Corporate Finance

Capital Structure

Presentation By:
CA Ashok Kumar Malhotra
7th Feb 2020
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 Capital Structure
• Revenue Generating Assets (analogy of Pizza)
• Operating Leverage versus financial leverage
• Objective: Optimum versus value
• Debt Characteristics versus equity
• Capital structure policy
• Ro, Rd, Re and WACC
• Arbitrage (example of full-cream milk business)

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 Factors influence Capital Structure
1. attitude of management,
2. situation of capital market, 9. growth opportunities,
3. guidelines issued by 10. size of the firm,
regulatory authorities, 11. nature of business,
4. terms and conditions of 12. profitability,
financing institutions, 13. liquidity,
5. cost of debt, rate of return on 14. prevailing rate of interest,
investment, 15. earning volatility,
6. tax shield on debt and 16. cash flow,
operating expenses, 17. possibility of take over etc.
7. existing capital structure,
8. pay out policy

These factors are highly psychological, conflicting, complex, and qualitative

in nature and sometimes beyond control also.

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 Capital Structure Theories -I
1. Net Income Approach

2. Net Operating Income (NOI) Approach

3. Modigliani Miller (MM) Approach

4. MM hypothesis under Corporate Taxes

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 Capital Structure Theories - II
These may be taken up later
5. Traditional Approach

6. Miller’s Model under Corporate Taxes and personal taxes

7. The Trade -Off Theory: Cost of Financial Distress and

agency

8. Pecking Order Theory

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• Net Income Approach:
EBIT - Interest - Income Tax = Net Income

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 Net Income Approach: Assumptions

1. There are no corporate taxes.

2. The cost of debt is less than the cost of equity i.e.
the capitalization rate of debt is less than the rate of
equity capitalization. This prompts the firm to
borrow.
3. The debt capitalization rate and the equity
capitalization rate remain constant.
4. The proportion of the debt does not affect the risk
perception of the investors. Investors are only
concerned with their desired return.
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 Net Income Approach: Assumptions

5. The cost of debt remains constant at any level of

debt.
6. Dividend pay out ratio is 100%.
7. No Bankruptcy

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 Criticism of NI Approach
1. Cost of debt at any level of debt is constant. In realty, the
funds providers insist for more rate of interest above
certain level of debt.
2. Constant risk perception of equity share holders is also
not correct. As the debt increases the financial risk also
increases and equity share holders will expect more
return on their investment and hence the rate equity
capitalization also increases with the increase in financial
leverage.
3. 100% dividend payout and absence of corporate tax are
not practically possible.

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Net Operation Income Approach (NOI) = EBIT

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 Net Operation Income Approach (NOI) -
Assumptions
1. There are no corporate taxes.
2. Cost of debt remains constant at all level of debt.
3. WACC does not change with the change in financial leverage
(Ko)
4. Value of the firm depends on expected net operating income
(EBIT) and overall capitalization rate or the opportunity cost
of capital (Ko)
5. Net operating income of the firm is not affected by the degree
of financial leverage. It is affected by the operating leverage
6.  The operating risk or business risk does not change with the
change in debt equity mix.

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 NOI - criticism
1. In real life absence of corporate tax is not correct.
2. The cost of debt increases with the increase in the quantum
of debt.
3. As the cost of debt increases with the increase in financial
leverage, the overall cost of capital also increases with
increase in financial leverage.
4. An investor values differently the firm having higher level of
debt in its capital structure than the firm having less debt or
no debt.

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 Assumptions of the M&M Model
• Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
– Perfect competition (leads to arbitrage process)
– Firms and investors can borrow/lend at the same rate
– Equal access to all relevant information
– No transaction costs
– No taxes
MM theory is just similar to NOI approach with a basic difference. The basic
difference is that the NOI approach explains the concept without investors’
behavioral justification, whereas M.M. Approach provides behavioral justification
in favour of the theory.
 MM Proposition I (No Taxes)
• We can create a levered or unlevered position
by adjusting the trading in our own account.
• This homemade leverage suggests that capital
structure is irrelevant in determining the value
of the firm:
VL = VU
 MM Proposition II (No Taxes)
• Proposition II
– Leverage increases the risk and return to stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
 MM Proposition II (No Taxes)
The derivation is straightforward:
B S
RW ACC   RB   RS Then set RW ACC  R0
BS BS
B S BS
 RB   RS  R0 multiply both sides by
BS BS S
BS B BS S BS
  RB    RS  R0
S BS S BS S
B BS
 RB  RS  R0
S S B
B B RS  R0  ( R0  RB )
 RB  RS  R0  R0 S
S S
 MM Proposition II (No Taxes)
Cost of capital: R

