Capital Structure Theories School of Management Learning Objectives • Understand the importance of capital structure. • Highlight the relationship between capital structure and value of the firm. • Understand the different theories of capital structure & how do they differ. • Focus on the advantage of debt as well as its disadvantage. • Understand the optimal proportion of Equity & Debt in the capital structure of a firm. • Highlight the relationship between capital structure and the cost of capital. What is “Financial Structure”? Balance Sheet Current Assets Current Liabilities Debt Preference shares Fixed Assets Ordinary shares Financial Structure What is “Capital Structure”? Balance Sheet Current Assets Current Liabilities Debt Fixed Assets Preference shares Ordinary shares Capital Structure Why should we care about capital structure? • By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm What is an optimal capital structure? • An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value • Cost of Capital: – Each source of financing has a different cost – The WACC is the “Weighted Average Cost of Capital” – Capital structure affects the WACC Capital Structure Theories • Basic question – Is it possible for firms to create value by altering their capital structure? • Major theories – Net Income Approach – Traditional Approach – Net Operating Income Approach – Modigliani and Miller Approach Net Income Approach • Cost of Debt kd = Annual Interest charges(I) Value of Debt (D) • Cost of Equity ke = Net Income Value of Equity (E) • Value of the firm = E+D • Overall cost of capital ko = Net Operating income (NOI) Value of the firm • WACC = kd(D/V) + ke(E/V) Firm’s value is inversely related to k o . Net Income(NI) Approach • According to NI approach capital structure is relevant and affects the value of the firm. • The firm that finances its assets by equity & debt is called a levered firm. • The firm that uses no debt and finances its assets entirely by equity is called an unlevered firm. • The Firm operates in a frictionless world – no tax & transaction cost. • The cost of equity & debt will remain constant independent of the capital structure. • The firm’s WACC will reduce with financial leverage, since debt is a cheaper source of finance than equity. • The value of firm increases steadily with debt. • The optimum capital structure would be 100 per cent debt financing under NI approach where the firm will have the maximum value & minimum WACC. • NI approach has no basis in reality. Example: Firm Value Under Net Income Approach • Suppose a firm has no debt in its capital structure. It has an expected annual net operating income of Rs 100000 & the equity capitalization rate, ke of 10 %. Now assume the firm is able to change its capital structure replacing equity by debt of Rs 300000. The cost of debt is 5%. Suppose the firm uses more debt in place of equity & increases debt to Rs 900000. What is the effect of leverage on the value of the firm & cost of capital. • Solution : By increasing debt , the firm is able to increase the value of the firm & lower the WACC. Traditional Approach • The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase the firm value. • The initial increase in the cost of equity is more than offset by the lower cost of debt. • But as debt increases, shareholders perceive higher financial risk & the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity. • Thus, the value of the firm first increase with moderate leverage, reach the maximum value & then start declining with higher leverage. Traditional Theory has 3 stages • First Stage: Increasing Stage – The cost of equity either remains constant or rises slightly with debt. The cost of debt remains constant. As a result WACC decreases with increasing leverage. The total value of the firm also increases. • Second Stage: Optimum Value – Subsequent increase in leverage beyond a limit will have a negligible effect on WACC & the value of the firm. The increased cost of equity due to added financial risk just offsets the advantage of low cost debt. WACC will be minimum & the maximum value of the firm will be obtained. • Third Stage: Declining Value – Beyond the acceptable limit of leverage, the value of the firm decreases with leverage as WACC increases with leverage. Investors perceive a higher degree of financial risk & demand a higher equity-capitalization rate, which exceeds the advantage of low cost debt. Example: Firm Value Under Traditional Approach • A firm is expecting a perpetual net operating income of Rs 150 cr on assets of Rs 1500 cr, entirely financed by equity. The firm’s equity capitalization rate is 10%. It is considering substituting equity capital by issuing perpetual debentures of Rs 300 cr 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 600 cr & replace equity. The debt holders will charge interest of 7% & the cost of equity will rise to 12.5% to compensate shareholders for higher financial risk. What is the effect of leverage on the value of the firm & cost of capital. Cost ke WAC C kd Leverage Criticisms of Traditional Theory • The contention that moderate amount of debt in ‘sound’ firms does not really add very much to the ‘riskiness’ of the shares, is not defensible. • No sufficient justification for the assumption that investors’ perception about the risk of leverage is different at different levels of leverage. Net Operating Income Approach • According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. • The critical premise of this approach is that market capitalizes the value of the firm as a whole . Split between debt & equity is not important. • The market uses an overall capitalization rate which is independent of the firm’s D/E Ratio & depends on business risk. If business risk is assumed to remain unchanged, the capitalization rate is constant. • The use of less costly debt funds increases the risk of shareholders which increases the equity-capitalization rate to increase. Thus the advantage of debt is offset exactly by the increase in equity-capitalization rate. • The debt capitalization rate is constant. • The corporate income taxes do not exist. Net Operating Income Approach • The value of