Capital Structure Theories

CAPITAL
STRUCTURE &
VALUE OF THE FIRM
 What is the relationship between capital structure and
the firm value?
 How do suppliers of capital value a company in relation

to other firms when the company changes its capital
structure?
 Whether a firm can affect its total valuation and its cost
of capital by changing its financing mix?
Optimal capital structure
 Given a level of EBIT, value of the firm is
maximized when WACC is minimized.
Different opinions
 Net Income Approach (NI)
 Net Operating Income Approach (NOI)
 Traditional Approach
 Modigliani and Miller Approach (MM)
Assumptions
 There are only two sources of finance – Debt and Equity
 The operating profits of the firm are given (EBIT) and are not
expected to grow
 The firm has a policy of distributing the entire distributable profit
amongst shareholders implying that there are no retained earnings
 The ratio of debt to equity can be changed by issuing debt to
repurchase stock or by issuing stock to pay off debt
 There are no taxes, corporate or personal
 The investors have same subjective probability distribution of
expected operating profits of the firm
Symbols
 Market value of equity : E
 Market value of debt : D
 Total value of the firm : E + D : V
 Interest payment on debt : I
 Cost of debt : I / D : kd
 Expected dividend at the end of year 1 : D1
 Current market price of the share : P0
 Cost of equity : ke = D1 / P0
 Net operating profit : NOP or EBIT
 Net profit : NP or PAT
 WACC : k0 = EBIT / V
Net Income Approach :
Capital Structure Matters
 There is a relationship between capital structure and the value of
the firm
 A firm can affect its value by increasing or decreasing the debt
proportion in the overall financing mix
 It assumes the following:
 Total capital requirement is given and constant
 Cost of debt < Cost of equity
 Cost and debt and cost of equity remain constant
 As Cost of debt < Cost of equity, when D/E increases, WACC
decreases, leading to an increase in the value of the firm
Net Operating Income Approach :
Capital Structure Does Not Matter
 Market value of the firm depends upon NOP or EBIT and the WACC
 The financing mix is irrelevant
 It assumes the following:
 Investors capitalize total earnings of the firm to find the value of the firm
as a whole
 WACC is constant and remains unchanged irrespective of the level of
gearing
 Cost of debt is also constant
 As more and more of debt is introduced in the capital structure, it
increases the risk of shareholders who then increase their expected
return.
 The increase in cost of equity is such as to completely offset the benefits of
employing cheaper debt. Thus overall cost of capital remains constant
 There is no one ‘optimal’ capital structure
Traditional Approach :
A Practical Viewpoint
 It takes a compromising view between the Net Income approach
and Net Operating Income approach
 A firm, by making a judicious use of both debt and equity, can arrive
at a capital structure that may be called an ‘Optimal Capital
Structure’. Here the WACC is the minimum and the value of firm the
maximum
 Cost of debt is assumed to be less than cost of equity
 There is a particular leverage or a range of leverage which
separates favorable leverage from unfavorable leverage
 It implies towards “one” optimal capital structure
Traditional Approach :
A Practical Viewpoint
 In case of 100% equity firm:
 WACC = Cost of equity
 When cheaper debt is introduced, financial leverage increases:
 Cost of equity initially remains the same as equity investors accept a minimum leverage in
every firm
 A constant cost of debt and equity makes WACC to fall initially
 As leverage is increased further:
 It increases the risk of shareholders and cost of equity start to rise
 However the benefits of using ‘cheaper’ debt may far outweigh the effect of increase in cost
of equity
 Thus WACC may still continue to fall and may later become constant
 If firm increases leverage further:
 Risk of debt investor may also increase and cost of debt also starts rising
 The already increasing cost of equity with now increasing cost of debt makes WACC to rise
 This would result in a decrease in the value of firm
Modigliani-Miller Model
 MM advocate the relationship between leverage, cost of capital and value of the firm
as explained under NOI Approach
 They further offer a behavioral justification for having WACC constant for all degrees
of leverage
 Assumptions:
 Perfect capital market
 Securities are infinitely divisible
 Investors are rational
 Investors hold identical expectations about future operating earnings
 There are no taxes
 Firms can be grouped into ‘equivalent risk class’
 Personal and corporate leverage are perfect substitutes
 The total value of the firm is equal to the capitalized value of operating earnings,
made at a rate appropriate to the risk class of the firm
 If two firms are alike in all respects except from their financing pattern and value,
investors would develop a tendency to sell the shares of the overvalued firm and buy
the shares of undervalued firm through the process of ARBITRAGE
Modigliani-Miller Model
 Investors are able to substitute personal (homemade) leverage for
corporate leverage i.e. they are able to replicate the capital structure
of the firm
 Practical considerations:
 Different borrowing rates for corporate and individuals
 Capacity of gearing
 Inconvenience associated with gearing
 Transaction costs
 Taxes
 Institutional investor
M M Model with taxes
 PROPOSITION 1:
 The value of the levered firm is equal to the value of the unlevered firm
in the same risk class + gains from leverage
 VU = EBIT (1 – t)
WACC
 VL = VU + D (t)
 PROPOSITION 2:
 The cost of equity of a levered firm is equal to the cost of equity of an
unlevered firm in the same risk class + risk premium, tax rate and
financial leverage used
 ke,l = ke,u + (ke,u – kd) (1- t) (D/E)
HAMADA Model
 A combination of CAPM model and MM model after taxes
 It segregates the required rate of return on equity of a levered firm
into three components:
 Risk free rate which is a compensation for TVM factor
 Business risk premium
 Financial risk premium
 ke,l = kr,f + (km - kr,f) bu + (km - kr,f) bu (1 – t) (D/E)

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 How do suppliers of capital value a company in relation

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