CAPITAL STRUCTURE DECISIONbhushan

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MEANINGCapital structure is the proportion of debt, preference and equity shares on a firms balance sheet.

Total capitalEquity capitalDebt capitalEquity share capitalPreference share capRetained earnings Share premiumTerm loansDebenturesDeferred payment liabilitiesOther long term debt bhushan

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Optimum capital structureIs the capital structure at which the weighted average cost of capital is minimum and thereby maximum value the firm.The optimum capital structure minimizes the firms overall cost of capital and maximizes the value of the firm.Optimum capital structure is also referred as appropriate capital structure and sound capital structure bhushan

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Factors determining capital structureFactors Internal Cost of capitalRisk factor Control factorObjectives Constitution of the company Attitude of the management External Economic conditionsInterest ratesPolicy of lendingTax policiesStatutory restrictions bhushan

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Theories of capital structureBasic assumptionsThere are only two sources of funds used by a firm: perpetual risk less debt and ordinary shares.There are no corporate taxes. This assumption is removed later.The dividend-payout ratio is 100%. that is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings.The total assets are given and do not change. The investment decisions are in other words assumed to be constant. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the cost of equity capital. bhushan

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Contd6. The operating profits (EBIT) are not expected to grow.All investors are assumed to have same subjective probability distribution of the future expected EBIT for a given firm.Business risk is constant over time and is assumed to be independent of its capital structure and financial risk.Perpetual life of the firm.bhushan

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Theories of capital structure Net Income NI approachNet Operating Income NOI approachModigliani Miller MM approachTraditional approach bhushan

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Net Income approach This approach is given by Durand DavidAssumptions: this approach is based on three assumptions There are no taxesCost of debt is less than the cost of equity Use of debt does not change the risk perception of the investor. According to this approach, the capital structure decision is relevant to the valuation of the firm.

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Contd A change in the capital structure causes a overall change in the cost of capital and also in the total value of the firm.A higher debt content in the capital structure means a high financial leverage and this results in the decline in the overall weighted average cost of capital and therefore there is increase in the value of the firm.Thus with the cost of debt and the cost of equity being constant, the increased use of debt (increase in leverage), will magnify the share holders earnings and, thereby, the market value of the ordinary shares. bhushan

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ContdNI Net Income= EBIT-I or earnings available to equity share holders.Value of the firm= market value of debt+ market value of equity. over all cost of capitalization (ko) = EBIT/V or (ko) = ki (B/V) + ke (S/V)Ki= cost of debt Ke= cost of equity B= total market value of debt S= total market value of equity bhushan

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ContdNet income approach view of capital structure: Average cost of capital Cost of debt Cost of equity Cost of capital Degree of leverage bhushan

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Net operating income approach This is another theory suggested by Durand NOI approach is opposite to NI approachAccording to NOI approach value of the firm is independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm Any change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage bhushan

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Assumptions The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole The overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchangedThe cost of debt (kd) is also constant There is no taxThe use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke) bhushan

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Prepositions NOI approach is based on the following prepositions:Overall cost of capital/ capitalization rate (ko) is constant: this approach argues that the overall capitalization rate of the firm remains constant for all degrees of leverage. The value of the firm given the level of EBIT is determined by V= EBIT/koEBIT= earnings before interest and taxKo= overall cost of capital or V=EBIT(1-t) + Bt keB= value of debtThe split of the capitalization between debt and equity is therefore not significantbhushan

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ContdResidual value of equity : The value of equity is the residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V)(S) = V-BS= value of equity V= value of firmB = value of debtbhushan

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ContdChange in cost of equity capitalThe equity capitalization rate or cost of equity capital (Ke) increases with the degree of leverage. The increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the increased risk to the ordinary shareholders would expect a higher rate of return on their investment. The increase in the equity capitalization rate would match in the increase in debt equity ratio. bhushan

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ContdKe = Ko + (Ko-Ki) (B/S) OrKe= EBIT-I/V-B bhushan

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ContdCost of debtThe cost of debt (Ki) has two partsExplicit costImplicit cost hidden costExplicit cost is the rate of interest paid by debt.Implicit cost is the increase in the cost of equity due to increase in debt.

