Capital Structure

CAPITAL STRUCTURE

Designing and Theories

CAPITAL STRUCTURE

The term capital structure is used to represent the proportionate relationship between debt and equity in a firm’s total capital. It is also referred to as the debt-equity mix or capital-mix.

The inclusion of debt capital into the capital structure of a company is called financial leverage.

CAPITAL STRUCTURE…

Caution while designing the capital structure:

Increase in financial riskOptimal capital structure: One

at which the market value of the firm is maximized.

Criteria for determining the Pattern of Capital Structure

1. Assets: Tangible or Intangible Assets?2. Growth Opportunities3. Debt and Non-Debt tax shields4. Financial flexibility and Operating

strategy5. Loan Covenants6. Financial Slack (unused debt capacity,

excess liquid assets, access to untapped sources of finance)

Criteria for determining the Pattern of Capital Structure….

7. Sustainability & Feasibility8. Control : Widely held company

or Closely held company9. Marketability & Timings10.Issue costs (or Floatation

Costs)11.Capacity of raising funds (Size

of the company)

Factors Influencing the Pattern of Capital Structure

1. Profitability aspect2. Liquidity aspect3. Control4. Leverage ratios in industry5. Nature of industry

Factors Influencing the Pattern of Capital Structure…

6. Consultation with investment bans/lenders

7. Commercial strategy8. Timing9. Company characteristics10.Tax planning

CAPITAL STRUCTURE: THEORIES

RELEVANCE THEORY:The Net Income (NI) Approach

IRRELEVANCE THEORIES:The Net Operating Income (NOI)

ApproachThe Modigliani-Miller (MM)

Hypothesis (without corporate taxes)

Assumptions (Basic for all theories)

1. Firms employ only two types of capital : debt and equity.

2. The firm pays 100 % dividends. There is no retention of dividends. Hence, b=0 (b=retention ratio), therefore growth rate g = b X ROE = 0.

3. The operating earnings (Earnings Before Interest and Tax EBIT) are not expected to grow.

4. There are no taxes – whether personal or corporate.

Net Income (NI) Approach

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

Net Income (NI) Approach…

Assumptions: 1. Use of debt doesn’t make the

investors thin that the firm is risky.

2. There is no corporate income tax

3. kd (cost of debt) & ke (cost of equity) remain unchanged.

Net Income (NI) Approach…

ke

kokd

Debt

Cost

kd

ke, ko

Net Operating Income (NOI) Approach

According to NOI approach the value of the firm and the weighted average cost of capital (k0) are independent of the firm’s capital structure. Hence, the capital structure of a firm is irrelevant in influencing the value of a firm. In other words the benefits of using leverage is exactly offset by the rising cost of equity.

Net Operating Income (NOI) Approach…

ke

ko

kd

Debt

Cost

Net Operating Income (NOI) Approach…

Assumptions:1. The market capitalizes the value of a

firm as a whole, so the split between debt and equity is not important

2. The use of debt funds in the capital structure , increases the risk of the shareholders, thus the cost of shares (ke) is also likely to increase

3. The cost of debt (kd) remains constant

4. There are no corporate taxes

Modigliani-Miller Hypothesis M-M Hypothesis is identical with NOI Approach. M-M argue that – In the absence of taxes, a firm’s market

value and cost of capital do not change in relation to changes in the capital structure. They propound that the value of a firm is based on its investing decisions (risk of assets and earnings) and not on the financing decisions (the way these assets have been financed).

Modigliani-Miller Hypothesis

Proposition I: The overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure.

Proposition II: Along with the increase in leverage the cost of equity increases in a way so as to exactly offset the benefit of leverage.

Proposition III: The cut-off rate for investment purposes is completely independent of the way in which an investment is financed.

Modigliani-Miller Hypothesis…

Assumptions: 1.Perfect Capital Markets :

It means that the investors are free to buy or sell the securities are their will. They can borrow without restrictions at the same terms as firms do. They behave rationally. Transaction costs, i.e. costs of buying and selling securities do not exist. All informations in the market are readily available to the investors and they behave rationally.


2.Homogenous Risk Classes : Firms can be grouped into

homogenous risk classes. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics.


3.Risk : Risk is defined as variability of

the Net operating Income (NOI).4.No Taxes:

There are no corporate taxes.5.Full Payout:

Dividend payout by firms is 100%.


The basic operational justification for the M-M hypothesis is the arbitrage process.

Arbitrage : The term arbitrage refers to the act of buying an asset/security in one market (at lower prices) and selling it in another (at higher prices). As a result of which an equilibrium is set up in the market prices of securities. It is basically a balancing operation.

Modigliani-Miller Hypothesis…Arbitrage (Modus Operandi) Investors of shares in firm whose value is

higher (Fl) will sell their shares and buy the shares of the firm whose value is lower (Fu).

This will lead to: Increasing the share prices (value) of the

firm whose shares are being purchased. Decreasing the share prices (value) of

the firm whose shares are being sold.This will continue till the market prices of

both the firms become equal.


ko

Debt

Cost

MM's Proposition I

Modigliani-Miller Hypothesis… Proposition II: The cost of equity for

a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.


ke

k0

kd

Cost

DebtMM’s Proposition II

Capital Structure

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