the firm = (D+E) = NOI ko • The cost of equity ke = NOI - INT = NI V–D E ABC Co has an annual net operating income of Rs 100000. An average cost of capital, ko, of 10% and an initial debt of Rs 500000 at 6% rate of interest. If debt is increased from Rs 500000 to Rs 700000 what is the effect of leverage on the value of the firm & cost of capital? Net Operating Income Approach ke Cost of Capital ko ko kd Leverage Modigliani and Miller Approach Without Taxes Modigliani and Miller (MM) differ from the traditional view. According to them a firm’s market value and the cost of capital is independent of the capital structure. The value of the firm depends on the earnings and the business risk. Assumptions • Perfect Capital Market : Information is freely available and there is no problem of asymmetric information, transactions are costless , securities are infinitely available. • Rational Investors and Managers : Investors rationally choose a combination of risk and return that is most advantageous to them. Managers act in the interest of shareholders. • Equivalent Risk Classes: Firms can be grouped into ”equivalent risk classes” on the basis of their identical risk characteristics. (operate in similar business condition). Firms within the same industry. • Absence of Taxes : There is no tax. • Full payout : Firms distribute all net earnings to shareholders. Firms allow a 100 percent dividend payout. Proposition I MM’s proposition I is that, for firms in the same risk class, the total market value is independent of the debt-equity mix & is given by capitalizing the expected net operating income by the capitalization rate appropriate to that risk class. • MM’s Approach is a net operating income approach. • Value of levered firm = Value of unlevered firm • Value of the firm = Net operating income Firm’s cost of capital • The WACC for two identical firms, one levered & another unlevered, will be equal to the overall cost of capital. • kl = ko = ku • MM’s Proposition I states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage. Example • Suppose there are 2 firms U(unlevered) & L( levered) with identical conditions. NOI is Rs 10,000. Cost of equity for firm U is 10%. Firm L employs 6% Rs 50,000 debt & cost of equity is 11.7%. Calculate the market value of the firms? Assume you hold 10% of shares of the levered firm L & 10% of firm L’s corporate debt. What is your return from your investment in the shares of firm L? You are entitled to 10% of equity income( dividends). Proposition II • 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 (i.e., cost of equity) on their investment to compensate for higher risk. • The higher the financial risk the higher the shareholder’s required rate of return or the cost of equity. • The cost of equity for a levered firm should be higher than the overall cost of capital, ko; that is, the levered firm’s ke> ko. • It should be equal to constant ko, plus a financial risk premium. Cont…. • The excessive use of debt increases the risk of default; cost of debt will increase with high level of financial leverage. • When kd increases, ke will increase at a decreasing rate & may even turn down eventually. • The reason is that debt holders, in the extreme leveraged situations, own the firm’s assets & bear some of the firm’s business risk. • Since the operating risk of shareholders is transferred to debt-holders, k e declines. M&M Proposition II Cost ke ko kd Risk free debt Risky debt Leverage Criticisms of MM Hypotheses • MM approach will not work because of market imperfections. • Lending & Borrowing Rates Discrepancy: The assumption that firms & individuals can borrow & lend at the same rate of interest does not hold in practice. • Transaction costs are involved in buying & selling of securities. • The incorporation of Corporate tax will affect MM’s conclusion. • It is incorrect to assume that personal leverage is a perfect substitute for corporate leverage.( unlimited liability Vs limited liability) MM Hypothesis Under Corporate Taxes • The MM’s “tax corrected” view suggests that the value of the firm will increase with debt due to deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm. Value Of Interest Tax Shield • Under the assumption debt, the present value of Interest Tax Shield can be determined as follows: PV of Interest Tax Shield = Corporate tax rate * Interest Cost of debt PVINTS = T * kdD kd = TD Value of levered firm • Value of unlevered firm = After tax net operating income Unlevered firm’s cost of capital • Vu = NOI (1-T) ku • Vl = NOI (1-T) + PV of tax shield ku Vl = NOI (1-T) + Corporate tax rate * Interest ku Cost of debt • When corporate tax rate is positive, the value of the levered firm will increase continuously with debt. • The value of the firm is maximized when it employs 100% debt. Value of Levered firm Value Vl Value of interest tax shield Vu Leverage Questions 1. 2. 3. X Co. has a net operating income of Rs 2,00,000 on an investment of Rs 10,00,000 in assets. It can raise debt at 16% rate of interest. Assume that taxes do not exist. a) Using NI approach & an equity capitalization rate of 18%, compute the total value of the firm & the weighted average cost of capital if the firm has i) no debt, ii) Rs 3,00,000 debt, iii) Rs 6,00,000 debt. b) Using the NOI approach & an overall capitalization rate of 12%, compute the total value of the firm, value of shares & cost of equity if the firm has i) no debt, ii) Rs 3,00,000 debt, iii) Rs 6,00,000 debt. Calculate the values for two firms X – an unlevered firm & Y – a levered firm with Rs 6,00,000 debt at 6% rate of interest using MM approach. Equity capitalization rate for X is 11.1% & Y is 12.5%. Also calculate the overall cost of capital. An investor holds 2% worth of Y’s shares. Show the process by which he can earn same return at a lesser cost. NOI is Rs 2,00,000. Firms Y & Z are similar except that Y is unlevered, while Z has Rs 2,00,000 of 5% debentures outstanding. NOI is Rs 40,000 & the cost of equity is 10% for both the firms. i) Calculate the value of the firms, if MM assumptions are met. ii) Assume an investor owns 10% of Z Co’s shares. Show how it can earn same return at a lesser cost by using arbitrage.
