capital structure theories

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Capital Structure :

Capital Structure

Capital structure :

Issues: What is capital structure and optimal capital structure? What are the sources of capital available to a company? Why is it important? What are the main theories of capital structure? Is there an optimal capital structure? Capital structure

What is “Capital Structure”?:

Definition Capital Structure: The capital structure of a firm is the mix of different sources of finance used by the firm to finance its operations . Optimal Capital Structure: The capital structure or combination of debt and equity at which the WACC is minimum and it leads to maximum value of the firm What is “Capital Structure”?

Sources of capital:

Debt Bank loans Corporate bonds Equity Ordinary shares (common stock) Preference shares (preferred stock) Retained Earnings Sources of capital

Why is it important?:

Capital Structure affects the value of the firm by affecting either: Cost of Capital, or Expected earnings, or Both Why is it important?

Capital Structure Theories:

Basic question Is it possible for firms to create value by altering their capital structure? Major Theories Net Income Approach Net Operating Income Approach Modigliani- Miller (MM) Approach Traditional Approach Capital Structure Theories

Assumptions – CS Theories :

There are only two sources of funds used by a firm. There are no corporate taxes. This assumption is removed later. The dividend-payout ratio is 100. The total assets are given and do not change. The total financing remains constant. The firm can change its degree of leverage (capital structure. The operating profits (EBIT) are not expected to grow. All investors – same expectation for the future expected EBIT for a given firm. Business risk is constant over time and is assumed to be independent of its capital structure and financial risk. Perpetual life of the firm. Assumptions – CS Theories

Symbols – CS Theories:

E = Total market value of equity D = Total market value of debt V = Total market value of firm = D + E I = Total Interest payments NI = Net Income available to equity-holders D 1 = Net Dividend P 0 = Current Mkt price of shares g = growth rate b = retention rate r= rate of return Symbols – CS Theories

Definitions – CS Theories:

Cost of debt k d Cost of Equity k e Per share basis Total basis Overall Cost of Capital or WACC k o Definitions – CS Theories


Capital structure is relevant It affects overall cost of capital and value of the firm & market price of ordinary shares Assumptions: No Taxes K d < K e Use of debt does not change the risk perception of investors Implications of the assumptions NET INCOME (NI) APPROACH


NOI is diametrically opposite of NI Approach Capital structure decision is irrelevant NOI is based on the following propositions: k o is constant E = V- D Increase in D/E ratio = Increase in k e K d has two parts – Explicit cost & Implicit cost Nothing such as optimum capital structure. MPS will also not get affected. NET OPERATING INCOME (NOI) APPROACH


It supports the NOI Approach- k o and V do not change with change in degree of leverage. NOI is definitional or Conceptual. MM Approach offers operational justification. Basic Proposition : k o and V are constant for all degrees of leverage MODIGILIANI-MILLER (MM) APPROACH

MM APPROACH - Assumptions:

Perfect Capital Markets. Securities are infinitely divisible. Investors are free to buy/sell. Investors can borrow freely and at the same rate of interest as the corporation. No transactions costs. Information is perfect i.e. each investor has the same information. Investors are rational. MM APPROACH - Assumptions


All investors have same expectation of firms EBIT with which to evaluate the firm. All firms within an industry have the same risk regardless of capital structure The dividend pay-out ratio is 100%. All earnings are paid out as dividends (thus, earnings are constant and there is no growth) No taxes (we will relax this assumption subsequently) contd …..

MM – Operational Justification:

Arbitrage Process Illustrated with reference to two identical firms, differing only in their capital structure, must have identical total values. If they did not, individuals would engage in arbitrage and create the market forces that would drive the two values to be equal. Risk is not increased ‘Personal’ Leverage or ‘Home-made’ leverage MM – Operational Justification

MM APPROACH - Limitations:

Risk Perception Convenience Cost Institutional Restrictions Double Leverage Transaction Costs Taxes MM APPROACH - Limitations


MM agree the V will increase and ko will decline with leverage, if corporate taxes are introduced Tax deductibility of interest payments MM states that V l = V u + Dt Implication – V is maximized when CS contains only D However Excessive use of debt has certain disadvantages Optimal CS is not one that has max debt but one which has the desired amt of debt, determined at a point where ko is minimum. MM APPROACH – Taxes


Midway between NI and NOI Approach – Intermediate Approach NI Approach Agrees - k o and V are not independent of CS Disagrees – V will increase for all degrees of leverage NOI Approach Agrees – Beyond a certain degree of leverage, k o increase leading to decrease in V Disagrees – WACC is constant for all degrees of leverage TRADITIONAL APPROACH


A judicious combination of Debt and Equity, a firm can increase its V and reduce its k o upto a certain point. Beyond a certain point, use of additional debt will lead to increase in k o . At this point the CS is optimum i.e k d = k e . Effect of Increase in leverage on k o and V involves three phases U-shaped cost of capital. TRADITIONAL APPROACH - Crux

WACC (intermediate view):

k D E k d k e WACC - k o WACC (intermediate view)

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