CAPITAL STRUCTURE

Capital Structure
 Capital Structure
This is concerned with the question as
to whether there is an optimal capital
mix of debt and capital which a
company should try to achieve.
There are three major theories:
 Net Income (NI) approach

 Traditional view

 Modigliani and Miller

Net Income Approach
 Suggested by David Durand
 Capital structure affect the value of the
firm
 Change in the capital structure causes a
corresponding change in the overall cost of
capital and the total value of the firm
 Higher financial leverage will result in the
decline in the WACC
 Causing the increase in the value of the firm
 And the increase in the value of the firm
Net Income Approach
 Assumptions of the NI Approach
ii. There are no corporate taxes
iii. The cost of debt is less than the cost of equity
iv. The debt content does not change the risk
perception of the investors
 The value of the firm
V = Ve + Vd
Where Ve = Market value of equity
Vd = market value of debt
Ve= NI/re
Traditional View
 The traditional view of Capital
structure
 There is an optimal capital structure
 The company can increase its total value
by a suitable debt finance in its capital
structure.
Assumptions:
c) The company pays out all its earnings
as dividends
d) The leverage of the company can be
changed immediately by issuing debt
 Traditional View

Assumptions:
b) The company pays out all its earnings as
dividends
c) The leverage of the company can be
changed immediately
 by issuing debt to purchase shares,
 or by issuing shares to repurchase debt
d) The earnings of the company are expected
to remain constant in perpetuity
 and all investors share the same expectations
e) Business risk is also constant, regardless of
how the company invests its funds
f) Taxation, for the time being, is ignored
Traditional View
a) As the level of leverage increase, the cost of
debt remains unchanged up to a certain level.
 Beyond this level the cost of debt will
increase
b) The cost of equity rises as the level of leverage
increases and financial risk increases.
 There is a non-linear relationship between
the cost of equity and leverage
c) The WACC does not remain constant
 falls initially as the proportion of debt capital
increases
 Then begins to increase as the rising cost of
equity becomes significant
Traditional View
d) The optimum level of leverage is where
the company WACC is minimized.
Modigliani-Miller (MM) View
 Assumptions of MM view
b) A perfect capital market exists in which
 investors have the same information
 Upon which they act rationally
 To arrive to the same expectations about
future earnings and risks
c) There are no taxes or transaction costs
d) Debt is risk-free and freely available at
the same cost to investors and
companies alike.
Modigliani-Miller (MM) View
 In 1958 Modigliani and Miller proposed
MM Proposition I
 The total market value of a company, in the
absence of tax will be determined by two
factors
3. Total earnings of the company
4. The level of operating risk attached to
those earnings
(The total market value would be computed
by discounting the total earnings at a rate
that is appropriate to the level of operating
risk. The WACC)
Thus the capital structure has no effect on the
Modigliani-Miller (MM) view
MM justified their approach by the use
of arbitrage.
MM Proposition II
3. The cost of debt remains unchanged
as the level of leverage increases
4. The cost of equity rises in such a
way as to keep the WACC constant.
Graphical MM view

The MM view would be represented on a graph as

shown below
Modigliani-Miller (MM) view
 Summing up MM view:
 MM hypothesis is based on the idea that
 No matter how you divide up the capital
structure of a firm among debt, equity and
other claims, there is a conservation of
investment value
 Since total investment value of a corporation
depends on its underlying profitability and
risk.
 Total investment value is invariant w.r.t.
relative changes in the firm’s financial
Market imperfections
 In 1963 MM modified their theory
 Admitted
the effect of tax relief on interest
payment to the WACC
 Interest on debt is tax deductible
 Saving from tax relief on debt is called tax
shield.
 They claimed that the WACC will continue to
fall up to 100% gearing.
 This suggests that companies should have a
capital structure made up entirely of debt.
 This does not happen because of market
imperfections
Market imperfections
 Value of the interest tax shield = (T x rd x
Vd )/rd
 = T x Vd
 VL = VU + (TxVd)
 Vu = EBIT (1-T)/rU

 Taxes, WACC and Proposition II

 WACC(rA) =
Market imperfection
 re = rA + (rA –rd) (Vd/Ve)
 MM demonstrates that in the world with
corporate taxes
 re = ru + (ru –rd) (Vd/Ve)x (1-T)
 This results indicates a positive
relationship between the expected return
on equity and debt equity ratio
 It implies that the rA decreases as the
amount of debt increases
Market Imperfections
1. Bankruptcy costs
 One assumption of MM theory is perfect
capital market
 But in reality, at higher levels of
leverage there is an increasing risk of
the company being unable to meet its
interest payment and being declared
bankrupt
 At these higher levels of leverage the
bankruptcy risk means that required
rate of return will be higher.
Market Imperfections
2. Agency Costs
 At Higher levels of leverage, there are

also agency costs

 Due to actions taken by concerned debt
holders
 Restrictive covenants: limit to dividends
and minimum level of liquidity, by debt
providers to protect investments.
 Higher levels of monitoring
Market Imperfections
3. Tax Exhaustion
 As the companies increase their level of

leverage
 they may reach a point where there are not
enough profits from which to obtain all
available tax benefits
 Bankruptcy and agency costs will rise, but
benefits of tax shield will not rise
sufficiently.
 So market imperfections undermine the
tax advantage of debt finance.
Optimal Capital Structure
 Financial distress costs are insignificant
for a firm with little or no debt.
 so if an unlevered firm adds a small
amount of debt
 It benefits from the tax shield on debt
 Without incurring significant costs of
financial distress
 As a firm uses more and more debt
 The tax savings are eventually offset by the
higher likelihood of financial distress
Optimal Capital Structure
 The point where these two factors offset
each other is where the firm value is
maximized.
STATIC THEORY OF CAPITAL STRCUTURE
 A Firm uses debt financing up to the point

where tax benefits from additional debt

exactly offsets the cost associated with an
increased likelihood of financial distress.
 That is the optimal capital structure
 Optimal capital structure
 Minimum WACC
 Maximizes the firm value
Optimal Capital Structure
 Recommendations From The Static
Theory of Capital
2. Firms with higher tax rates should
borrow more as long as they don’t have
other tax shields
3. Firms with higher risk of distress (due to
higher operating risks) should borrow
less
4. Firms for which the cost of financial
distress is higher should borrow less