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Capital structure theories - NI Approach, NOI approach & MM Approach

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Capital structure theories - NI Approach, NOI approach & MM Approach. Meaning of capital structure , Features of An Appropriate Capital Structure, Determinants of Capital Structure, Planning the Capital Structure Important Considerations,

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FINANCIAL MANAGEMENT UNIT 04 CAPITAL STRUCTURE THEORIES
CONTENT Traditional view vs MM hypothesis, MM position I &II, Capital structure designing in practice – EBIT- EPS analysis, the pecking order theory. Factors impacting leverage decision
MEANING OF CAPITAL STRUCTURE Capital structure is proportions of debt Instruments, preferred and common stock on a company’s balance sheet. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid up share capital, share premium and reserves and surplus(Retained earnings).
FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE Optimal capital structure Profitability / Return Solvency / Risk Flexibility Conservation / Capacity Control Optimal 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.
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
Capital structure theories - NI Approach, NOI approach & MM Approach
PLANNING THE CAPITAL STRUCTURE IMPORTANT CONSIDERATIONS Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share. Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends. Risk: insolvency risk associated with high debt component. Control: avoid dilution of management control, hence debt preferred to new equity shares. Flexible: altering capital structure without much costs & delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and principal.
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
INTRODUCTION TO THE THEORY • Can a company affect its total valuation and its required return by changing its financing mix? • In this unit, we are going to find out what happens to the total valuation of the firm and to its cost of capital when the ratio of debt to equity, or degree of leverage, is varied. • We use a capital market equilibrium approach because it allows us to abstract from factors other than leverage that affect valuation.
ASSUMPTIONS AND DEFINITIONS To present the analysis as simply as possible, we make the following assumptions: 1. There are no corporate or personal income taxes and no bankruptcy costs. (Later, we remove these assumptions.) 2. There are no transaction costs-The ratio of debt to equity for a firm is changed by issuing debt to repurchase stock or issuing stock to pay off debt. 3. The firm has a policy of paying 100 percent of its earnings in dividends. Thus, we abstract from the dividend decision.
CONTD…. 4. Investors are rational-The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. 5. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.
CAPITAL STRUCTURE THEORIES The Net Income Approach (NI) The Traditional Approach The Net Operating Approach (NOI) The Modigliani- Miller Approach (MM)
NET INCOME APPROACH (NI) Net Income approach proposes that there is a definite relationship between capital structure and value of the firm. The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm. NI approach assumptions – • Continuous increase in debt does not affect the risk perception of investors. • Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ] • Corporate income taxes do not exist.
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
NET OPERATING INCOME Assumptions – WACC is always constant, and it depends on the business risk which remains constant. Value of the firm is calculated using the overall cost of capital i.e. the WACC only. Thus the split between debt and equity is not important. The cost of debt (Kd) is constant. Corporate income taxes do not exist.
NET OPERATING INCOME Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Thus there is no Optimal Capital Structure. NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (Ke) A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt (Kd ). In other words, the finance mix is irrelevant and does not affect the value of the firm.
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
Capital structure theories - NI Approach, NOI approach & MM Approach
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 referred to as asymmetric information. • Managers will issue debts when they are positive about their firms future prospects and will issue equity when they are unsure. • A commitment to pay to fixed amount of interest and principal to debt- holders implies that the company expects steady cash flows. On the other hand, an equity issue would indicate that the current share price is overvalued. • This implies that firms always use internal finance and choose debt over new issue of equity when external financing is required.
CONTD… • Hence Myers has called it the ‘ Pecking order’ theory . Since there is not well defined debt-equity target. • There are two kinds of equity, internal and external. • Debt is cheaper than internal and external equity because of interest deductibility. • Internal equity is cheaper and easier to use than external equity because 1. No taxes paid on retained earnings. 2. No transaction costs

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Capital structure theories - NI Approach, NOI approach & MM Approach

  • 1. FINANCIAL MANAGEMENT UNIT 04 CAPITAL STRUCTURE THEORIES
  • 2. CONTENT Traditional view vs MM hypothesis, MM position I &II, Capital structure designing in practice – EBIT- EPS analysis, the pecking order theory. Factors impacting leverage decision
  • 3. MEANING OF CAPITAL STRUCTURE Capital structure is proportions of debt Instruments, preferred and common stock on a company’s balance sheet. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid up share capital, share premium and reserves and surplus(Retained earnings).
  • 4. FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE Optimal capital structure Profitability / Return Solvency / Risk Flexibility Conservation / Capacity Control Optimal 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.
  • 5. 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
  • 7. PLANNING THE CAPITAL STRUCTURE IMPORTANT CONSIDERATIONS Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share. Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends. Risk: insolvency risk associated with high debt component. Control: avoid dilution of management control, hence debt preferred to new equity shares. Flexible: altering capital structure without much costs & delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and principal.
  • 10. INTRODUCTION TO THE THEORY • Can a company affect its total valuation and its required return by changing its financing mix? • In this unit, we are going to find out what happens to the total valuation of the firm and to its cost of capital when the ratio of debt to equity, or degree of leverage, is varied. • We use a capital market equilibrium approach because it allows us to abstract from factors other than leverage that affect valuation.
  • 11. ASSUMPTIONS AND DEFINITIONS To present the analysis as simply as possible, we make the following assumptions: 1. There are no corporate or personal income taxes and no bankruptcy costs. (Later, we remove these assumptions.) 2. There are no transaction costs-The ratio of debt to equity for a firm is changed by issuing debt to repurchase stock or issuing stock to pay off debt. 3. The firm has a policy of paying 100 percent of its earnings in dividends. Thus, we abstract from the dividend decision.
  • 12. CONTD…. 4. Investors are rational-The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. 5. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.
  • 13. CAPITAL STRUCTURE THEORIES The Net Income Approach (NI) The Traditional Approach The Net Operating Approach (NOI) The Modigliani- Miller Approach (MM)
  • 14. NET INCOME APPROACH (NI) Net Income approach proposes that there is a definite relationship between capital structure and value of the firm. The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm. NI approach assumptions – • Continuous increase in debt does not affect the risk perception of investors. • Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ] • Corporate income taxes do not exist.
  • 18. NET OPERATING INCOME Assumptions – WACC is always constant, and it depends on the business risk which remains constant. Value of the firm is calculated using the overall cost of capital i.e. the WACC only. Thus the split between debt and equity is not important. The cost of debt (Kd) is constant. Corporate income taxes do not exist.
  • 19. NET OPERATING INCOME Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Thus there is no Optimal Capital Structure. NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (Ke) A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt (Kd ). In other words, the finance mix is irrelevant and does not affect the value of the firm.
  • 31. 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 referred to as asymmetric information. • Managers will issue debts when they are positive about their firms future prospects and will issue equity when they are unsure. • A commitment to pay to fixed amount of interest and principal to debt- holders implies that the company expects steady cash flows. On the other hand, an equity issue would indicate that the current share price is overvalued. • This implies that firms always use internal finance and choose debt over new issue of equity when external financing is required.
  • 32. CONTD… • Hence Myers has called it the ‘ Pecking order’ theory . Since there is not well defined debt-equity target. • There are two kinds of equity, internal and external. • Debt is cheaper than internal and external equity because of interest deductibility. • Internal equity is cheaper and easier to use than external equity because 1. No taxes paid on retained earnings. 2. No transaction costs