B
RS  R0   ( R0  RB )
(%)

SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity B
Ratio S
 MM Propositions I & II (With Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is
offset by the interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
 MM Proposition I (With Taxes)
The total cash flow to all stakeholde rs is
( EBIT  RB B )  (1  TC )  RB B
The present value of this stream of cash flows is VL
Clearly ( EBIT  RB B)  (1  TC )  RB B 
 EBIT  (1  TC )  RB B  (1  TC )  RB B
 EBIT  (1  TC )  RB B  RB BTC  RB B
The present value of the first term is VU
The present value of the second term is TCB
VL  VU  TC B
 MM Proposition II (With Taxes)
Start with M&M Proposition I with taxes: VL  VU  TC B
Since VL  S  B  S  B  VU  TC B
VU  S  B (1  TC )
The cash flows from each side of the balance sheet must equal:
SRS  BR B  VU R0  TC BR B
SRS  BR B  [ S  B(1  TC )]R0  TC RB B
B B B
Divide both sides by S RS  RB  [1  (1  TC )]R0  TC RB
S S S
B
Which quickly reduces to RS  R0   (1  TC )  ( R0  RB )
S
 The Effect of Financial Leverage

Cost of capital: R B
(%)
RS  R0   ( R0  RB )
SL

B
RS  R0   (1  TC )  ( R0  RB )
SL

R0

B SL
RW ACC   RB  (1  TC )   RS
BSL B  SL
RB

Debt-to-equity
ratio (B/S)
 Traditional Approach - three stage
• The approach was propounded by Ezra
Soloman in 1963 (Pandey, 2005)
• The approach rejects both extreme
prepositions of relevance approach of NI
theory and irrelevance approach of NOI
theory.
• Is the compromise between NI approach and
NOI approach.

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Traditional Approach

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 Traditional Approach
• WACC decreases only up to a certain level of
financial leverage and
• Then starts increasing beyond certain level of
judicious mix of debt and equity
• Assumes that up to a certain level of debt, it
remains cheaper and beyond that level, it
becomes costly.

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 First Stage of traditional approach
• The ‘Re’ either remains constant or rises slightly
with increase in debt.
• ‘ Re’ increase is less than the advantage of ‘Rd’
(Tax shield).
• During this stage, Rd remains constant since, it is
considered as a rational decision
• Consequently, the overall cost of capital (Ro or
WACC) decreases with increase in leverage and
thus the total value of the firm also increases.
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 Second Stage of traditional
approach
• Second Stage: Optimum Value
• At this stage, ‘Re’ increases faster than it
increases at the first stage when debt is
increased. Further the benefit of low ‘Rd’ is
wiped off by increase in cost of equity beyond
certain level, hence, the firm reaches at a
stage of minimum weighted

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 Third Stage: Declining Value
• As the debt is increased beyond certain level, the
increase in ‘Re’ becomes greater than the advantage
of low ‘Rd’ and therefore WACC increases and the
market value of the firm decreases.
• At this stage, the value of the firm goes on declining
with every increase in debt replacing the equity. This
happens because investors perceive a higher degree
of financial risk and demand a higher rate of return
on equity, which exceeds the advantage of low cost
debt.
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 Trade-off Theory:
between tax shield and financial
distress

Financial Distress
 Bankruptcy Cost
 Agency Cost

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 Tax Effects and Financial Distress

• There is a trade-off between the tax

advantage of debt and the costs of financial
distress.
• It is difficult to express this with a precise
and rigorous formula.
 Tax Effects and Financial Distress
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
V L = V U + T CB

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B *

Optimal amount of debt

 Costs of Financial Distress
• Direct Costs
– Legal and administrative costs
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)
– Agency Costs when in fin. Dist.- conflict of interest
magnified
• Shareholders’ Incentive to take large risks
• Incentive toward underinvestment for good projects
• Milking the property
 Can Costs of Debt Be Reduced?
• Protective Covenants
– Positive Covenants
– Negative Covenants
• Debt Consolidation:
– If we minimize the number of parties, contracting
costs fall.
 The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
• VT = S + B + G + L
S
• The essence of the M&M intuition B
is that VT depends on the cash flow
L G
of the firm; capital structure
just slices the pie.
 Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.

B
RS  R0   ( R0  RB )
SL
 Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.
B
RS  R0   (1  TC )  ( R0  RB )
SL