Capital Structure

Meaning of Capital Structure

Theories of Capital Structure
 Meaning and Definition of Capital Structure

Estimation of capital requirement is necessary, but the
formation of a capital structure is important

According to Gerestenbeg, “Capital structure of a company
refers to the composition or make-up of its capitalization
and it includes all long-term capital resources viz., loans,
reserves, shares and bonds”

Capital structure refers to the kinds of securities and the
proportionate amounts that make up capitalization.

For raising long-term finances, a company can issue three
types of securities viz., Equity shares, Preference shares
and Debentures.

A decision about the proportion among these type of
securities refers to the capital structure of the enterprise
 Capitalization, Capital Structure and
Financial Structure

The terms capitalization, capital structure and
financial structure do not mean the same

Capitalization is a quantitative aspect of the
financial planning of an enterprise. It refers to the
total amount of securities issued by a company

Financial structure means the entire liabilities side
of the balance sheet. It refers to all the financial
resources marshaled by the firm, short as well as
long-term, and all forms of debt as well as. Thus,
financial structure generally, is composed of a
specified percentage of short-term debt, long-term
debt and shareholder’s funds.
 Capital structure and Firms value

The choice of a firm’s capital is marketing problem. A firm
decides how the cash flows is used to meet the obligations
toward debt capital and a residual that belongs to equity
shareholders

Since the objective of financial management is to maximize
the shareholder’s wealth, the key issue is: What is
relationship between capital structure and firms value?
Alternatively, what is the relationship between capital
structure and cost of capital?

If capital structure decision can affect a firm’s value, then it
would like to have a capital structure, which maximizes the
market value. However, there exist conflicting theories on
the relationship between capital structure and the value of
a firm.
 Theories of Capital Structure

Different kinds of theories have been propounded
by different authors to explain the relationship
between capital structure, cost of capital and value
of the firm. The important theories are:
1. Relevance of capital structure: The Net Income
approach (NI)
2. Irrelevance of capital structure: The Net
Operating Income approach (NOI)
3. Traditional view/position
4. Modigliani and Miller position (MM)
 The Net Income Approach

The NI approach is recommended by Durand

According to NIA, the capital structure decision is relevant
to the valuation of the firm.

In other words, a change in the financial leverage will lead
to a corresponding changes in the overall cost of capital as
well as the total value of the firm

That is, if the degree of financial leverage as measured by
ratio of debt to the equity is increased the WACC will
decline, while the value of the firm as well as the market
price of equity shares will increase. Conversely, a decrease
in the financial leverage will cause an increase in the
overall cost of capital and a decline in both the value of the
firm as well as the market price of the equity shares
 Assumption of NIA

There are no taxes

The cost of debt is less than the equity
capitalization rate or cost of equity

The use of debt does not change the risk
aspect of the investors
A firm that finance its assets by equity
and debt is called levered firm
A firm that finances its assets entirely by
equity is called unlevered firm
 The Net Operating Income Approach

The Net Operating Income position has been
advocated by David Durand

But this NOI approach is quite contrary to the NI
approach

According to the NOI, whatever be the pattern of
the capital structure the overall cost of capital
remains one and the same as the total value of the
firm remains constant. The only change that can
be noticed from one type of capital structure to
another type is change in the cost of equity and
there by value of equity
 The Net Operating Income Approach

The critical premise of this approach is that the market
capitalizes the firm as a whole at a discount rate which is
independent of the firm’s debt-equity ratio. As such the
division between debt-equity is irrelevant

According to this approach the market value of a firm
depends on its net operating income and business risk. The
change in the financial leverage employed by a firm cannot
change these underlying factors. It merely changes the
distribution of income and risk between debt and equity,
without affecting the total income and risk which influence
the market value of the firm.

In other words, whatever be the pattern of capital structure
we maintain the overall cost of capital remains one and the
same and as such the total value of the firm remains
constant. The only change that can be noticed from one
type of capital structure to another type is change in the
cost of equity and there by the value of equity

This approach also assumes there are no taxes
 Traditional Position/Approach

The traditional view has emerged as a
compromise to the extreme position taken by the
NI and NOI approach

According to this view, a judicious mix of debt and
equity capital can increase the value of the firm by
reducing the WACC up to certain level of debt. The
WACC decreases only within the reasonable limit
of financial leverage and reaching a minimum
level, it starts increasing with financial leverage

Hence, a firms optimum capital structure that
occurs when WACC is minimum, and there by
maximizing the value of the firm.
 Why does WACC decline?

Low cost debt is replaced for expensive equity capital

This financial leverage results in risk to shareholders,
will in turn cause the cost of equity to increase

However, the increase in the cost of equity is offset by
the lower cost of debt

But further when leverage increases the WACC also
starts to increase as the advantage of cheaper debts
are taken off

This can be illustrated by an example
 Suppose a firm is expecting a perpetual net
operating income of Rs. 1,50,000 on assets of Rs.
15,00,000 which are entirely financed by equity.
The firms equity capitalization rate is 10%.
It is considering substituting equity capital by
issuing perpetual debentures of Rs. 3,00,000 at 6%
interest rate. The cost of equity is expected to
increase to 10.56%.
The firm is also considering the alternative of
raising perpetual debentures of Rs. 6,00,000 at 7%
interest rate and cost of equity will rise to 12.5%
calculate the firm’s value in each alternative
 Modigliani-Miller Position/Hypothesis

MM Position or MM Hypothesis was 1st formal
theory of capital structure proposed by Franco
Modigliani and Merton Miller

The following are the assumptions of MM
proposition I
1. Perfect Capital Market
2. Rational investors and managers
3. Homogeneous expectations
4. Equivalent risk classes
5. Absence of corporate taxes
 MM Proposition I

The value of a firm depends upon its expected net
operating income and the overall capitalization rate or the
opportunity cost of capital.

