Capital Structure Theory

CAPITAL STRUCTURE THEORY

USE OF FINANCIAL LEVERAGE –

INCREASES SHAREHOLDERS EXPECTED RETURNS ALSO IT INCREASES RISK FOR SHAREHOLDERS

BECAUSE OF FINANCIAL LEVERAGE THE SHAREHOLDERS WILL ALSO HAVE TO BEAR FINANCIAL RISK ALONG WITH BUSINESS RISK

The question is:

Is the increase in expected return sufficient to compensate the risk? TO HELP ANSWER THIS QUESTION IT’S USEFUL TO EXAMINE CAPITAL STRUCTURE THEORY THEORY DOES NOT PROVIDE INSIGHTS INTO THE EFFECTS OF DEBT VERSUS EQUITY FINANCING AN UNDERSTANDING OF “CAPITAL STRUCTURE THEORY” WILL AID MANAGERS IN ESTABLISHING THEIR FIRM’S OPTIMAL CAPITAL STRUCTURE

ASSUMPTIONS OF THE THEORY 1. Firms employ only two types of capital: debt and equity 2. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debt. 3. Investors have the same subjective probability distributions of expected future operating earnings for a given firm. 4. The firm has a policy of paying 100 per cent dividends 5. The operating earnings of the firm are expected to be constant 6. The business risk is assumed to be constant and independent of capital structure and financial risk 7. The corporate and personal income taxes do not exist (Though the assumption is relaxed later)

NET INCOME APPROACH ACCORDING TO NET INCOME APPROACH: THE FIRM CAN INCREASE ITS VALUE OR LOWER THE OVERALL COST OF CAPITAL BY INCREASING THE PROPORTION OF DEBT IN THE CAPITAL STRUCTURE

ASSUMPTIONS OF NET INCOME APPROACH 1. The use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, ke, and the debt capitalisation rate kd, remain constant with changes in leverage 2. The debt capitalisation rate is less than the equity capitalisation rate 3. The corporate income taxes do not exist.

Assume that a firm has an expected annual net operating income of Rs.200,000, an equity rate, ke, of 10% and Rs. 10,00,000 of 6% debt. The value of the firm according to NET INCOME approach: Net Operating Income NOI 2,00,000 Total cost of debt Interest= KdD, (10,00,000 x .06) 60,000 Net Income Available to shareholders, NOI – I 1,40,000 Therefore:

Market Value of Equity (Rs. 140,000/.10) Market value of debt D (Rs. 60,000/.06) Total

14,00,000 10,00,000 24,00,000

The cost of equity and debt are respectively 10% and 6% and are Assumed to be constant under the Net Income Approach

Ko= NOI/V = 200,000/24,00,000 = 0.0833 Or Ko = Kd (D/V) + Ke (S/V) = 0.06 (10,00,000/24,00,000) + 0.10 (14,00,000/24,00,000) = 0.025 + 0.0583 = 0.0833 or 8.33% If the firm employs a debt or Rs.14,00,000 instead of Rs. 10,00,000 The value of the firm under NET INCOME approach will be

The value of the firm according to NET INCOME approach: Net Operating Income NOI 2,00,000 Total cost of debt Interest= KdD, (14,00,000 x .06) 84,000 Net Income Available to shareholders, NOI – I 1,16,000 Therefore:

Market Value of Equity (Rs. 116,000/.10) Market value of debt D (Rs. 60,000/.06) Total

11,60,000 14,00,000 25,60,000

Ko= NOI/V = 200,000/25,60,000 = 0.078125 Or Ko = Kd (D/V) + Ke (S/V) = 0.06 (14,00,000/25,60,000) + 0.10 (11,60,000/25,60,000) = 0.03281+ 0.04531 = 0.07812 or 7.81%

NET OPERATING INCOME APPROACH ACCORDING TO NET OPERATING APPROACH (NOI) THE MARKET VALUE OF THE FIRM IS NOT AFFECTED BY THE CHANGE IN CAPITAL STRUCTURE THE WEIGHTED AVERAGE COST OF CAPITAL IS SAID TO BE CONSTANT

