CAPITAL STRUCTURE

BY DR.SAYLEE GHARGE

Reference: Capital Structure theories by Dev Tech Finance

 Capital Structure
 Capital structure represents the financial composition of firm to raise
fund for its business activities
 The financing decision involves generating capital from different
sources of fund like debt, equity, preference, retained earning.
 An optimum financing mix can maximize the value of firm in long run.
 An efficient capital structure helps in managing the cost of raising
capital for the firm.
 Ultimate objective is to maximize the shareholder’s wealth which
depends on the value of firm.
 Capital Structure

According to Gerestenbeg, “Capital structure of a company refers to

the composition or make-up of its capitalization and it includes all
long-term capital resources viz : loans, reserves, shares and books.”
The capital structure is made up of debt and equity securities and
refers to permanent financing of a firm. It is composed of long-term
debt, preference share capital and shareholder’s funds.
Forms /patterns of Capital Structure
 Capital structure theories

 Capital structure theories represents the relationships between

the capital structure ,cost of capital and value of firm.

 These theories are based on certain assumptions.

 Capital structure theories argues whether any change in the

financing mix would have impact on the value of the firm or not.
 Theories of Capital Structure

1.Net Income approach

2.Net Operating Income Approach
3.Modigilani –Miller Approach
4.Traditional Approach
 Assumptions

 There are only two source of financing –Debt and Equity.

 The firm has decided to distribute all its earnings as dividend rather than
keeping as retained earning (100% dividend payout)
 The operating profit of firm is given and is not expected to grow or decline
over time.
 The business risk will remain constant irrespective of financial composition.
 There is no income tax or corporate tax.
 No transaction cost
 No change in investment decision or assets.
NET INCOME APPROACH
 Introduction

 Capital structure matters in determining the value of firm.

 It suggests that the value of the firm increases by decreasing the weighted
average cost of capital.
 Weighted average cost of capital could be reduced with higher debt proportion
in financing.
 Cost of raising fund through debt is lower as compared to equity capital Kd < Ke
 Lower cost of raising fund through debt results in decrease in overall cost of
capital.
 Thus, the value of firm is maximized.
 Assumptions

 There are only two sources of financing

 Debt and Equity
 No transaction cost
 Risk perception of the investors remain same.
 Dividend pay-out ratio is 1.
 No taxes
 No retained earning
NET OPERATING INCOME APPROACH
 Introduction
 Capital Structure does not matter in determining the value of firm.
 It suggests that the value of firm remains same and is not affected by
the change in debt composition of financing.
 Increases in debt composition results in increased risk perception by
investors.
 Thus, firm appears to be more risky with more debt as capital which
results in higher required rate of return by investors.
 The weighted average cost of capital and market value of firm remains
same with increases cost of equity.
 Assumptions
 There are only two sources of financing
 Debt and Equity
 Value of equity is calculated by deducting the value of debt
from total value of firm.
 Value of firm is EBIT/Overall cost of capital.
 WACC remains constant and with an increase in debt ,the cost
of equity increases.
 Dividend pay-out ratio is 1.
 No taxes and No retained earning
 NOI Approach to Capital Structure

 WACC (Weightage Average Cost of

Capital) remains constant and with the
increase in debt, the cost of equity
increases.
 Increase in debt in the capital structure
results in increased risk for shareholders.
 As a compensation of investing in highly
leveraged company, the shareholders
expect higher return resulting in higher
cost of equity capital.
TRADITIONAL APPRAOCH
 Introduction
 It suggests that the firm value is maximum with right proportion of debt
and equity mix.
 As per this approach, debt funding should exist in the capital structure
only up to a certain level ,after which any increase in debt funding would
result in the reduction in the value of the firm by increasing cost of
equity.
 It advocates that there exists an optimum level of debt and equity at
which the WACC is the lowest and the market value of the firm is the
highest.
 Assumptions

 There are only two sources of financing –Debt and Equity

 The interest rate on debt remains constant to a certain level after which
it increases with an increase in debt financing.
 The expected rate of return on equity increases gradually to certain level
after which it increases speedily with increase in debt because of the
financial risk involved.
 WACC first decreases and then starts increasing with increased interest
rate on debt and increased required rate of return on equity.
 No taxes and transaction cost.
 Traditional Approach
 This approach of capital structure is based on the conviction that
optimal capital structure always exists, and financer can increase the
value of firms by making use of leverage.
 It is a combination of two previous approaches (NI and NOI). It has
three stages.
 The supporter of Traditional theory were financial experts Ezta
Solomon and Weston.
 According to this theory, good combination of debt and equity will
always lead to market value improvement of the firm.
 Traditional Approach