Since the form of financing (debt or equity) can neither
change the firm’s net operating income nor its operating
risk, the value of levered and unlevered firms ought be the
same

Financing changes the way in which the net operating
income is distributed between equity holders and debt-
holders. Firms, with identical net operating income and
business (operating) risk, but differing capital structure,
should have same total value

MM proposition I is that, for firms in the same risk class,
the total market value is independent of the debt-equity
mix and is given by capitalizing the expected net operating
income by the capitalization rate (i.e., the opportunity cost
of capital) appropriate to that risk class.
 Arbitrage Process/Argument

Arbitrage process is a process by which the investors of
levered firm ‘L’ sell their equity and buy the equity in
unlevered firm ‘U’ with personal leverage, the market
value of firm L tends to decline and the market value of
firm U tends to rise

This process continues until the market values of both
the firms become equal because only then the possibility
of earning a higher income, for a given level of
investment and leverage, by arbitraging is eliminated. As
a result, the cost of capital for both the firms becomes
the same

To see how arbitrage mechanism work, we can consider
the following illustration
 MM Proposition II

According to MM second proposition “the expected return on equity is equal to
the expected rate of return on assets, plus a premium. The premium is equal to
the debt-equity ratio times the difference between the expected return on
assets and the expected return on debt.”

Financial leverage does not affect a firm’s net operating income but it does
affect shareholder’s return (EPS and ROE). EPS and ROE increase with leverage
when the interest rate is less than the firm’s return on assets. Financial
leverage also increases shareholder’s financial risk by amplifying the
variability of EPS and ROE.

Thus, financial leverage causes two opposing effects: it increases the
shareholder’s return but it also increases their financial risk. Shareholders will
increase the required rate of return on their investment to compensate for the
financial risk. The higher financial risk, the higher the shareholder’s required
rate of return or the cost of equity. This is MM proposition II

In simple words, MM proposition II states that the cost of equity, ke, will
increase enough to offset the advantage of cheaper cost of debt so that the
opportunity cost of capital, kc, does not change. A levered firm has financial
risk while an unlevered firm is not exposed to financial risk
 Paul, the CEO of the company, believes that the shareholders would
benefit if the company employs debt and equity in equal proportions.
So he proposes to issue Rs. 10 million of debentures carrying an
interest rate of 15% and use the proceeds to buy back 500,000 equity
shares. The following additional information is available.
Existing capital structure:
Operating income: Rs 4,000,000
number of shares: 1,000,000
price per share: Rs 20
market value of shares: Rs 20,000,000
Proposed capital structure:
operating income: Rs 4,000,000
number of shares: 500,000
price per share: Rs 20
market value of shares: Rs 10,000,000
market value of debt: Rs 10,000,000
interest at 15%: Rs 1,500,000
Analysis at different operating income
Existing Capital Structure
Basic data
Operating income: Rs. 4,000,000
Number of shares: 1,000,000
Price of share: Rs. 20
Market value of shares: Rs. 20,000,000
Possible Outcome
Operating income: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000
Equity earnings: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000
EPS: Rs. 2 Rs. 4 Rs. 6
ROE: 10% 20% 30%
Proposed Capital Structure
Basic data
Operating income: Rs. 4,000,000
Number of shares: 500,000
Price of share: Rs. 20
Market value of shares: Rs. 10,000,000
Market value of debt: Rs. 10,000,000
Interest at 15%: Rs. 1,500,000
Possible Outcome
Operating income: Rs. 2,000,000 Rs. 4,000,000 Rs. 6,000,000
Interest: Rs. 1,500,000 Rs. 1,500,000 Rs. 1,500,000
Equity earnings: Rs. 500,000 Rs. 2,500,000 Rs. 4,500,000
EPS: Rs. 1 Rs. 5 Rs. 9
ROE: 5% 25% 45%
 The Risk-Return Tradeoff

MM proposition I says that financial leverage has
no effect on the wealth of shareholders and MM
proposition II says that the rate of return expected
by shareholders increases with financial leverage

Why are shareholders indifferent to increased
leverage when it enhances expected return?

The reason is that an increase in expected return
is accompanied by an increase in risk which in
turn raises the shareholder’s required rate of
return
 Effect of Leverage on Risk
Operating Income

Rs. 2,000,000 Rs. 4,000,000

Existing debt-equity is 0:1
EPS Rs. 2 Rs. 4
ROE 10% 20%
Proposed debt-equity is 1:1
EPS Rs. 1 Rs. 5
ROE 5% 25%
 Criticisms of MM Theory

Existence of corporate tax

Lending and borrowing rates discrepancy

Non-substitutability of personal and
corporate leverages

Transaction costs, agency costs exists

Informational asymmetry exists because
managers are better informed than
investors