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Optimal capital structureThe total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is the total value of the firm remain constant. The market price of shares will also not change with the change in debt equity ratio.There is nothing such as optimum capital structure any capital is optimum according to NOI approach. bhushan

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Degree of leverageCost of capitalkekokibhushan

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Modigliani Miller Approach The M.M thesis relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI approach.

The NOI approach does not provide operational or behavioral justification for the irrelevance of the capital structure.

The significance of M.M approach lies in the fact that it provides behavioral justification for constant overall cost of capital and therefore total value of firm.

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Assumptions

Perfect capital market-Securities are infinitely divisibleInvestors are free to buy/ sell securities Investors can borrow without restrictions on the same terms and conditions as the firm can There are no transactions costs Information is perfect, that is each investor has same information which is readily available to him without cost and Investors are rational and behave accordingly.

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Contdb) Given the assumption of perfect information and rationality all investors have the same expectations of firm net operating income (EBIT) with which to evaluate the value of a firmc) Business risk is equal among all the firm within similar operating environment, that means all the firms can be divided into equivalent risk class. The term equivalent/homogeneous risk class means that the expected earnings have identical risk characteristics and firm within an industry are assumed to have same risk characteristics d) The dividend payout ratio 100%e) There are no taxes. This assumption is removed later

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Basic prepositionsThere are three basic preposition of M.M approach.Preposition 1The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure, the ko and V are constant for all degrees of leverages. the total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. V=EBIT ko V is determined by the assets in which the company has invested and not how those assets are financedbhushan

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Contd Degree of leverage (B/V)VKo %bhushan

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ContdPreposition 2The second preposition of M.M approach is that the ke is equal to the capitalization rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalization rate (ke) and (ki) times the ratio of debt to equity. In other words ke increases in the manner to offset exactly the use of a less expensive source of funds represented by debt. OrThe rate of return required by the shareholders increases linearly as the debt/equity ratio is Increased. Ke(L) = Ke(u)+[(ke(u)-ki)*D/E]

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Contd Proposition 3The cut-off rate for the investment purpose is completely independent of the way in which an investment is financed. The cut off rate for investment will be in all cases the WACC bhushan

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MM theory : Arbitrage Proposition 1:The basic premise of MM approach is that given the above assumptions the total value of a firm must be constant irrespective of degree of leverage (debt-equity ratio) similarly, the cost of capital as well as the market price of shares must be the same regardless of the financing-mix.The operational justification for the MM hypothesis is the Arbitrage process. bhushan

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Arbitrage The term arbitrage refers to an act of buying an asset/security in one market (at lower price) and selling it in another market (at higher price) to derive benefits from the price differentials The increase in demand will force up the price of lower priced goods and increase in supply will force down the price of the high priced goods.MM argues that the process of arbitrage will prevent the different market values for equivalent firms, simply because of capital structure difference.

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Arbitrage process The investor of the firm whose value is higher(overvalued) will sell their shares and instead buy the shares of the firm whose value is lower (undervalued) The behavior of investors will have the effect of (i) increasing the share prices (value) of the firm whose shares are being purchased;(ii) lowering the share prices (value) of the firm whose shares are being sold .This will continue till the market prices of both the firms become identical . bhushan

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ContdThe use of debt by the investor for arbitrage is called as Home Made or Personal leverage bhushan

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Limitations or Criticism of MM approachRisk perceptionConvenience Cost Institutional restrictions Double leverageTransaction cost Taxes bhushan

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Risk perception In the first place, the risk perceptions of personal and corporate leverage are different.The risk exposure to investor is greater with personal leverage than with corporate leverage.The liability of an investor is limited in corporate enterprise. The risk to which he is exposed is limited to his relative holdings in the company The liability of an individual borrower is, on the other hand, unlimited as even his personal property is liable to be used for payment to the creditors. The risk to the investor with personal borrowings is higher.bhushan

