Capital Structure Debt versus Equity Introduction Capital structure of a company refers to the composition or make up of its capitalisation and includes all long term capital resources viz: loans, reserves, shares and bonds. Refers to permanent financing of a firm. Composed of long term debt, preference share capital and equity. Capital structure Capitalisation- quantitative aspect, refers to the total amount of securities issued by the company Capital structure-qualitative aspect, refers to the proportionate amount that makes up capitalisation Financial structure- Entire liabilities side of the balance sheet Importance of Capital structure Refers to the relationship between the various long term forms of financing. The use of long term fixed interest bearing debt and preference share capital along with equity shares is called financial leverage or trading on equity. Capital structure cannot affect the total earnings of a firm but it can affect the share of earnings available for equity share holders. The Choices in Financing There are only two ways in which a business can make money. • The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. • The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments. Advantages of Debt • Interest is tax deductible (lowers the effective cost of debt) • Debt-holders are limited to a fixed return – so stockholders do not have to share profits if the business does exceptionally well • Debt holders do not have voting rights Disadvantages of Debt • Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk) What is the optimal debt-equity ratio? • Need to consider two kinds of risk: – Business risk – Financial risk Optimal capital structure “ The capital structure that leads to the maximum value of the firm”. Maximizes the value of the company and hence the wealth of its owners and minimizes the company’s cost of capital. Every firm should aim at achieving the optimal capital structure. V= D + S Considerations for achieving the optimal capital structure If the ROI> fixed cost of funds, company should make maximum possible use of leverage Firm saves considerable amount called tax leverage Avoid undue financial risk as it will reduce the market price of the shares The capital structure should be flexible Risk and Return trade off Financial Risk- Arises on account of use of debt or fixed interest bearing securities Non employment of Debt capital riskHigher the Debt Equity ratio or leverage, lower is this risk. Business Risk • Standard measure is beta (controlling for financial risk) • Factors: – Demand variability – Sales price variability – Input cost variability – Ability to develop new products – Foreign exchange exposure – Operating leverage (fixed vs variable costs) Financial Risk • The additional risk placed on the common stockholders as a result of the decision to finance with debt Example of Business Risk • Suppose 10 people decide to form a corporation to manufacture disk drives. • If the firm is capitalized only with common stock – and if each person buys 10% -each investor shares equally in business risk Example of Relationship Between Financial and Business Risk • If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity • The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered). Business and Financial Risk • Financial leverage concentrates the firm’s business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk. Financial Risk • Leverage increases shareholder risk • Leverage also increases the return on equity (to compensate for the higher risk) Question? • Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in risk? Theories of capital structure Net Income Approach Net operating Income Approach The Traditional Approach Modigliani and Miller Approach Relationship – Capital structure, Ko, Value of the firm Theories Relevance Cap structure effects Ko-variable Value of the firm NI Traditional Irrelevance CS does not effect Ko- constant NOI MM Net Income Approach Firm can minimize WACC and increase its value by increasing the proportion of debt in capital structure. When Financial Leverage is reduced, the WACC will increase and the total value of the firm will decrease. V= S+D V= Total market value of the firm S= Market value of equity shares Earnings (NI)/Equity capitalisation rate D= Market value of Debt WACC K0 =EBIT/V Net Operating Income Approach (NOI) Suggested by Durand. Diametrically opposite to NI approach. Change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. There is nothing as an optimal capital structure and every capital structure is the optimal one. V = EBIT/K0 V= value of the firm K0= Cost of capital S= V-D S= Market value of equity shares D= Market value of Debt The Traditional Approach A compromise between two extremes of NI and NOI approaches Overall cost of capital decreases upto a certain point, remains more or less unchanged for moderate increase in debt thereafter, and increases or rises beyond a certain point. Even cost of debt may increase at this stage due to increased financial risk. K0= EBIT/V V= value of the firm Modigliani and Miller Approach MM hypothesis is similar to NOI approach K0is not affected by changes in the capital structure or D/E ratio is irrelevant in the determination of total value of a firm. Although, the financial leverage affects the cost of equity, the overall cost of capital remains constant. https://www.youtube.com/ Operating income is the determinant of total value. Beyond a certain limit of debt, Kd increases but the cost of equity falls thereby balancing the two costs. Two identical firms cannot have different market values or K0 because of arbitrage process. MM- Theory of irrelevance In the absence of taxes When taxes exist D/E mix is irrelevant in determination of total value of the firm Value of the unlevered firm Vu=EBIT(1-t)/Ko With increased use of debt the cost of equity increases Although financial leverage affects the cost of equity, the overall cost of capital remains constant. WACC = kd × D V + ke × E V ke = WACC + (WACC − kd) × D E Value of levered firm VL=Vu+D(t) ke = WACC + (WACC − kd) × (1 − t) × D E The implication of M&M theory with tax is that the capital structure is no longer irrelevant. The value of a company with debt is higher than the value of a company with no or lower debt. VL=Vu+D(t) Tax shield for a levered firm = Interest (tax) D= MV of Long term debt Tax savings= Dx Rf x t PV of tax savings = (D*Rf*t)/(1+Rf)^n PV of perpetuity = A/Rf D*Rf*t = D*t Rf Modigliani and Miller • Any combination of securities is as good as any other. • Example: – Two Firms with the same operating income who differ only in capital structure • Firm U is unlevered: VU=EU • Firm L is levered: EL= VL-DL Modigliani and Miller Revisited • • M&M proposition 1: A firm’s total value is independent of its capital structure Assumptions needed for Prop 1 to hold: 1. Capital markets are perfect and complete 2. Before-tax operating profits are not affected by capital structure 3. Corporate and personal taxes are not affected by capital structure 4. The firm’s choice of capital structure does not convey important information to the market Modigliani and Miller Revisited • M&M Proposition 2: The return on equity will rise as the debt-equity ratio rises in order to compensate equity holders for the additional (financial) risk. • Note: Proposition 2 does not rely on default risk – rE rises because of the rise in financial risk WACC (M&M view) r rE WACC rD D E Capital Structure D x rD x Tc PV of Tax Shield = (assume perpetuity) = D x Tc rD Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 / .10 = $400 PV Tax Shield = D x Tc = 1000 x .4 = $400 Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400 Firm Value with 1/2 Debt = $6,400 Factors Determining The Capital Structure Financial leverage or trading on equity Growth and stability of sales Cost of capital Cash flow and ability to service debt Nature and size of the firms Floatation costs Corporate tax rate Legal requirements Degree of Financial Leverage Measures the impact of change in operating income (EBIT) on change in earning on equity capital. DFL= % Change in EPS % Change in EBIT DFL= EBIT EBIT-I DFL 2 shows that 1% change in company’s leverage will change company’s operating income by 2%. Financial Leverage Significance Planning of Capital structure Profit planning Limitations Double edged weapon Benefits only to companies having stability of earnings Increases risk and rate of interest Restrictions from financial institutions Operating Leverage Operating Leverage results from the presence of fixed costs in magnifying net operating income fluctuations. The fixed cost is fulcrum or leverage Fixed costs remaining the same, the % change in operating revenue will be more than the % change in sales. OL= sales –Variable costs = contribution Sales-VC- FC Operating Profit Operating and Combined Leverage DOL= % change in profits % change in sales Example: If DOL is 3 means, 10% increase in sales will result in a 30% increase in operating income. Measures the sensitivity of operating income to its sales. Operating leverage affects the income FL is the result of financial decisions CL focuses on the entire income of the concern. DCL= % change in EPS or OL x FL % change in sales Break Even Point = Fixed cost p/v ratio P/v ratio = Contribution/ sales
