CAPITAL STRUCTURE THEORY

CAPITAL STRUCTURE THEORYCAPITAL STRUCTURE AND VALUECapital 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.2Practical Considerations in Determining Capital StructureAssetsGrowth OpportunitiesDebt and Non-debt Tax ShieldsFinancial Flexibility and Operating StrategyLoan CovenantsFinancial SlackControlMarketability and TimingIssue CostsCapacity of Raising Funds3COMMON ASSUMPTIONS FORTHE ANALYSISFollowing assumptions are required to arriveat optimal capital structure To analyse effects of capital structure one form of capital needs to be replaced with another formMaximisation of value of the firm is consistent with maximisation of shareholders wealthOptimal capital structure is one that minimises WACC Earning levels remain constant4CAPITAL STRUCTURE THEORIESNet Income ApproachNet Operating Income ApproachTraditional ApproachMM Theory of Capital Structure5NET INCOME APPROACHNet Income (NI) 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.6NET INCOME APPROACH

7NET INCOME APPROACHCAPITALIZATION RATES

8NET INCOME APPROACHKo = Ke (Ke-Kd)*D/V

9NET INCOME APPROACHOPTIMAL CAPITAL STRUCTURENet 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% debt10NET OPERATING INCOMEAPPROACH

11NET OPERATING INCOMEAPPROACH

12NET OPERATING INCOMEAPPROACHUnder 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 : re = 20 + (20 10) x 100/2400 = 20.42%Scenario B : re = 20 + (20 10) x 500/2000 = 22.50%Scenario C : re = 20 + (20 10) x 900/1600 = 25.63%13NET OPERATING INCOMEAPPROACH- CAPITALIZATION RATES

14TRADITIONAL APPROACHTraditional approach recognises the advantage of debt only up to certain level. Any increase in debt beyond a point causes cost of equity to rise.15TRADITIONAL APPROACH

16TRADITIONAL APPROACH

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18MODIGLIANI AND MILLER (MMTHEORY WITHOUT TAXESMM Proposition I without taxesCapital structure is irrelevant.The value of levered firm and unlevered firm would be equal. VU = VL19MM PROPOSITION- IIWITHOUT TAXESWith 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 isgiven by: Ke= Ko + (Ko-Kd)D/E20MM THEORY WITHOUT TAXESCAPITALIZATION RATES

21MM PROPOSITION IIIWITHOUT TAXESthe cutoff rate for investment purposes will in all cases be WACC and will be completely unaffected by the type of security issued to finance the investment.WACC for levered firm = WACC for unlevered firm22ExampleAssuming a world of NO TAX , the WACC of a firm is 18% with the D/E=1:4. The cost of borrowing is 10%. Find the cost of Equity of firm.What will be its WACC if the firm takes further debt to have D/E=1:1?Will the cost of Equity remains same as above?23MM 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.24ASSUMPTIONS AND LIMITATIONSMMS THEORY OF IRRELEVANCEIdentical 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.25MM THEORYWITH TAXES

26MM THEORYVALUE OF FIRM WITH TAXESVL = VU + T x D

VL = VU + Value of Tax Shield27MM THEORYCOST OF EQUITY WITH TAXESMM Proposition II under taxes recognises that with increasing debt the cost of equity would rise though at a lesser rate than what it would in the absence of taxes.28MM THEORYCOST OF CAPITAL WITH TAXESMM Proposition III under taxes recognizes that with increasing debt the cost of capital too would rise though at a lesser rate than what it would in the absence of taxes.29MM THEORYCAPITALIZATION RATES WITH TAXES

30MM THEORY OFIRRELEVANCE

31DEFINING TARGET/OPTIMALCAPITAL STRUCTURE Profitability Market and Operational risks Liquidity and Norms Financial Flexibility & Investment Policy Management and Control Quality of Asset & Security3233