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Capital Structure Theories and Firm Value

Prof. SB Mishra1

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Learning Objectives

• How does financial leverage or Capital Structure decisions affect Firm’s value?

• What are different theories on Capital structure and how do they differ?

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The Chapter tries to answer the following Questions

? What should be the proportions of Equity and Debt in the capoital structure of a firm?

? How much financial leverage should a firm employ.

? What is the relationship between capital structure and firm value.

? What is the relationship between capital structure and cost of capital.

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Cost of Capital Concepts

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CAPITAL STRUCTURE INCLUDES

OWNERSHIP / EQUITY SHARE CAPITAL

DEBT CAPITAL (PREFERENCE SHARE CAPITAL , DEBENTURE & LONG TERM DEBT)

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COST OF DEBT CAPITAL

= K D =

Annual Interest Charges ( I)

Value of Debt (D)

COST OF EQUITYCAPITAL

= KE =

Equity Earnings (P)

Value of Equity ( E )

FORMULA

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AVERAGE COST OFCAPITAL = KO =

OPERATING INCOME ( O)

VALUE OF THE FIRM ( V )

So

D =E =

V =

I

KD KE

P

KO

O

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KE = Equity Capitalization Rate

KD = Debt Capitalization Rate

KO = Overall Capitalization Rate

Firm’s Value is inversely related to KO

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“The CS Theories tries to examine whether

KE , KD and KO is affected by D/E Ratio”

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“Leverage matters” Theories

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Net Income 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.

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NI continued

• This happens because when D/E increases , KD which is lower than KE receives a higher weight in the calculation of KO .

• This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

•

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ke

kokd

Debt

Cost

kd

ke, ko

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Traditional Approach

• The traditional approach argues that moderate degree of debt can lower the firm’s 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.

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ke

ko

kd

Debt

Cost

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Financial Leverage does not matter theories.

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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.

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NOI Contd….

• The critical premise of this approach is that market capitalises the firm as a whole at a discount rate which is independent of the firm’s D/E Ratio.

• This happens because an increase in the use of Debt funds which are “apparently cheaper” is offset by an increase in the equity capitalisation rate because Equity shareholders seek higher compensation for the higher risk.

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ke

ko

kd

Debt

Cost

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Modigliani-Miller Approach (MM) Assumptions

• Perfect Capital Market : Information is freely available and there is no problem of asymmetric information, transactions are costless , there is no bankruptcy costs , securities are infinitely.

• Rational Investors and Managers : Investors rationally choose a combination of risk and return that is most advantageous to them. Managers act in the interest of shareholders.

• Homogeneous Expectations : Investors hold identical expectations about future operating earning.

• Equivalent Risk Classes: Firms can be grouped into ”equivalent risk classes” on the basis their business risk.

• Absence of Taxes : There is no tax.

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MM- PROPOSITION -I

“ The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its Capital Structure.”

V = D + E = O / r

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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.

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Proposition-I contid…

• MM Proposition holds good because of the effect of arbitrage which makes sure that value of two firms with equal risk class have the same value irrespective of whether they are levered or not. If a levered firms value is slightly higher it will not remain so because investors will sell its equity and buy that of lower valued firm and make a profit. This will continue till the value of firm is same.

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ko

Debt

Cost

MM's Proposition I

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Arbitrage

Levered Firm ( ):

60,000 50,000 110,000

interest rate 6%; NOI 10,000

shares held by an investor in 10%

Unlevered Firm ( ):

100,000

NOI 10,000

l l l

d

l

u u

L

V S D

k X

L

U

V S

X

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Arbitrage

Return from Levered Firm:

10 110,000 50 000 10% 60,000 6 000

10% 10,000 6% 50,000 1,000 300 700

Alternate Strategy:

1. Sell shares in : 10% 60,000 6,000

2. Borrow (personal leverage):

Investment % , ,

Return

L

10% 50,000 5,000

3. Buy shares in : 10% 100,000 10,000

Return from Alternate Strategy:

10,000

10% 10,000 1,000

: Interest on personal borrowing 6% 5,000 300

Net return 1,000 300 700

Ca

U

Investment

Return

Less

sh available 11,000 10,000 1,000

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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.

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ke

ko

kd

Debt

Cost

MM's Proposition II

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MM Propositions I and II

/

o

o

de

e o o d

MM Proposition I :

XV

k

Xk

VMM Proposition II :

X k Dk

Sk k (k k )D S

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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.

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MM Hypothesis with Corporate Tax

After-tax earnings of Unlevered Firm:

(1 )Value of Unlevered Firm:

(1 )

After-tax earnings of Levered Firm:

( )(1 )

(1 )

Value of Levered Firm:

(1 )

T

u

T

d d

d

dl

u d

u

u

X X T

X TV

k

X X k D T k D

X T Tk D

T k DX TV

k k

V TD