capital structure theory

1. Capital Structure
Theories

2. Capital Structure And Value
• Capital structure decision is one of the key
decisions that focuses on finding the capital
structure with the objective of
maximisation of value of the firm.
• It is perhaps the key strategic decision that
has occupied much of the time and
attention of academicians and managers
alike.
• The issue revolves around the question of
an optimal capital structure, if there is any.

3. Common Assumptions
for the Analysis
• Following assumptions are required to
arrive at optimal capital structure
– To analyse effects of capital structure one form
of capital needs to be replaced with another
form
– Maximisation of value of the firm is consistent
with maximisation of shareholders’ wealth
– Optimal capital structure is one that minimises
WACC
– Earning levels remain constant

4. Target Capital Structure
• Target capital structure is the debt equity ratio
deemed most appropriate by the management.
• Target capital structure is determined by several
factors like
• taxes,
• Interest,
– And practical issues like
• market practices,
• lenders’ perspectives, and
• industry norms.

5. Net Income Approach
• Assumes that capitalisation of the firm is
based on the net income derived by each
supplier of capital discounted at fixed rates
irrespective of levels of debt.
E+D
EBIT
=
firmtheofueMarket val
supplierscapitalalltoEarnings
=kWACC;
.
E
I-EBIT
=
equityofueMarket val
rsshareholdeequityforEarnings
=kEquity;ofCost
D
i
=
debtofueMarket val
Interest
=kDebt;ofCost
e
d
o

6. Net Income Approach
Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value)
Debt (Book Value)
900.00
100.00
500.00
500.00
100.00
900.00
Capitalisation Rate
Equity, ke
Debt, kd
20%
10%
20%
10%
20%
10%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 50.00 90.00
EBT 490.00 450.00 410.00

7. Net Income Approach
Capitalization Rates
EBT 490.00 450.00 410.00
Taxes Assumed no taxes
Earnings available to
shareholders
490.00 450.00 410.00
Market value of debt
(I/kd)
100.00 500.00 900.00
Market value of equity
(EBIT – I - Taxes)/ke
2,450.00 2,250.00 2,050.00
Total Value of the firm 2,550.00 2,750.00 2,950.00
Overall capitalisation
rate (k)
19.61% 18.18% 16.95%

8. Net Income Approach
Rates of Return
ke
k
kd
0 D/E

9. Net Income Approach
Optimal Capital Structure
• Net Income approach assumes that capitalisation
rates are constant and increasing debt would
– reduce overall capitalization rate (WACC), and
– increase the value of the firm.
• Optimal capital structure under net income
approach is 100% debt
DE
D
k
DE
E
kk de





10. Net Operating Income Approach
Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value)
Debt (Book Value)
900.00
100.00
500.00
500.00
100.00
900.00
Capitalisation Rate
Debt
Overall
10%
20%
10%
20%
10%
20%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 50.00 90.00
EBT 490.00 450.00 410.00

11. Net Operating Income Approach
• Under net operating income approach the cost of
equity rises so as to compensate the reduced cost
of debt keeping the overall capitalisation rate
constant.
Scenario A : ke = 20 + (20 - 10) x 100/2400 = 20.42%
Scenario B : ke = 20 + (20 - 10) x 500/2000 = 22.50%
Scenario C : ke = 20 + (20 - 10) x 900/1600 = 25.63%
E
D)k-(k+k= d00ek

12. Net Operating Income Approach
Capitalization Rates
• Under net operating income approach no capital
structure is optimal, alternatively all capital structures
are optimal.
NET OPERATING INCOME APPROACH: CAPITALISATION RATES
Rates of
Return
ke
k0
k
kd
0 D/E
de k
DE
D
k
DE
E
k



0

13. Traditional Approach
• Initially the cost of capital for the firm will fall as cheaper
debt replaces expensive equity.
• Even though the cost of equity rises with increased debt the
advantages of debt would outweigh the increased cost of
equity.
• Beyond a certain level of leverage the cost of equity starts
rising disproportionately, more than offsetting the
advantage of debt, raising the overall cost of capital for the
firm.
• Since cost of capital falls initially and then starts rising there
exists a point where cost of capital would be least.
• This point of least cost of capital would maximise the value
of the firm and is the optimal capital structure.

14. Traditional Approach
Scenario A Scenario B Scenario C
Project Cost 1,000.00 1,000.00 1,000.00
Sources of Finance
Equity (Book Value)
Debt (Book Value)
900.00
100.00
500.00
500.00
100.00
900.00
Capitalisation Rate
Debt
Equity
10%
20%
11%
20%
12%
30%
EBIT 500.00 500.00 500.00
Interest (I) 10.00 55.00 108.00
EBT 490.00 445.00 392.00

15. Traditional Approach
Capitalization Rates
• With increasing level of debt the overall cost of capital falls
initially because cost of debt is less than the cost of equity,
thereafter it rises because equity holders expect greater
returns due to increasing perceived risk from the debt
holders.
Rates of
Return c = optimal capital structure
ke
k0
k
kd
O C D/E

16. Modigliani And Miller (MM) Theory –
Without Taxes
• Capital structure is irrelevant.
• The value of levered firm and
unlevered firm would be equal.
VU = VL

17. MM Proposition II
Without Taxes
• With increasing leverage the cost of equity
rises exactly to offset the advantage of
reduced cost of debt.
• To keep the value of the firm constant.
• The cost of equity for varying levels of debt
is given by:
E
Dkkkk de )-( 00 

18. MM Theory – Arbitrage
• MM Proposition of irrelevance of capital
structure is based on the principle of
arbitrage i.e. the discrepancy in valuation of
levered firm and unlevered firm would be
set right by investors by selling the
overvalued and buying the undervalued
asset.

