Chapter – 19

Capital Structure and Firm Value

 OVERVIEW
• What should be the proportions of equity and debt in the capital
structure of the firm?
or
• How much leverage should a firm employ?

• What is the relationship between capital structure and firm

value?
or
• What is the relationship between capital structure and firm
value?
 Capital Structure Theories:
– Net operating income (NOI) approach.
– Net income (NI) approach.
– Traditional approach
– MM hypothesis without corporate tax.
– MM hypothesis with corporate tax.
– Miller’s hypothesis with corporate and personal taxes.
– Trade-off theory: costs and benefits of leverage.

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 Assumptions
Assumptions made towards examining the relation between capital
structure and cost of capital:
 There is no income tax, corporate or personal.

 Firm pursues with 100% dividend payout ratio.

 Investors have identical subjective probability distributions of

operating income for each firm.

 Operating income remains constant over time.

 A firm can change its financing mix instantaneously without

incurring transaction costs.
 Assumptions
I Annual interest charges
Cost of debt (rD ) = =
D Market value of debt

E Equity earnings
Cost of equity (rE ) = =
D Market value of equity

E Operating income
Overall capitalization rate (rA) = =
D Market value of the Firm

D E
rA = rD ( ) + rE ( )
D+E D+E

V =D + E
Market Value of firm = Market Value of Debt + Market Value of Equity
 Net Income Approach (NIA)
Assumptions:
 There are no taxes and transaction costs.
 Debt is risk free.
 Shareholders perceive no financial risk arising from the use of debt.

• As per this approach, the cost of debt rD and the cost of equity rE remains
unchanged when D/E varies.

D E
rA= rD( ) + rE( )
D+E D+E

• 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 APPROACH
According to this approach, rD and rE remain unchanged when D/E varies. The
constancy of rD and rE with respect to D/E means that rA declines as D/E
increases.

As D/E increases rD which is lower than rE receives a higher weight in the

calculation of rA.
 Net Income Approach (NIA)
• Two firms A & B similar in all aspects except the degree of leverage report the
following financials:
Item Firm A Firm B
Operating income 10,000 10,000
Debt interest 0 3,000
Equity earnings 10,000 7,000
Cost of equity 10% 10%
Cost of debt 6% 6%
Market value of equity 1,00,000 70,000
Market value of debt 0 50,000
Total value of firm 1,00,000 1,20,000

rA for firm A = 0.06 x (0/1,00,000) + 0.10 x (1,00,000/1,00,000) = 10%

rA for firm B = 0.06 x (50,000/1,20,000) + 0.10 x (70,000/1,20,000) = 8.3%

 Net Income Approach (NIA)
• Value of the firm under NI approach.
re = 10 % re = 10 % re = 10 %
Replaces equity by Replaces equity by
Zero debt 5% ₹ 300,000 debt 5% ₹ 900,000 debt
Net operating Income (NOI) 100,000 100,000 100,000
Interest (I) 0 15,000 45,000
Net Income (NI) 100,000 85,000 55,000
Market Value of Equity 100,000/.10 85000/.10 55000/.10
(E) = NI/rE = 1000,000 = 850,000 = 550,000
Market Value of debt 0 15000/.05 45000/.05
(D) = I/rD = 300,000 = 900,000
Market Value of the firm 1,000,000 1,150,000 1,450,000
(V) = D + E or NOI/rA

Debt to total Value (D/D+E) 0.00 0.261 0.62

D E 0.10 0.087 0.081
WACC or rA = rD ( ) +rE ( )
D+E D+E

Therefore, as a firm increases debt proportion in the capital structure, the WACC
decreases and market value of the firm increases.
 Net Operating Income Approach (NOIA)
• The overall capitalization rate (rA) and the cost of debt (rD) remains
constant for all degrees of leverage.
D E
rA= rD( )+ r E( )
D+E D+E

• Given this, cost of equity can be expressed as

D
rE = rA + (rA – rD) ( )
E

• Underlying premises of this approach are:

