capital structure fm sudhindra bhat_ppt

Excel BooksExcel BooksFINANCIAL MANAGEMENT, Dr. Sudhindra Bhat

Copyright © 2008, Dr Sudhindra Bhat

2 ND

14 – 1

CAPITAL STRUCTURE

THEORY

Chapter

CAPITAL STRUCTURE



2 ND

14 – 2

CAPITAL STRUCTURE

THEORY

Capital Structure Defined

The term capital structure is used to represent the proportionate relationship

between debt and equity.

The various means of financing represent the financial structure of an enterprise.

The left-hand side of the balance sheet (liabilities plus equity) represents the

financial structure of a company. Traditionally, short-term borrowings are excluded

from the list of methods of financing the firm’s capital expenditure.



2 ND

14 – 3

CAPITAL STRUCTURE

THEORY

Questions while Making the Financing Decision

How should the investment project be financed?

How does financing affect the shareholders’ risk, return and value?

Does there exist an optimum financing mix in terms of the maximum value to the

firm’s shareholders?

What factors in practice should a company consider in designing its financing

policy?



2 ND

14 – 4

CAPITAL STRUCTURE

THEORY

Features of An Appropriate Capital Structure

capital structure is that capital structure at that level of debt – equity proportion

where the market value per share is maximum and the cost of capital is minimum.

Appropriate capital structure should have the following features

Profitability

Solvency

Flexibility

Control



2 ND

14 – 5

CAPITAL STRUCTURE

THEORY

Determinants of Capital Structure Seasonal Variations

Tax benefit of Debt

Flexibility

Control

Industry Leverage Ratios

Agency Costs

Industry Life Cycle

Degree of Competition

Company Characteristics

Requirements of Investors

Timing of Public Issue

Legal Requirements



2 ND

14 – 6

CAPITAL STRUCTURE

THEORY

Definitions used in Capital Structure…• E = Total Market Value of Equity.

• D = Total Market Value of Debt.• V = Total Market Value of the Firm.• I = Annual Interest payment.• NI = Net Income.• NOI = Net Operating Income.• Ee = Earning Available to Equity Shareholder.



2 ND

14 – 7

CAPITAL STRUCTURE

THEORY

Patterns / Forms of Capital Structure

Following are the forms of capital structure:

Complete equity share capital;

Different proportions of equity and preference share capital;

Different proportions of equity and debenture (debt) capital and

Different proportions of equity, preference and debenture (debt) capital.



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14 – 8

CAPITAL STRUCTURE

THEORY

Assumption of Capital Structure Theories

There are only two sources of funds i.e.: debt and equity.

The total assets of the company are given and do not change. [Investment decision is

assumed to be constant].

The total financing remains constant. [Total capital is same, but proportion of debt and

equity may be changed].

Operating profits (EBIT) are not expected to grow.

All the investors are assumed to have the same expectation about the future profits.

Business risk is constant over time and assumed to be independent of its capital

structure and financial risk.

Corporate tax does not exit.

The company has infinite life.

Dividend payout ratio = 100%.



2 ND

14 – 9

CAPITAL STRUCTURE

THEORY

A Conceptual Look --Relevant Rates of Return

kkdd = the yield on the company’s debt = the yield on the company’s debt

Annual interest on debt

Market value of debt

I

D==kkdd

Assumptions:• Interest paid each and every year• Bond life is infinite• Results in the valuation of a perpetual bond• No taxes (Note: allows us to focus on just capital structure issues.)



2 ND

14 – 10

CAPITAL STRUCTURE

THEORY

E

S


==

kkee = the expected return on the company’s equity = the expected return on the company’s equityEarnings available to Earnings available to common shareholderscommon shareholders

Market value of common Market value of common stock outstandingstock outstanding

kkee

Assumptions:• Earnings are not expected to grow• 100% dividend payout• Results in the valuation of a perpetuity• Appropriate in this case for illustrating the theory of the firm

E

S



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14 – 11

CAPITAL STRUCTURE

THEORY

O

V


=

Ko = an overall capitalization rate for the firmKo = an overall capitalization rate for the firm

Earnings to all capital supplierTotal Market value of the firmKoKo

Assumptions:• V = B + S = total market value of the firm• Earnings to all capital supplier or EBIT=Interest plus earnings available

to common shareholders



2 ND

14 – 12

CAPITAL STRUCTURE

THEORY

Debt-equity Mix and the Value of the Firm

Capital structure theories:

Traditional approach and Net income (NI) approach.