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Convenience Apart from higher risk exposure the investor would find the personal leverage inconvenient. This is so because with corporate leverage the formalities and procedures involved in borrowing are to be observed by the firms. In case of personal leverage these will be the responsibility of the investor borrower. bhushan

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Cost Another constraint on the perfect substitutability of personal and corporate leverage and, hence, the effectiveness of the arbitrage process is the relatively high cost of borrowing with personal leverage.As a general rule, large borrowers with high credit standing can borrow at a lower rate of interest compared to borrowers who are small and do not enjoy high credit standing.For this reason it is reasonable to assume that a firm can obtain a loan at a cost lower than what a individual investor would have to pay As a result of higher interest charges, the advantage of personal leverage would disappear and the MM assumption of corporate and personal leverage being perfect substitutes would be a doubtful validity bhushan

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Institutional restrictions Yet another problem with the MM hypothesis is that institutional restrictions stand in the way of smooth operation of the arbitrage process. Several institutional investors such as insurance companies, mutual funds, commercial bank and so on are not allowed to engage in personal leverage.Thus switching the option from the unlevered to levered firm may not apply to all investors and, to that extent, personal leverage is an imperfect substitute for corporate leverage. bhushan

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Double leverage A related dimension is that in certain situations, the arbitrage process may not actually work.For instance, when an investor has already borrowed funds while investing in shares of an unlevered firm.If the value of that is more than that of a levered firm, the arbitrage process will require selling securities of the overvalued firm (unlevered) and purchasing the securities of undervalued firm(levered).Thus, an investor would have double leverage both in personal portfolio as well as in the firms portfolio.The MM assumption will not hold true in such a situation.

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Transaction costTransaction cost would effect arbitrage process.The effect of transaction/flotation cost is that the investor would receive net proceeds from the sale of securities which will be lower than the investment holding in the levered/unlevered firm, to the extent of brokerage fees and other costs.He would therefore have to invest a large amount in the shares of the unlevered/levered firm, than his present investment, to earn the same returns.This implies that the arbitrage process will be hampered and will not be effective.bhushan

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Taxes Finally if the corporate taxes are taken into account, the MM Approach will fail to explain the relationship between financing decision(capital structure) and the value of the firm MM themselves are aware of it and in fact, recognized it.

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Corporate Taxes in MM ApproachMM agrees that the value of firm will increase and cost of capital will decline with leverage, if corporate taxes are introduced in the exercise.Since the interest on debt is tax deductible the effective cost of borrowing is less than the contractual rate of interest.Debt, thus, provide a benefit to the firm because of tax deductibility of interest payments Therefore a levered firm would have greater market value than the unlevered firm

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ContdSpecifically, MM states that the value of the levered firm would exceed that of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax rate.Symbolically, V(l) = V(u) + Bt V(u) = EBIT(1-t) KeWhere V(l)= value of levered firm Vu = value of unlevered firm B= amount of debt and t = tax rate bhushan

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ContdSince the value of the levered firm is more than that of the unlevered firm, it is implied that the over all cost of capital of the former would be lower than that of the later.The implication of MM analysis in this case is that a firm can lower its cost of capital continually with increased leverage. However, the extensive use of debt financing would expose business to high probabilities of default. Therefore an excessive use of debt may cause rise in the cost of capital and therefore reduce value of the firm.