 Market capitalizes the firm as a whole at a discount rate which is
independent of the firm’s debt-equity ratio.
 Division between debt and equity becomes irrelevant.
 An increase in use of debt of funds which are cheaper is offset by an
increase in the equity capitalization rate.
 It results because equity investors seek higher compensation as they are
exposed to greater risk on account of enhanced degree of leverage.
 Thus, they raise rE as the degree of leverage increases.
 NET OPERATING INCOME APPROACH
According to this approach the overall capitalisation rate (rA) and the cost of debt (rD) remain
constant for all degrees of leverage. Hence rE = rA + (rA – rD) (D/E)
 Net Operating Income Approach (NOIA)
• Two firms A & B similar in all aspects except the degree of leverage report the
following financials:
Item Firm A Firm B
Operating income 10,000 10,000
Overall capitalization rate 15% 15%
Total market value (NOI/rA ) 66,667 66,667
Debt interest 1,000 3,000
Debt capitalization rate 10% 10%
Market value of debt(D) = I/rD 10,000 30,000
Market value of equity (E) = NI/rE 56,667 36,667
D/E 0.176 0.818

rE for firm A = (10,000 – 1,000)/56,667 = 15.9%

or rE for firm A = 15 + (15-10) 0.176 = 15.9%
rE for firm B = (10,000 – 3,000)/36,667 = 19.1%
or rE for firm B = 15 + (15-10) 0.818 = 19.1%
 Traditional Approach (TA)
• The chief assertions of the traditional approach are:
 Cost of debt rD remains majorly constant up to a certain level of leverage but rises
thereafter at an increasing rate.
 Cost of equity rE remains more or less constant or rises gradually up to a certain level of
leverage and rises sharply thereafter.
 Average cost of capital (rA) as a result of such behavior of rD and rE
 Decreases up to a certain point
 Remains unchanged for moderate increases in leverage thereafter
 Rises beyond a certain point

Optimal Capital Structure:

 Initially the cost of capital for the firm will fall as cheaper debt replaces expensive equity.
 Even though the cost of equity rises with increased debt the advantages of debt would
outweigh the increased cost of equity equity.
 Beyond a certain level of leverage the cost of equity starts rising disproportionately,
more than offsetting the advantage of debt, raising the overall cost of capital for the firm.
 Since cost of capital falls initially and then starts rising there exists a point where cost of
capital would be least.
 This point of least cost of capital would maximise the value of the firm and is the optimal
capital structure of the firm and is the optimal capital structure.
 Traditional Approach (TA)

TA suggests that the cost of capital is dependent on the capital structure and there is an
optimal capital structure which minimizes the cost of capital.
Below optimal point MC of Debt < MC of Equity
At the optimal point MC of Debt = MC of Equity
Beyond optimal point MC of Debt > MC of Equity MC: Marginal Cost

The traditional theory on the relationship between capital structure and the firm value
has three stages:
• First stage: Increasing value
• Second stage: Optimum value
• Third stage: Declining value
 Traditional Approach (TA)
re = 10 % re = 10.56 % re = 12.5 %
Replaces equity by Replaces equity by
Zero debt 6% ₹ 300 cr. debt 7% ₹ 600 cr. debt
(₹ in cr.) (₹ in cr.) (₹ in cr.)
Net operating Income (NOI) 150 150 150
Interest (I) 0 18 42
Net Income (NI) 150 132 108
Market Value of Equity 150/.10 132/.1056 108/.125
(E) = NI/rE = 1500 = 1250 = 864

Market Value of debt 0 18/.06 42/.07

(D) = I/rD = 300 = 600
Market Value of the firm 1,500 1,550 1,464
(V) = D + E or NOI/rA
Debt to total Value (D/D+E) 0.00 0.194 0.410
D E 0.10 0.0970 0.1030
WACC or rA = rD ( ) +rE ( )
D+E D+E
 Modigliani & Miller Approach (MM)
Assumptions:
 Perfect capital market
 Securities are indefinitely divisible.
 Investors are free to buy/sell securities.
 Investors can borrow on the same terms and conditions as firms can.
 There are no transaction costs.
 Information is perfect, that is, each investor has the same information
which is readily available to him without cost.
 Investors are rational and behave accordingly.

 Homogenous expectations
 Equivalent risk classes
 Absence of tax
 The dividend payout ratio is 100 per cent.
Modigliani & Miller Approach (MM)
Proposition-1 (without taxes):
The value of a firm is equal to its expected operating income divided by the
discount rate appropriate to its risk class. It is independent of its capital structure.

V = D + E = O/r

V = Market value of the firm, D = Market value of debt, E = Market value of equity
O = Expected operating income, r = Discount rate applicable to the risk class to
which the firm belongs.

