Capital Structure Theories

Capital Structure Theories

• Traditional Approach

• Modern Approach

Traditional Theories

Net Income Approach

• Suggested by Durand

• Assumptions– No corporate taxes

– Kd<ke

– Increase in Debt doesn’t increase risk perception

Net Income Approach

• Financial leverage decreases WACC (ko)

• Increase in debt weight decreases weight of equity (we)

• Cost of debt (kd) and cost equity (ke) remains constant

• ko comes down due to decreasing (we)

• Financial leverage increases value of firm

Net Income ApproachWd Kd Ke We Ko

0.0 12.0 20.0 1.0 20.0

0.1 12.0 20.0 0.9 19.2

0.2 12.0 20.0 0.8 18.4

0.3 12.0 20.0 0.7 17.6

0.4 12.0 20.0 0.6 16.8

0.5 12.0 20.0 0.5 16.0

0.6 12.0 20.0 0.4 15.2

0.7 12.0 20.0 0.3 14.4

0.8 12.0 20.0 0.2 13.6

0.9 12.0 20.0 0.1 12.8

1.0 12.0 20.0 0.0 12.0

Net Income Approach

0.02.04.06.08.0

10.012.014.016.018.020.022.0

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Debt Ratio

Cos

t of c

apita

l KeKoKd

Net Operating Income Approach

• Proposed by Durand• There is no optimal capital structure and any

combination is good• Assumptions

– No corporate taxes– ko remains constant for all degrees of capital mix– Market capitalizes the value of a firm as a whole and

split between debt and equity is not important– kd remains constant – Debt increases equity share holders risk further

increasing ke

Net Operating Income Approach

• Increase in debt enhances equity risk

• Debt increases cost of equity ke

• Increased debt weight keeps ko constant

• Financial Leverage doesn’t influence the value of the firm

Net Operating Income Approach

0.02.04.06.08.0

10.012.014.016.018.020.022.024.026.028.030.032.0

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Debt Ratio

Cos

t of c

apita

l KeKoKd

Traditional Approach

• An intermediate approach between NI and NOI approaches

• Optimal capital structure lies where Ko is minimum

Traditional Approach

• kd remains constant till appoint of leverage and rises after that

• ke rises constantly till a point of leverage and rises sharply after that

• ko decreases till some extent, remains constant till a point and rises beyond that

Traditional Approach

0.02.04.06.08.0

10.012.014.016.018.020.022.024.026.028.030.032.0

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Debt Ratio

Co

st o

f ca

pit

al KeKoKd

Modern Capital Structure Theories

Modern Capital Structure Theories

• MM theory– Zero taxes

– Corporate taxes

– Corporate and personal taxes

• Trade-off theory

• Signaling theory

• Debt financing as a managerial constraint

MM Theory

Assumptions

• Perfect capital markets

• No brokerage

• No bankruptcy costs

• Personal and corporate borrowing rates are same

• Investors have all company information

MM Theory: Zero Taxes

• Propositions– Proposition I : VL = VU = EBIT/WACC – Proposition II :keL= keU + Risk Premium = keU +(keU-kd)(D/E)

• MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:

VL = VU.• Therefore, capital structure is irrelevant.

• Any increase in ROE resulting from financial leverage is exactly offset by the increase in weight of debt so WACC is constant.

MM Theory: Corporate Taxes

• Corporate tax laws favor debt financing over equity financing.

• With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.

• Propositions

– Proposition 1 : VL = VU + Present value of tax shields

= VU + TD.

Proposition 2 : KeL = KeU +(KeU-kd)(1-T)(D/E)

• Optimum capital structure is virtually 100% debt

• Ke increases as leverage increases but not at a pace without taxes

• WACC falls as debt is added.

MM Theory and Hamada’s Equation

• Increase in debt increases risk faced by shareholders

• Hence keL increases

• Beta of companies with equity and mix of debt are different– ßL = ßU [ 1 + (1-T)(D/E) ]– ßU = ßL / [ 1 + (1-T)(D/E) ]

• CAPM can be expressed as

keL = kf + (km - kf) ßU[ 1 + (1-T)(D/E)]

Value of Firm, V

0Debt

VL

VU

Firm value and debt with corporate taxes

Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.

TD

Cost of Capital (%)

0 20 40 60 80 100Debt/Value Ratio (%)

MM relationship between capital costs and leverage when corporate taxes are considered.

ke

WACCkd(1 - T)

Trade-off Theory

• MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.

• At low leverage levels, tax benefits outweigh bankruptcy costs.

• At high levels, bankruptcy costs outweigh tax benefits.

• An optimal capital structure exists that balances these costs and benefits.

Signaling Theory

• MM assumed that investors and managers have the same information.

• But, managers often have better information. Thus, they would:– Sell stock if stock is overvalued.– Sell bonds if stock is undervalued.

• Investors understand this, so view new stock sales as a negative signal.

• Implications for managers?– Issue of debt sends positive or at least neutral signal to share holders. – Companies would try to avoid issue stock to avoid negative signal and maintain

reserve borrowing capacity

Optimum Capital Structure

Features of an optimum capital structure

• Low cost of capital

• Maximize value of the firm

• Maximize market price of the stock

Market price of the stock

• Debt raises equity risk

• Equity risk makes stocks price to come down

• Higher ROE raises stock price

Optimum Capital Structure and Market price of the stock

• Stock prices fall to a given increase in debt

• Stock prices go up as ke goes up due increase in financial risk

• It is difficult to measure optimum mix of debt and equity as it is difficult to measure the fall/gain of market price of the stock to a given increase in debt component

Process of Estimating Optimum Capital Structure

• Estimating Cost of Debt

• Estimating Cost of Equity

• Estimating WACC

• Estimating Firm’s Value

• Estimating Share holders wealth and stock price

Optimum Capital Structure

Debt in %

D/E After Tax Kd

Estimated ß

Ke WACC Firm Value

0 0 4.80 1.00 12.0 12.00 200,000

10 11.11 4.80 1.07 12.4 11.64 206,186

20 25.00 4.86 1.15 12.9 11.29 212,540

30 42.86 5.10 1.26 13.5 11.01 217,984

40 66.67 5.40 1.40 14.4 10.80 222,222

50 100 6.60 1.60 15.6 11.10 216,216

60 150 8.40 1.90 17.4 12.00 200,000

Thank You

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