Capital Structure

CAPITAL STRUCTURE

Capital Structure Capital Structure This is concerned with the question as to whether there is an optimal capital mix of debt and capital which a company should try to achieve. There are three major theories:  Net Income (NI) approach  Traditional view  Modigliani and Miller 

Net Income Approach  

Suggested by David Durand Capital structure affect the value of the firm  Change

in the capital structure causes a corresponding change in the overall cost of capital and the total value of the firm

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Higher financial leverage will result in the decline in the WACC  Causing

the increase in the value of the firm  And the increase in the value of the firm

Net Income Approach 

Assumptions of the NI Approach

ii. There are no corporate taxes iii. The cost of debt is less than the cost of equity iv. The debt content does not change the risk perception of the investors 

The value of the firm V = Ve + Vd Where Ve = Market value of equity Vd = market value of debt Ve= NI/re

Traditional View 

The traditional view of Capital structure  There

is an optimal capital structure  The company can increase its total value by a suitable debt finance in its capital structure.

Assumptions: c) The company pays out all its earnings as dividends d) The leverage of the company can be changed immediately by issuing debt

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Traditional View Assumptions: b) The company pays out all its earnings as dividends c) The leverage of the company can be changed immediately  

by issuing debt to purchase shares, or by issuing shares to repurchase debt

d) The earnings of the company are expected to remain constant in perpetuity 

and all investors share the same expectations

e) Business risk is also constant, regardless of how the company invests its funds f) Taxation, for the time being, is ignored

Traditional View a) As the level of leverage increase, the cost of debt remains unchanged up to a certain level.  Beyond this level the cost of debt will increase b) The cost of equity rises as the level of leverage increases and financial risk increases.  There is a non-linear relationship between the cost of equity and leverage c) The WACC does not remain constant  falls initially as the proportion of debt capital increases  Then begins to increase as the rising cost of equity becomes significant

Traditional View d) The optimum level of leverage is where the company WACC is minimized.

Modigliani-Miller (MM) View Assumptions of MM view b) A perfect capital market exists in which 

  

c) d)

investors have the same information Upon which they act rationally To arrive to the same expectations about future earnings and risks

There are no taxes or transaction costs Debt is risk-free and freely available at the same cost to investors and companies alike.

Modigliani-Miller (MM) View 

In 1958 Modigliani and Miller proposed MM Proposition I  The

total market value of a company, in the absence of tax will be determined by two factors 3. Total earnings of the company 4. The level of operating risk attached to those earnings (The total market value would be computed by discounting the total earnings at a rate that is appropriate to the level of operating risk. The WACC) Thus the capital structure has no effect on the

Modigliani-Miller (MM) view MM justified their approach by the use of arbitrage. MM Proposition II 3. The cost of debt remains unchanged as the level of leverage increases 4. The cost of equity rises in such a way as to keep the WACC constant. 

Graphical MM view The MM view would be represented on a graph as shown below

Modigliani-Miller (MM) view  

Summing up MM view: MM hypothesis is based on the idea that  No

matter how you divide up the capital structure of a firm among debt, equity and other claims, there is a conservation of investment value  Since total investment value of a corporation depends on its underlying profitability and risk.  Total investment value is invariant w.r.t. relative changes in the firm’s financial

Market imperfections 

In 1963 MM modified their theory  Admitted

the effect of tax relief on interest payment to the WACC



Interest on debt is tax deductible  Saving

from tax relief on debt is called tax

shield.  They claimed that the WACC will continue to fall up to 100% gearing.  This suggests that companies should have a capital structure made up entirely of debt.  This does not happen because of market imperfections

Market imperfections 

Value of the interest tax shield = (T x rd x Vd )/rd

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= T x Vd

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VL = VU + (TxVd)

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Vu = EBIT (1-T)/rU

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Taxes, WACC and Proposition II

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WACC(rA) =

Market imperfection  

 

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re = rA + (rA –rd) (Vd/Ve) MM demonstrates that in the world with corporate taxes re = ru + (ru –rd) (Vd/Ve)x (1-T) This results indicates a positive relationship between the expected return on equity and debt equity ratio It implies that the rA decreases as the amount of debt increases

Market Imperfections 1.

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Bankruptcy costs One assumption of MM theory is perfect capital market But in reality, at higher levels of leverage there is an increasing risk of the company being unable to meet its interest payment and being declared bankrupt At these higher levels of leverage the bankruptcy risk means that required rate of return will be higher.

Market Imperfections 2. Agency Costs  At Higher levels of leverage, there are also agency costs  



Due to actions taken by concerned debt holders Restrictive covenants: limit to dividends and minimum level of liquidity, by debt providers to protect investments. Higher levels of monitoring

Market Imperfections 3. Tax Exhaustion  As the companies increase their level of leverage 





they may reach a point where there are not enough profits from which to obtain all available tax benefits Bankruptcy and agency costs will rise, but benefits of tax shield will not rise sufficiently.

So market imperfections undermine the tax advantage of debt finance.

Optimal Capital Structure 



Financial distress costs are insignificant for a firm with little or no debt. so if an unlevered firm adds a small amount of debt  It

benefits from the tax shield on debt  Without incurring significant costs of financial distress 

As a firm uses more and more debt  The

tax savings are eventually offset by the higher likelihood of financial distress

Optimal Capital Structure The point where these two factors offset each other is where the firm value is maximized. STATIC THEORY OF CAPITAL STRCUTURE  A Firm uses debt financing up to the point where tax benefits from additional debt exactly offsets the cost associated with an increased likelihood of financial distress. 

 That 

is the optimal capital structure

Optimal capital structure  Minimum

WACC  Maximizes the firm value

Optimal Capital Structure 

2.

3.

4.

Recommendations From The Static Theory of Capital Firms with higher tax rates should borrow more as long as they don’t have other tax shields Firms with higher risk of distress (due to higher operating risks) should borrow less Firms for which the cost of financial distress is higher should borrow less