Net operating income (NOI) approach

MM hypothesis with and without corporate tax.

Miller’s hypothesis with corporate and personal taxes.

Trade-off theory: costs and benefits of leverage.



2 ND

14 – 13

CAPITAL STRUCTURE

THEORY

Net Income Approach…• A change in the proportion in capital structure will lead to a corresponding change in

Ko and V.• Assumptions:

(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change the risk

perception of investors.

(iv) Cost of debt and cost of equity remains constant;



2 ND

14 – 14

CAPITAL STRUCTURE

THEORY

Net Income (NI) Approach 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.

ke

kokd

Debt

Cost

kd

ke, ko



2 ND

14 – 15

CAPITAL STRUCTURE

THEORY

Formula used for NI Approach…• Net Income [NI] = EBIT – Debenture Interest.

• Market Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D]

• Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke]

• Market value of Debt [D] = Interest [I] / Cost of Debt [Kd]

• Cost of Capital [Ko or R] = EBIT / V * 100 or EBIT/ (E+D) * 100



2 ND

14 – 16

CAPITAL STRUCTURE

THEORY

Net Operating Income Approach…• There is no relation between capital structure and Ko and V.

• Assumptions: Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. The market capitalizes the total value of the firm as a whole and no importance

is given for split of value of firm between debt and equity; The market value of equity is residue [i.e., Total value of the firm minus market

value of debt) The use of debt funds increases the received risk of equity investors, there by

ke increases The debt advantage is set off exactly by increase in cost of equity. Cost of debt (Ki) remains constant There are no corporate taxes.



2 ND

14 – 17

CAPITAL STRUCTURE

THEORY

Net Operating Income (NOI) Approach According to NOI approach the value

of the firm and the weighted average

cost of capital are independent of the

firm’s 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.

ke

ko

kd

Debt

Cost



2 ND

14 – 18

CAPITAL STRUCTURE

THEORY

Formula used for NOI Approach…• Value of the Firm [V] = EBIT / Ko• Market Value of Equity [E] = V – D• Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT – I /

V - D



2 ND

14 – 19

CAPITAL STRUCTURE

THEORY

MM Approach Without Tax: Proposition I

MM’s Proposition I states that the firm’s value is independent of its capital

structure. With personal leverage, shareholders can receive exactly the same

return, with the same risk, from a levered firm and an unlevered firm. Thus, they

will sell shares of the over-priced firm and buy shares of the under-priced firm until

the two values equate. This is called arbitrage.



2 ND

14 – 20

CAPITAL STRUCTURE

THEORY

MM’s Proposition II

The cost of equity for a levered firm equals the constant overall cost of capital

plus a risk premium that equals the spread between the overall cost of capital

and the cost of debt multiplied by the firm’s debt-equity ratio. For financial

leverage to be irrelevant, the overall cost of capital must remain constant,

regardless of the amount of debt employed. This implies that the cost of equity

must rise as financial risk increases.



2 ND

14 – 21

CAPITAL STRUCTURE

THEORY

MM Hypothesis With Corporate Tax

Under current laws in most countries, debt has an important advantage over

equity: interest payments on debt are tax deductible, whereas dividend

payments and retained earnings are not. Investors in a levered firm receive in

the aggregate the unlevered cash flow plus an amount equal to the tax

deduction on interest. Capitalising the first component of cash flow at the all-

equity rate and the second at the cost of debt shows that the value of the

levered firm is equal to the value of the unlevered firm plus the interest tax shield

which is tax rate times the debt (if the shield is fully usable).

It is assumed that the firm will borrow the same amount of debt in perpetuity and

will always be able to use the tax shield. Also, it ignores bankruptcy and agency

costs.



2 ND

14 – 22

CAPITAL STRUCTURE

THEORY

Features of an Appropriate Capital Structure

Profitability

Solvency

Return

Risk

Flexibility

Capacity

Control

Conservatism

capital structure fm sudhindra bhat_ppt

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