19. MM Theory – Arbitrage
ALLEQ CODEQ
EBIT 5,00,000 5,00,000
Interest @ 10% - 1,00,000
EBT 5,00,000 4,00,000
Taxes (Assumed no taxes) - -
EAT 5,00,000 4,00,000
Market value of debt - 10,00,000
Market value of equity,
capitalisation rate 20%
25,00,000 20,00,000
Value of the firm 25,00,000 30,00,000

20. MM Theory - Arbitrage
25,00,000Rs.
0.2
5,00,000
k
Dividend
=
k
suppliersequitytoEarnings
=ALLEQofequitytheofueMarket val

20,00,000Rs.
0.2
4,00,000
k
Dividend
=
k
suppliersequitytoEarnings
=CODEQofequityofueMarket val

00Rs.10,00,0=
0.10
1,00,000
=
k
Interest
=CODEQofdebtofueMarket val
d

21. MM Theory – Arbitrage
• An investor owns 10% of CODEQ. Since ALLEQ is
cheap, he sells holding in CODEQ and realizes Rs.
2,00,000 (10% of the market value he holds).
• To keep his risk profile identical to that of CODEQ
he borrows an amount equal to 10% of debt of
CODEQ.
• The cost of his borrowing is assumed identical to
that of CODEQ i.e. 10%.
• He borrows Rs. 1,00,000 (10% of the value of debt of
CODEQ).
• To keep position same he acquires 10% of ALLEQ
by investing Rs. 2,50,000 (10% of market value of
ALLEQ).

22. MM Theory – Arbitrage
Cash flow and returns for investor swapping position Rs.
Swapping position - Cash flow
Initial cash flow
Selling 10% of CODEQ
Borrowing
Investing 10% in ALLEQ
Surplus (Deficit) cash
+2,00,000
+1,00,000
- 2,50,000
+ 50,000
If invest in
CODEQ
If invest in
ALLEQ
Returns
10% of shareholders’ fund
Less: Borrowing cost
Net Income
40,000
-
40,000
50,000
10,000
40,000

23. Assumptions and Limitations
MM’s Theory of Irrelevance
• Identical expectations of earnings.
• All earnings are distributed.
• No transaction cost.
• Free and instantaneous flow of information.
• Absence of taxes.
• Replication of leverage in personal capacity,
the home made leverage.

24. MM Theory - With Taxes
ALLEQ CODEQ
EBIT 5,00,000 5,00,000
Interest @ 10% - 1,00,000
EBT 5,00,000 4,00,000
Taxes @ 40% 2,00,000 1,60,000
EAT 3,00,000 2,40,000
Earnings available to
suppliers of debt and equity
3,00,000 3,40,000

25. MM Theory
Value of Firm With Taxes
VL = VU + T x D
0
)1(
r
TEBIT
VU 
TD+
k
T)(1EBIT
k
kxDxT
+
k
T)(1xEBIT
=
ShieldTaxofValue+V=V
0
d
d
0
UL


26. MM Theory
Value of Firm With Taxes
VL = VU + T x D
0
)1(
k
TEBIT
VU 
TD+
k
T)(1EBIT
k
kxDxT
+
k
T)(1xEBIT
=
ShieldTaxofValue+V=V
0
d
d
0
UL


27. MM Theory
Capitalization Rates With Taxes
• In the presence of corporate tax the optimal capital
structure would be 100% debt according to MM
propositions
M & M POSITION (with taxes)
VALUE OF THE FIRM
Value
VL
PVTS=TxD
VU
D/E
M & M POSITION (With Taxes)
CAPITALISATION RATES
Rates of
Return
ke
k0 k
kd(1-T)
D/E

28. MM Theory Of Irrelevance
MMs Propositions – With and Without Corporate Taxes
Without Taxes With Taxes
Proposition I
Value of the firm
VL = VU
VL = E + D
VL = VU + PVTS
VU = EBIT (1-T)/k0
Proposition II
Cost of equity
Proposition III
Cost of capital
WACCU = WACCL = k0
E
D
kkkk de )-( 00 
E
TD
kkkk de
)-1(
)-( 00 
DE
TD
k
DE
E
kkWACC
ED
PV
WACCWACC
deL
TS
UL












)-1(
;
)-1(
DE
D
k
DE
D
kkWACC de



;

29. Cost Of Financial Distress &
Agency Cost
• Costs of financial distress tend to decrease the
value of the firm offsetting some of the advantage
of tax shield of debt.
– Agency Cost of Debt
– High amount of debt is against the principles of
capital budgeting and encourages managers to
take undue risk to increase the welfare of
shareholders at the expense of debt holders.
– Agency cost of debt relate to the conflict of
interest between debt holders and shareholders.

30. Trade Off Theory Of Capital
Structure
TRADE OFF THEORY
COST OF FINANCIAL DISTRESS AND TAX SHIELD
Market value of the firm
Cost of financial distress and agency
Value of
the firm
Value of tax shield
Value of unlevered firm
Optimal capital Debt/Equity
structure

31. Donaldson’s
Pecking Order Theory
• Donaldson study suggests the pecking order of
financing specifies that firms
1. will finance from internal accruals, then
2. raise debt or convertible debt, and finally
3. resort to issue of equity.
• Pecking order theory relies on the assumption
that mobilization of fresh capital is not greeted
with cheers in the capital markets.

32. Signalling, Asymmetric Information
Theory
• Contradiction in Donaldson’s pecking
order and trade off models can be
explained partially on the information
asymmetry that exists between
shareholders and managers of the firm.

33. Free Cash Flow Hypothesis
• Free cash flow hypothesis states that
managers would have tendency to waste
if cash available is high. Debt would
reduce the availability of free cash flow
and therefore check indiscretion.