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Traditional approach In the earlier discussions we have seen that the net income approach (NI) as well as net operating income approach(NOI) represent two extremes as regards the theoretical relationship between the capital structure, the weighted average cost of capital and value of the firm.While the NI Approach takes the position that the use of debt in the capital structure will always affect the overall cost of capital and the total valuation, the NOI approach argues that capital structure is totally irrelevant. The MM Approach supports the NOI approach. But the assumptions of MM approach are of doubtful vaidity.bhushan

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ContdThe traditional approach is the midway between the NI and NOI approaches.It partakes of some features of both these approaches.It is also known as Intermediate approach.It resembles or agrees with the NI approach in arguing that cost of capital and total value of the firm are not independent of the capital structure. But it dose not agree with the view that the value of firm will necessarily increase at all degrees of leverage

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ContdIt shares a feature with NOI approach also that beyond a certain degree of leverage, the overall cost increases leading to decrease in the total value of the firm. And it differs with NOI approach in that it dose not argue that the weighted average cost of capital is constant for all degrees of leverage. bhushan

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ContdThe crux of traditional view relating to leverage and valuation is that through judicious use of debt-equity proportions, a firm can increase its total value and there by reduce its over all cost of capital.The rationale behind this view is that debt is relatively cheaper source of funds as compared to ordinary shares.With a change in the leverage, that is , using more debt in place of equity, a relatively cheaper source of fund replaces a source of fund which has relatively higher cost. This obviously causes a decline in the over all cost of capital.

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ContdIf the debt-equity ratio is raised further, the firm would become financially more risky to the investors who will penalize the firm by demanding a higher equity capitalization rate (ke). But the increase in ke may not be so high to neutralize the benefit of using cheaper debt.If, however, the debt is increased further two things are likely to happen:(i) owing to increased financial risk ke will record a substantial rise ;(ii) the firm would become very risky to creditors who also would be compensated by a higher return such that ki will rise bhushan

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ContdThe use of debt beyond a certain point will, therefore, have the effect of raising the weighted average cost of capital and conversely reducing the total value of the firm.Thus up to a point the use of debt will favorably affect the value of the firm; beyond that point use of debt will adversely affect the value of the firm. At that level of debt-equity ratio, the capital structure is an optimal capital structure.

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Contd At the optimal capital structure, the marginal real cost of debt, defined to include both implicit and explicit, will be equal to the real cost of equity. For a debt equity ratio before that level, the marginal real cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of the equity.bhushan

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Over all cost of capital and optimum leverageWACCCost of equity KeCost of debt KiOptimum level of capital Cost of capitalDegree of leveragebhushan

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Overall cost of capital and value of the firm Market value Value of firmValue of equityValue of debtOptimum level of capital Degree of leveragebhushan

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EBIT-EPS analysis Keeping in mind the primary objective of financial management of maximizing the market value of the firm, the EBIT-EPS analysis should be considered logically as the first step in the direction of designing a firms capital structure.EBIT-EPS analysis shows the impact of various financing alternatives on EPS at various levels of EBIT. bhushan

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Contd This analysis is useful for two reasons The EPS is the measure of firms performance given the P/E ratio, the larger the EPS the larger would be the value of the firm The EBIT-EPS analysis information can be extremely useful to finance manager in arriving at an appropriate financing decision.bhushan

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ContdIn general, the relationship between EBIT and EPS is as follows EPS= (EBIT-I) (1-t) NWhere EPS= earning pre share EBIT= earnings before interest and tax I= interest t= tax N= number of equity shares bhushan

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Break even EBIT level or Indifferent point The breakeven EBIT for two alternative financing plans is the level of EBIT for which the EPS is the same under both the financing plans. (EBIT-I) (1-t) = (EBIT-I) (1-t) N Nbhushan

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ContdEBITEPSbhushan

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Financial breakeven It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. interest and preference dividends.It denotes the level of EBIT for which the firms EPS just equals to zero.If EBIT is less than financial break even point, then EPS will be negative But if the expected level of EBIT exceeds than that of break even point more fixed costs financing instruments can be inducted in the capital structure otherwise the use of equity will be preferred. bhushan

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ROI-ROEROI= EBIT/D+EROE= (EBIT-I) (1-t)/EMathematical relationship ROE= (ROI+ (ROI-r)D/E) (1-t)bhushan

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