Value of levered firm = Value on unlevered firm

• Proposition – 1 is identical to net operating income approach. MM invoked an
arbitrage argument to prove this proposition.
 Arbitrage Process:
• Two firms U and L, similar in all respects except in their capital structure.
Firm U Firm L
Operating Income (EBIT) 150,000 150,000
Interest 0 60,000
Net Income or Equity Earnings 150,000 90,000
Cost of Equity 0.15 0.16
Market Value of Equity 1,000,000 562,500
Cost of debt - 0.12
Market value of debt 0 500,000
Market Value of the firm 1,000,000 1,062,500
Average CoC (WACC) 0.15 0.1412
Let Suppose, an investor owns 10% equity in firm L, he would do well to:
• Sell his equity in firm L for ₹ 56,250.
• Borrow 50,000, an amount equal to 10% of L’s debt, at an interest rate of 12%.
• Buy 10% of firm U’s equity for ₹ 100,000.
• His investment is ₹ 100,000, leaving him with a surplus amount of ₹ 6,250. Yet his income
remains the same:
Old income from investment in L New income from investment in U
10% of equity income 9,000 15000
12% interest on Loan - (6,000)
9000 9000
 Arbitrage Process
• Suppose two identical firms, except for their capital
structures, have different market values. In this situation,
arbitrage (or switching) will take place to enable investors to
engage in the personal or homemade leverage as against the
corporate leverage, to restore equilibrium in the market.

• On the basis of the arbitrage process, MM conclude that the

market value of a firm is not affected by leverage. Thus, the
financing (or capital structure) decision is irrelevant. It does
not help in creating any wealth for shareholders. Hence one
capital structure is as much desirable (or undesirable) as the
other.

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 Modigliani & Miller Position (MM)
Proposition-2 (without taxes):
• Value of the firm depends on the expected net operating income and opportunity
cost of capital (rA or ko).

• In the absence of corporate taxes, the firm’s capital structure (financial leverage)
does not affect its net operating income.

• The opportunity cost of capital, depends on firm’s operating risk. Since, financial
leverage does not affect the firm’s operating risk, therefore, it does not affect
opportunity cost of capital.

• Financial leverage causes two opposing effects: it increases the shareholders’ return
but it also increases their financial risk. Shareholders will increase the required rate
of return (i.e., the cost of equity) on their investment to compensate for the financial
risk. The higher the financial risk, the higher the shareholders’ required rate of
return or the cost of equity.

• The cost of equity for a levered firm should be higher than the opportunity cost of
capital, ko; that is, the levered firm’s ke > ko. It should be equal to constant ka, plus a
financial risk premium.
Modigliani & Miller Position (MM)
Proposition-2 (without taxes):
 An increase in financial leverage increases the expected earnings per
share but not the share price.
 The change in the expected EPS is offset by a corresponding change in the
return required by the shareholders.

rE = rA + (rA – rD) (D/E)

 The expected return on equity is equal to the expected rate of return on

assets, plus a premium.
 The premium is equal to the debt-equity ratio times the difference
between the expected return on assets and the expected return on debt.
Modigliani & Miller Position (MM)
Proposition-2 (without taxes):
Levered Firm Unlevered Firm
Debt/equity = 50:50
Ko = Ke Ko = kd + Ke Expected return on equity:
rE = rA + (rA – rD) (D/E)
= 15% = 10% (.50) + 20% (.50) = 15% + (15% - 10%) (.5/.5)
= 15% = 20%
Risk premium for equity:
= (rA – rD) (D/E)
= (15% - 10%) (.5/.5) = 5%
The cost of equity for a levered firm should be higher than the opportunity cost of
capital, ko; that is, the levered firm’s ke > ko , 20% > 15%
 Modigliani & Miller Position (MM)
Proposition-2 (without taxes) under Extreme Leverage:

• The excessive use of debt increases the risk of default. Hence, in practice, the
cost of debt (rD or kd) will increase with high level of financial leverage.
• To compensate for this, the rate of increase in rE or ke decreases and may even
turn down eventually.
• This happens because as the D/E ratio increases beyond the threshold level, a
portion of the firm’s business risk is borne by the suppliers of debt capital.
• As the firm borrows more, more of its business risk is shifted from shareholders
to creditors.
 Criticism of the MM Hypothesis

• Lending and borrowing rates discrepancy

• Non-substitutability of personal and corporate

leverages

• Transaction costs

• Institutional restrictions

• Existence of corporate tax

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 RELEVANCE OF CAPITAL STRUCTURE:
THE MM HYPOTHESIS UNDER CORPORATE TAXES
• MM show that the value of the firm will increase with debt due to the
deductibility of interest charges for tax computation, and the value of the
levered firm will be higher than of the unlevered firm.

