Unit – 3

Capital Structure

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 INTRODUCTION
• The objective of a firm should be directed
towards the maximization of the firm’s value.

• The capital structure or financial leverage

decision should be examined from the point of
its impact on the value of the firm.

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Capital Structure Theories:

1. Net income (NI) approach and

2. Traditional approach
3. Net operating income (NOI) approach.
4. MM hypothesis with and without corporate tax.

– Miller’s hypothesis with corporate and personal taxes.

– Trade-off theory: costs and benefits of leverage.

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 1. 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.
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The effect of leverage on the cost of
capital under NI approach

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 2. 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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 Traditional approach….

Cost

ke

ko

kd

Debt

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 Traditional approach…..

• The traditional theory on the relationship between

capital structure and the firm value has three stages:
• First stage: Increasing value
• Second stage: Optimum value
• Third stage: Declining value

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3. 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.
• MM’s approach is a Net Operating Income approach.

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4. The cost of capital under MM
proposition I

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 4. MM’s Proposition II
• Financial leverage causes two opposing effects: it increases
the shareholders’ return but it also increases their financial
risk. Shareholders will increase the required rate of return
(i.e., the cost of equity) on their investment to compensate
for the financial risk. The higher the financial risk, the higher
the shareholders’ required rate of return or the cost of equity.
• The cost of equity for a levered firm should be higher than the
opportunity cost of capital, ka; that is, the levered firm’s ke >
ka. It should be equal to constant ka, plus a financial risk
premium.

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 Criticism of the MM Hypothesis
• Lending and borrowing rates discrepancy
• Non-substitutability of personal and corporate
leverages
• Transaction costs
• Institutional restrictions
• Existence of corporate tax

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CAPITAL STRUCTURE PLANNING AND POLICY

• Theoretically, the financial manager should plan an

optimum capital structure for the company. The
optimum capital structure is one that maximizes the
market value of the firm.
• The capital structure should be planned generally,
keeping in view the interests of the equity shareholders
and the financial requirements of a company.
• While developing an appropriate capital structure for its
company, the financial manager should inter alia aim at
maximizing the long-term market price per share.

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 Elements of Capital Structure
1. Capital mix
2. Maturity and priority
3. Terms and conditions
4. Currency
5. Financial innovations
6. Financial market segments

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 Framework for Capital Structure:
The FRICT Analysis

• Flexibility
• Risk
• Income
• Control
• Timing

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Practical Considerations in Determining
Capital Structure
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack
7. Sustainability and Feasibility
8. Control
9. Marketability and Timing
10. Issue Costs
11. Capacity of Raising Funds

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RELEVANCE OF CAPITAL
STRUCTURE:
THE MM HYPOTHESIS UNDER
CORPORATE TAXES

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• MM show that the value of the firm will
increase with debt due to the deductibility of
interest charges for tax computation, and the
value of the levered firm will be higher than of
the unlevered firm.

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Example: Debt Advantage: Interest Tax Shields

• Suppose two firms L and U are identical in all respects except that firm L is
levered and firm U is unlevered. Firm U is an all-equity financed firm while
firm L employs equity and Rs 5,000 debt at 10 per cent rate of interest.
Both firms have an expected earning before interest and taxes (or net
operating income) of Rs 2,500, pay corporate tax at 50 per cent and
distribute 100 per cent earnings as dividends to shareholders.

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• You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered
firm L’s investors are ahead of the unlevered firm U’s investors by Rs 250.
You may also note that the tax liability of the levered firm L is Rs 250 less
than the tax liability of the unlevered firm U. For firm L the tax savings has
occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5 ×
(0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,

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 Value of Interest Tax Shield
• Interest tax shield is a cash inflow to the firm and therefore, it is
valuable.
• The cash flows arising on account of interest tax shield are less risky
than the firm’s operating income that is subject to business risk.
Interest tax shield depends on the corporate tax rate and the firm’s
ability to earn enough profit to cover the interest payments.
• The corporate tax rates do not change very frequently.
• Under the assumption of permanent debt, the present value of the
present value of interest tax shield can be determined as follows:

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Value of the Levered Firm

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Value of the levered firm

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Why do companies not employ extreme level of
debt in practice?

• First, we need to consider the impact of both corporate

and personal taxes for corporate borrowing. Personal
income tax may offset the advantage of the interest tax
shield.

• Second, borrowing may involve extra costs (in addition to

contractual interest cost)—costs of financial distress—
that may also offset the advantage of the interest shield.

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 PECKING ORDER THEORY
• The “pecking order” theory is based on the assertion that managers
have more information about their firms than investors. This disparity
of information is referred to as asymmetric information.
• The manner in which managers raise capital gives a signal of their
belief in their firm’s prospects to investors.
• This also implies that firms always use internal finance when
available, and choose debt over new issue of equity when external
financing is required.
• The pecking order theory is able to explain the negative inverse
relationship between profitability and debt ratio within an industry.
• However, it does not fully explain the capital structure differences
between industries.

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