Introduction to Capital Structure Theories

Capital Structure is the proportion of debt, preference, and equity capitals in the total financing of the firm’s assets. The main objective of financial management is to maximize the value of the equity shares of the firm. Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth of the equity shareholders. Such a capital structure is called the optimum capital structure. At the optimum capital structure, the weighted average cost of capital would be the minimum. The capital structure decision influences the value of the firm through its cost of capital and can affect the share of the earnings that pertain to the equity shareholders. 

 

There are 4 basic Capital Structure theories. They are:

1. Net Income Approach
2. Net Operating Income Approach
3. Modigliani-Miller (MM) Approach and
4. Traditional Approach

 

Generally, the capital structure theories have the following assumptions:

1)   There are no corporate taxes (this assumption has been removed later).

2)   The firms use only 2 sources of financing namely perpetual debts ad equity shares

3)   The firms pay 100% of the earnings as dividends. This means that the dividend payout ratio is 100% and there are no earnings that are retained by the firms.

4)   The total assets are given which do not change and the investment decisions are assumed to be constant.

5)   Business risk is constant over time and it is assumed that it is independent of the capital structure.

6)   The firm has a perpetual life.

7)   The firm's earnings before interest and taxes are not expected to grow.

8)   The firm's total financing remains constant. The firm's degree of leverage can be altered either by selling shares and retiring the debt using the proceeds or by raising more debt and reducing the equity financing.

9)   All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm.

Based on this assumption

Kd= I/B= annual interest expense/market value of debt

*Debt is regarded as perpetual debt

Ke=E/S = EARNING TO COMMON STOCKHOLDERS/ MARKET VALUE OF EQUITY

*ZERO GROWTH MODEL, THE FIRM PAYS ALL ITS EARNINGS IN DIVIDENDS.

 

OVERALL CAPITALIZATION RATE OR OVERALL COST OF CAPITAL

 

Ko= NOI/V= NET OPERATING INCOME/ TOTAL MARKET VALUE OF THE FIRM

 

V= B+S

B= MARKET VALUE OF DEBT                                                    

S=MARKET VALUE EQUITY

 

Ko= Kd(B/(B+S)+ Ke(S/(B+S) =

DEBT =50M

EQUITY= 50M

B+S= 100M

Kd=10%

Ke= 12%

 

 

 

 

 

 

 

 

 

Capital Structure Theory – Net Operating Income Approach

Net Operating Income Approach to capital structure believes that the value of a firm is not affected by the change of debt component in the capital structure. It assumes that the benefit that a firm derives by infusion of debt is negated by the simultaneous increase in the required rate of return by the equity shareholders. With an increase in debt, the risk associated with the firm, mainly bankruptcy risk, also increases and such a risk perception increases the expectations of the equity shareholders.

 

Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of the Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage. 

Features of NOI approach:

At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: 
Value of Equity = Total value of the firm - Value of debt

The cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in a highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

NOI APPROACH

VALUE OF FIRM(v)= NOI/Ko OR EBIT/Ko

Ke= E/S=

 

 

Net Income

The theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to the NI approach, if the financial leverage increases, the weighted average cost of capital decreases, and the value of the firm and the market price of the equity shares increase. Similarly, if the financial leverage decreases, the weighted average cost of capital increases, and the value of the firm and the market price of the equity shares decreases. 

Assumptions of NI approach:

1.   There are no taxes

2.   The cost of debt is less than the cost of equity.

3.   The use of debt does not change the risk perception of the investors

 

Modigliani Millar's approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for the constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for the independence of the company's cost of capital.

 

V= B+S

 

MARKET VALUE OF EQUITY=NOI-I / Ke

OR NI/ Ke

Ko= Kd(B/(B+S)+ Ke(S/(B+S)

 

 

 

 

 

Basic Propositions of MM approach:

 

At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in the future, discounted at an appropriate discount rate suitable for the risk undertaken.

 

1.   The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.

 

2.   The minimum cut-off rate for the purpose of capital investments is fully independent of how a project is financed.

 

Assumptions of MM approach:

 

1.   Capital markets are perfect.

 

2.   All investors have the same expectation of the company's net operating income to evaluate the value of the firm.

 

3.   Within similar operating environments, the business risk is equal among all firms.

 

4.   100% dividend payout ratio.

 

5.   An assumption of "no taxes" was there earlier, which has been removed.

 

Proposition I

The market value of any firm is independent of its capital structure AND is given capitalizing its expected return at an overall capitalization rate appropriate to the risk class

 

Ko= Kd(B/(B+S) + Ke(S/(B+S)

S= (EBIT-I)/Ke

Proposition II

Ke(L)= Ke(u)+( Ke(u)-Kd)(B/S)

Ke(L)=COST OF LEVERED EQUITY

Ke(u)= COST OF UNLEVERED EQUITY

 ( Ke(u)-Kd)(B/S)= RISK PREMIUM

 

TAXES AND CAPITAL STRUCTURE

VALUE OF UNLEVERED FIRM

Vu=EBIT(1-Tc)/Ke(U)

Vu= VALUE OF UNLEVERED FIRM

Tc= CORPORATE TAX

 

VALUE OF LEVERED FIRM=VALUE OF UNLEVERED+PV OF DEBT TAX SHIELD

OR, V(L)=Vu+B(Tc)

V(L) =Vu+B(Tc)-PV OF BANKRUPTCY COSTS