ASSUMPTIONS OF NOI APPROACH 1. The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not important. 2. The market uses an overall capitalisation rate, Ko to capitalise the net operating income. Ko depends on the business risk. If the business risk is assumed to remain unchanged, Ko is a constant. 3. The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate to increase. Thus the

PROBLEM ON NOI APPROACH Assume that a firm has annual net operating income of Rs. 2,00,000, an average cost of capital Ko, of 10 % and initial debt of Rs.10,00,000 at 6% Net Operating Income,

2,00,000

Therefore:

Market value of the Firm, V = S + D = 2,00,000/0.10 =

20,00,000

Market value of the Debt, D

-10,00,000

Market value of the Equity S = V – D

10,00,000

Ko= NOI/V = 200,000/0.10 = 20,00,000 Here, Ke is not a constant as that in NI approach It is computed by using the formula Ke = Ko + (Ko-Kd)D/S = 0.10 + (0.10 – 0.06) 10,00,000/10,00,000 = 0.10 + 0.04 (1) = 0.14 To verify that the weighted average cost of capital is a constant: Ko = Kd (D/V) + Ke (S/V) = 0.06 (10,00,000/20,00,000) + 0.14 (10,00,000/20,00,000) = 0.06 (0.50) + 0.14 (0.5) = 0.03 + 0.07 = 0.10

IF DEBT IS INCREASED FROM 10,00,000 TO 14,00,000

Ke is not a constant in NOI approach It has to be computed by using the formula With the increase in leverage the cost of equity tends to go up Ke = Ko + (Ko-Kd)D/S = 0.10 + (0.10 – 0.06) 14,00,000/6,00,000 = 0.10 + 0.04 (2.33) = 0.1933 or 19.33% To verify that the weighted average cost of capital is a constant: Ko = Kd (D/V) + Ke (S/V) = 0.06 (14,00,000/20,00,000) + 0.1933 (6,00,000/20,00,000) = 0.06 (0.70) + 0.1933 (0.3) = 0.042 + 0.05799 = 0.9999 or 10%

THE TRADITIONAL VIEW THIS IS ALSO KNOWN AS INTERMEDIATE APPROACH IT IS A COMPROMISE BETWEEN THE NI & NOI APPROACH ACCORDING TO THIS VIEW THE VALUE OF THE FIRM CAN BE INCREASED OR THE COST OF CAPITAL CAN BE REDUCED BY A JUDICIOUS MIX OF DEBT AND EQUITY CAPITAL THIS APPROACH IMPLIES THAT THE COST OF CAPITAL DECREASES WITHIN THE REASONABLE LIMIT OF DEBT AND THEN INCREASES THE WITH LEVERAGE

TRADITIONAL VIEW FIRST STAGE In the first stage, the cost of equity rises less than proportionate to cost of debt ie It does not increase fast enough to offset the advantage of low cost debt During this stage the cost of debt, Kd, remains constant or rises negligibly on the assumption that the market views use of debt as a reasonable policy

SECOND STAGE Once the firm has reached a certain degree of leverage, A further increase in leverage will have a negligible effect on the value, or the cost of the capital of the firm.

B’cause The increase in the cost of equity due to the added financial risk offsets the advantage of low cost debt. At a specific point, the value of the firm will be maximum or the cost of capital will be minimum

THIRD STAGE Beyond the acceptable limit of leverage, the value of the firm decreases with leverage or the cost of the capital increases with leverage

B’cause the investors perceive a high degree of financial risk and increase equity capitalisation rate by more than to offset the advantage of low cost debt.