 This approach admits that the equity

shareholders perceive financial risk
and expect premiums for the risks
undertaken.
 This theory also affirms that after a
level of debt in the capital structure,
the cost of equity capital upsurges.
 Modigliani and Miller
Approach (MM APPROACH)
 Introduction
 The capital structure of a company is the way a company finances its assets. A
company can finance its operations by either equity or different combinations of
debt and equity.
 The capital structure of a company can have a majority of the debt component
or a majority of equity, or an even mix of both debt and equity.
 Each approach has its own set of advantages and disadvantages.
 There are various capital structure theories that attempt to establish a
relationship between the financial leverage of a company (the proportion of
debt in the company’s capital structure) with its market value.
 One such approach is the Modigliani and Miller Approach.
 Introduction
 The Modigliani and Miller approach to capital theory, devised in the 1950s,
advocates the capital structure irrelevancy theory.
 The fundamentals of the Modigliani and Miller Approach resemble that of
the Net Operating Income Approach.
 This suggests that the valuation of a firm is irrelevant to the capital structure of
a company. Whether a firm is highly leveraged or has a lower debt component
has no bearing on its market value.
 The Modigliani and Miller Approach further states that the market value of a
firm is affected by its operating income, apart from the risk involved in the
investment.
 Assumptions
•There are no taxes.
•Transaction cost for buying and selling securities, as well as the bankruptcy
cost, is nil.
•There is a symmetry of information. This means that an investor will have
access to the same information that a corporation would and investors will
thus behave rationally.
•The cost of borrowing is the same for investors and companies.
•There is no floatation cost, such as an underwriting commission, payment to
merchant bankers, advertisement expenses, etc.
•There is no corporate dividend tax.
 Modigliani and Miller Approach

 The Modigliani and Miller Approach indicates that the value

of a leveraged firm (a firm that has a mix of debt and equity)
is the same as the value of an unleveraged firm (a firm that is
wholly financed by equity) if the operating profits and future
prospects are same.
 That is, if an investor purchases shares of a leveraged firm, it
would cost him the same as buying the shares of an
unleveraged firm.
Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1
 With the above assumptions of “no taxes”, the capital structure does not
influence the valuation of a firm.
 In other words, leveraging the company does not increase the market
value of the company.
 It also suggests that debt holders in the company and
equity shareholders have the same priority, i.e., earnings are split equally
amongst them.
Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 2
 It says that financial leverage is in direct proportion to the cost of equity. With an
increase in the debt component, the equity shareholders perceive a higher risk to
the company. Hence, in return, the shareholders expect a higher return, thereby
increasing the cost of equity.
 A key distinction here is that Proposition 2 assumes that debt shareholders have
the upper hand as far as the claim on earnings is concerned. Thus, the cost of
debt reduces.
 Proposition 2

Where WACC is the weighted-average cost of capital, kd is the cost of debt, ke is the

cost of equity, D is the absolute value of debt, E is the absolute value of equity
and V is the value of total assets of the company which is the sum of equity E and debt
D.

The above equation means that with an increase in debt-to-equity ratio (D/E), cost
of equity will increase resulting in a constant weighted-average cost of capital
(WACC) at any capital structure.
 Modigliani and Miller Approach: Propositions with Taxes
(The Trade-Off Theory of Leverage)
 The Modigliani and Miller Approach assumes that there are no taxes, but in
the real world, this is far from the truth. This theory recognizes the tax benefits
accrued by interest payments.
 The interest paid on borrowed funds is tax deductible. However, the same is
not the case with dividends paid on equity.
 In other words, the actual cost of debt is less than the nominal cost of debt
due to tax benefits.
 This brings us to M&M Theory 2 which relaxes the zero-tax assumption.
 Modigliani and Miller Approach: Propositions with Taxes
Proposition 1

In a tax environment, the value of a levered company is higher than the value of an
unlevered company by an amount equal to the product of absolute amount of debt
and tax rate. This can be expressed mathematically as follows:

VL = VUL + t × D

Where VL is the value of levered company i.e. company with some debt in

its capital structure, VUL is the value of an un-levered company i.e. with no

or lower debt, t is the tax rate and D is the absolute amount of debt.
 Modigliani and Miller Approach: Propositions with Taxes
Proposition 2
Since interest expense is tax-deductible, our equation for the weighted average
cost of capital modifies as follows:

WACC = ke × E/V + kd × (1 - t) × D/V

All other variables are the same as in Proposition 2 of Theory 1 except for the factor of
(1 − t) which represents the tax shield i.e. the decrease in effective cost of debt due to
existence of tax benefit of debt.
After some mathematical adjustment, we get the following function for cost of equity
in a positive-tax environment:
 Modigliani and Miller Approach: Propositions with Taxes

ke = WACC + (WACC − kd) × (1 − t) × D/E

The above equation is the same as in Proposition 2 of Theory 1 except for the factor
of (1 − t).
 The consequence of debt shield is that cost of equity increases with an increase
in D/E but the increase in less pronounced than in a no-tax environment.
 The implication of M&M theory with tax is that the capital structure is no longer
irrelevant.
 The value of a company with debt is higher than the value of a company with no
or lower debt.
 Modigliani and Miller Approach
Example: A company is considering a business in which the expected weighted average
cost of capital is 10% keeping in view the associated business risk. It has option to
incorporate in Country A which has no taxes or in Country B which as 20% corporate
taxes. If the company’s cost of debt is 6% in both countries, find out its cost of equity in
both countries at the following debt-to-equity ratio levels: (a) zero, (b) 1, and (c) 2.

Country A: Country A has no taxes, so we can use the cost of equity function
as in Proposition 2 of the Theory 1:
ke @ D/E of 0 = 10% + (10% − 6%) × 0 = 10%

ke @ D/E of 1 = 10% + (10% − 6%) × 1 = 14%

ke @ D/E of 2 = 10% + (10% − 6%) × 2 = 18%

 Modigliani and Miller Approach
We can demonstrate that the weighted average cost of capital at all level of debt-
to-equity ratio is the same i.e. 10%. Let’s see what happens at D/E of 1 or D/V of
50%: WACC = 50% × 6% + 50% × 14% = 10%

Country B: Existence of taxes creates a preference for debt resulting in a lower increase
in equity with addition of debt as demonstrated below:
ke @ D/E of 0 = 10% + (10% − 6%) × (1 − 20%) × 0 = 10%

ke @ D/E of 1 = 10% + (10% − 6%) × (1 − 20%) × 0 = 13.2%

ke @ D/E of 2 = 10% + (10% − 6%) × (1 − 20%) × 2 = 16.2%

The consequence of this less pronounced increase in cost of equity is that the weighted
average cost of capital decrease with increase in debt-to-equity ratio. Theoretically, the
value is maximized for an all-debt company.
Relation Between Capital
structure and corporate
Value
Relation Between Capital
structure and corporate
Value
optimal capital structure
 Optimal Capital Structure

 The capital structure is how a firm finances its

overall operations and growth by using
different sources of funds.
 The optimum capital structure indicates the
best debt-to-equity ratio for a firm that
maximizes its value.
 It is a financial measurement that firms use
to find out the best mix of debt and equity
financing to use for operations and
expansions.
 Optimal Capital Structure

The capital structure is said to be an optimal capital structure when

a company selects such a mix of debt and equity which:
 Minimises the overall cost of capital;
 Maximises the earning per share(EPS);
 Maximises the value of company;
 Maximises the market value of the company’s equity shares;
 Maximises the wealth of the shareholders.
 Features
 It maintains the financial stability of the firm.
 The finance manager determines the proportion of debt and equity in
such a manner that the financial risk remains low.
 The advantage of the leverage offered by corporate taxes is taken into
account in achieving the optimal capital structure.
 Borrowings help in increasing the value of company leading towards
optimal capital structure.
 The cost of capital reaches at its minimum and market price of share
becomes maximum at optimal capital structure.
 Optimal Capital Structure
Factors determining the optimum capital structure of an enterprise

1.Nature of business: The nature of business itself is one of the factors

determining a capital structure to be maintained.
2.Size of the company: Small enterprises have to rely less on borrowed capital
and depend more on owner’s capital.
3.Trading on equity: In case of trading on equity, there is greater dependence
on borrowed capital in the capital structure.
 Optimal Capital Structure

Factors determining the optimum capital structure of an enterprise

4.Cash flows: The more the cash inflows, more wilt be the amount (Ask)
of borrowed capital in the overall capital structure and vice-versa.
5.The purpose of financing: The purpose of financing also affects the
capital structure of the enterprise.
6.The condition of the future: The scope of changing the capital structure
in future is another basic consideration for determining capital the capital
structure of an enterprise