Value of levered firm = Value of unlevered firm + Gain from leverage i.e. PV of Tax Shield
VL = VU + tC D

𝑂(1−𝑡𝑐)
V = + tC D
r

where V = value of the firm

O = operating income
tC = corporate tax rate
r = capitalisation rate applicable to the unlevered firm
D = market value of debt
 Example: Debt Advantage: Interest Tax Shields
Suppose two firms L and U are identical in all respects except that firm L is levered
and firm U is unlevered. Firm U is an all-equity financed firm while firm L employs
equity and Rs 5,000 debt at 10 per cent rate of interest. Both firms have an
expected earning before interest and taxes (or net operating income) of Rs 2,500,
pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends
to shareholders.

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• Total income after corporate tax is Rs 1,250 for the unlevered firm U and Rs
1,500 for the levered firm L.
• Thus, the levered firm L’s investors are ahead of the unlevered firm U’s
investors by Rs 250.
• You may also note that the tax liability of the levered firm L is Rs 250 less than
the tax liability of the unlevered firm U.
• For firm L the tax savings has occurred on account of payment of interest to
debt holders.
• Hence, this amount is the interest tax shield or tax advantage of debt of firm L:
0.5 × (0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,

Interest tax shield = Corporate Tax Rate x interest = t𝐶𝑟𝐷𝐷

Corporate Tax Rate x interest t𝐶𝑟𝐷𝐷

PV of interest Tax shield = = = t𝐶𝐷
Cost of debt rD

*Interest tax shield is used for calculating total income of the levered firm.
*Present Value (PV) is used for calculating the market value of the levered firm.
 Implications of the MM Hypothesis with
Corporate Taxes
• The MM’s “tax-corrected” view suggests that, because of the tax deductibility of
interest charges, a firm can increase its value with leverage. Thus, the optimum
capital structure is reached when the firm employs almost 100 per cent debt.

• In practice, firms do not employ large amounts of debt, nor are lenders ready
to lend beyond certain limits, which they decide.

Why do companies not employ extreme level of debt in practice?

• First, we need to consider the impact of both corporate and personal taxes for
corporate borrowing. Personal income tax may offset the advantage of the
interest tax shield.

• Second, borrowing may involve extra costs (in addition to contractual interest
cost)—costs of financial distress—that may also offset the advantage of the
interest shield.
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 FINANCIAL LEVERAGE AND CORPORATE AND
PERSONAL TAXES
• Companies everywhere pay corporate tax on their earnings. Hence, the
earnings available to investors are reduced by the corporate tax.
• Further, investors are required to pay personal taxes on the income
earned by them.
• Therefore, from investors’ point of view, the effect of taxes will include
both corporate and personal taxes.
• A firm should thus aim at minimizing the total taxes (both corporate
and personal) to investors while deciding about borrowing.

How do personal income taxes change investors’ return

and value?
It depends on the corporate tax rate and the difference in the
personal income tax rates of investors.
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 Limits to Borrowings
• The attractiveness of borrowing depends on:
 corporate tax rate,
 personal tax rate on interest income and
 personal tax rate on equity income.

• The advantage of borrowing reduces :

 When corporate tax rate decreases, or
 when the personal tax rate on interest income increases, or
 when the personal tax rate on equity income decreases.

• When will a firm stop borrowing?

• A firm will stop borrowing when (1 – Tpd) becomes equal to (1 – Tpe) (1 – T). Thus, the
net tax advantage of debt or the interest tax shield after personal taxes is given by
the following:

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Interest income after personal taxes = Interest Income – Personal tax on interest
income
KdD (1-Tpd) = KdD – KdDTpd

Equity income after personal taxes = Net operating Income (1 – Corporate tax rate)
x (1 – Personal tax rate)
KeD (1-Tpd) = O (1−Tc) x (1−Tpe)

Net tax advantage of debt in % Net tax advantage of debt in

Amount
(when, Kpd = Kpe) Tc (1-Tp) KdD x Tc (1-Tp)
(when, Kpd ≠ Kpe ) (1-Tpd) – (1-T) x (1-Tpe) KdD x [(1-Tpd) – (1-T) x (1-Tpe)]

PV of interest tax shield

(when, Kpd = Kpe) KdD x Tc (1−Tp)
Kd (1 − Tpd)
(when, Kpd ≠ Kpe ) KdD x [(1−Tpd) – (1−Tc) x (1−Tpe)]
Kd (1 − Tpd)
 Value of Levered Firm: Corporate & Personal Taxes
Levered firm income After taxes (when, Kpd = Kpe) = Unlevered firm income after taxes +
Net tax advantage of debt
= O (1 – Tc) (1 – Tp) + KdD x Tc (1-Tp)

Kpd = personal tax on debt or interest income.

Kpe = personal tax on equity income.
O = Operating Income.
Tc = Corporation tax rate.
KdD = Interest Income
Tp = Personal tax rate, when then, Kpd = Kpe = Tp