GRAPHIC PRESENTATION Y V A L E U O F S T O C K

Threshold Debt Level Where bankruptcy costs become material

Optimal capital structure Marginal tax shelter benefits = marginal Bankruptcy related costs

LEVERAGE

X

Some considerations in the Capital Structure Decision: 1. Managerial conservatism 2. Lender and Rating Agency Attitudes 3. Reserve Borrowing capacity and Financing Flexibility 4. Control 5. Business Risk 6. Asset Structure 7. Growth Rate 8. Profitability 9. Taxes 10. Market conditions

MM HYPOTHESIS 1. Securities are traded in the perfect capital market situation. 2. Investors are free to buy and sell securities 3. They can borrow without restriction at the same terms as the firms do; 4. Investors behave rationally 5. There is no transaction cost 6. Firms can be grouped into homogeneous risk classes 7. The expected NOI is a random variable, with a constant mean probability distribution and a finite variance 8. Firms distribute all net earnings to the shareholders, which means the dividend payout ratio is 100% 9. No corporate income taxes (later they relaxed)

Assignment Problem Capital Structure

Debt (Rs.)

Kd% Ke%

I

3,00,000

10.0 12.0

II

4,00,000

10.0 12.5

III

5,00,000

11.0 13.5

IV

6,00,000

12.0 15.0

V

7,00,000

14.0 18.0

SOLUTION Particulars

Plan I

II

III

IV

V

EBIT

300000

300000

300000

300000

300000

Less Interest

30,000

40,000

55,000

72,000

98,000

Net Profit

270,000

260,000

245,000

228,000

202,000

Ke

0.12

0.125

0.135

0.15

0.18

MV of Eq. MV of Debt Total Mkt. Value Ko

22,50,000 300,000 25,50,000 11.76

20,80,000 400,000 24,80,000 12.10

18,14,815 500,000 23,14,815 12.95

15,20,000 600,000 21,20,000 14.15

11,22,222 7,00,000 18,22,222 16.46

CASE – SOFT DRINK COMPANY A SOFT DRINK MANUFACTURING COMPANY IS PREPARING TO MAKE CAPITAL STRUTURE DECISION. IT HAS OBTAINED ESTIMATE OF SALES AND THE ASSOCIATED LEVELS OF EARNINGS BEFORE INTEREST AND TAXES FROM ITS FORECASTING GROUP. THE PROJECTED SALES ACCORDING TO THE GROUP ARE AS FOLLOWS:

PROJECTED SALES SALES (25% CHANCE) 400,000 SALES (50% CHANCE) 600,000 SALES (25% CHANCE) 800,000 FIXED OPERATING 200,000 COSTS

VARIABLE OPERATING COSTS

50% OF SALES

Further . . . . . . . .

COMPANIES CURRENT CAPITAL STRUCTURE LIABILITIES

AMOUNT ASSETS

AMOUNT

EQUITY

500,000 FIXED AND CURRENT

500,000

LONG TERM DEBT

000,000 MISC. EXPENSES

000,000

TOTAL

500,000 TOTAL

500,000

ASSUME THAT THE SHARE VALUE IS Rs. 20

ASSUMPTIONS UNDERLYING THE CASE 1. THE FIRM HAS NO CURRENT LIABILITIES 2. ITS CAPITAL STRUCTURE CURRENTLY CONTAINS ALL EQUITY AS IN THE B/S. 3. THE TOTAL AMOUNT OF CAPITAL REMAINS CONSTANT. THAT THE FIRM IS CONSIDERING SEVEN ALTERNATIVE CAPITAL STRUCTURES WITH A DEBT OF 0, 10, 20, 30,40,50 AND 60 PER CENTS AND THE RATE OF INTEREST WILL BE 9.0%, 9.5%, 10.0%, 11.0%, 13.5%, AND 16.5% RESPECTIVELY.

WHAT TO DO? AS A FINANCE MANAGER – USING THE DATA – DECIDE UP ON A CHOICE OF THE CAPITAL STRUCTURE THAT YOU WOULD ADVISE THE FIRM. THE REASONS FOR THE SPECIFIC PROPORTION OF USAGE OF DEBT i.e. LEVERAGE WHAT CAN BE THE BEST OPTION FOR THE FIRM; WHY YOUR OPTION IS THE BEST BET – REASONS TO SUBSTANTIATE THE SAME.