60/110 50/110 0.091

MMs Proposition II
18

Financial

leverage causes two opposing effects: it increases the shareholders return 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
19

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

Cost of equity under the MM

20

IT ltd is an equity financed company.It has 10,000 shares,MV = Rs 1,20,000 It is expected operating Income = Rs 18,000 and EPS =18000/10000=Rs 1.8. Find its opportunity cost of capital:

MV of D + E

1,20,000

If IT ltd borrows Rs 60,000 and buys back 5000 shares at M V of Rs 60,000 Now Eq = 60,000 Debt = 60,000.D/E ratio =1 This change does not affect its assets and its earnings: Show the effect on EPS and cost of equity
EPS = Expected NI = 18,000 - 3600 = Rs 2.88 No of shares 5,000

Cont
21

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

Cost of equity under the MM

22

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

CAPITAL STRUCTURE PLANNING AND POLICY

23

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.

CAPITAL STRUCTURE PLANNING AND POLICY

Cost ke

24
ko

kd

Debt

The effect of leverage on the cost of capital under NI approach

Framework for Capital Structure: The FRICT Analysis

25

Flexibility-provide funds

when needed Risk-Economic,industry and firm specific risk Income-of shareholders to be maximized Control- concern over dilution Timing-market timing of financing

Practical Considerations in Determining Capital Structure

26

Assets tangible/intangible 2. Growth Opportunities high growthhigh mv/bv of assets due to intangible assets high risk so low debt 3. Debt and Non-debt Tax Shields 4. Financial Flexibility and Operating Strategy-to raise funds when required 5. Loan Covenants 6. Financial Slack- unused debt increases flexibility 7. Sustainability and Feasibility 8. Control 9. Marketability and Timing 10. Issue Costs 11. Capacity of Raising Funds
1.

27

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

Financial Distress
28

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

29

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
30

31

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
32

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

33

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.

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:
34

Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better.