Capital structure

Capital structure
theories and Planning
the capital structure
Capital structure
Capital structure of a company refers to the
composition or make-up of its capitalisation
and it includes all long term capital resources
viz:loans, reserves, shares and bonds
Capital structure decision is one of the key
decisions that focuses on finding the capital
structure with the single objective of
maximisation of the value of the firm.
Capitalisation, capital structure and
financial structure
Capitalisation refers to the total amount of securities
issued by the company and is a quantitative aspect
of the financial planning of an enterprise
Capital structure refers to the kinds of securities and
the proportionate amounts that make up
capitalisation. It is a qualitative aspect
Financial structure refers to all the financial
resources marshalled by the firm, short as well as
long-term.
Patterns of capital structure
1. Equity shares only
2. Equity and preference shares
3. Equity shares and debentures
4. Equity shares, preference shares and
debentures
Financial leverage or trading on equity
The degree to which an investor or business is utilizing
borrowed money and increases the earnings of equity
shareholders is known as financial leverage.
Companies that are highly leveraged may be at risk of
bankruptcy if they are unable to make payments on their debt;
they may also be unable to find new lenders in the future.
Financial leverage is not always bad, however; it can increase
the shareholders' return on investment and often there are tax
advantages associated with borrowing.
Illustration
A Ltd. Co. has equity share capital of Rs.5 million divided into
shares of Rs.100 each. It wishes to raise further Rs.3 million
for expansion cum modernisation plans. The company have
the following financing schemes:
a) All equity
b) Equity and debt in the ratio 1:2
c) All debts at 10%
d) Equity and 8% preference share capital in the ratio 2:1
The companys current EBIT is 1.5 million. Corporate taxation
is 50%. Calculate EPS and comment on financial leverage.

Point of indifference/Equivalency point
It refers to that EBIT level at which EPS
remains the same irrespective of different
alternatives of debt-equity mix.
It is the point where ROCE is equal to the
cost of debt and hence known as break-even
level of EBIT for alternative financial plans.
Algebraic equation for point of
indifference
(X I1) (1 T) PD = (X I2) (1 T) PD
S1 S2
X= Point of indifference
I1 = Interest under alternative financial plan 1
I2 = Interest under alternative financial plan 2
PD = preference dividend
S1 = Number or amount of equity shares under
financial plan 1
S2 = Number or amount of equity shares under
financial plan 2
Illustration
A project under consideration by your
company requires a capital investment of
Rs.6 million. Interest on debentures is 10%
p.a. and tax rate is 50%. Calculate the point
of indifference for the project, if the debt
equity ratio insisted by the financing
agencies is 2:1.
Optimal capital structure
The best debt-to-equity ratio for a firm that
maximizes its value.
The optimal capital structure for a company is one
which offers a balance between the ideal debt-to-
equity range and minimizes the firm's cost of capital.
In theory, debt financing generally offers the lowest
cost of capital due to its tax deductibility. However, it
is rarely the optimal structure since a company's risk
generally increases as debt increases.


Debt-equity Mix and the Value of the
Firm
Capital structure theories:
Net income (NI) approach.
Net operating income (NOI) approach.
Traditional approach
MM hypothesis with and without corporate tax.
Millers hypothesis with corporate and personal taxes.
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.
ke
ko
kd
Debt
Cost
kd
ke, ko
Net Income (NI) Approach
Assumptions
1. Cost of debt is less than cost of equity
2. No corporate taxes
3. Risk perception of investors is not changed
by the use of debts
Computation of market value of a firm
V = S + D
V = Total market value of the firm
S = Market value of equity shares
i.e., Earnings available to equity shareholders
Equity capitalisation rate
D = Market value of debt
WACC or K0 =EBIT
V
Illustration
A company expects a net income of
Rs.80000. It has Rs.2 Lakhs, 8% debentures.
The equity capitalisation rate of the company
is 10%. Calculate the value of the firm and
overall capitalisation rate according to NI
approach.
If the debenture debt is raised to
Rs.3 Lakhs, what shall be the value of the
firm and the overall capitalisation rate?
Net Operating Income (NOI) Approach
According to NOI
approach the value of the
firm and the weighted
average cost of capital are
independent of the firms
capital structure. In the
absence of taxes, an
individual holding all the
debt and equity securities
will receive the same cash
flows regardless of the
capital structure and
therefore, value of the
company is the same.

ke
ko
kd
Debt
Cost
Net Operating Income (NOI) Approach
Assumptions
The market capitalises the value of the firm
as a whole
The business risk remains constant while
equity shareholders risk increases with
increased use of debt
There are no corporate taxes

Net Operating Income (NOI) Approach
V = EBIT
K0
S = V D
The value of the firm is determined first and
market value of equity is the residual value
which is determined by deducting the market
value of debentures form the total market
value of the firm.
Illustration
A company expects a net operating income of
Rs.100000. It has Rs.500000, 6% debentures. The
overall capitalisation rate is 10%. Calculate the value
of the firm and the equity capitalisation rate
according to NOI approach.
If the debenture debt is increased to Rs.750000,
what will be the effect on the value of the firm and
the equity capitalisation rate?
Traditional Approach
The traditional approach
argues that moderate degree
of debt can lower the firms
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 risk and 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.
ke
ko
kd
Debt
Cost
MM Approach Without Tax:
Proposition I
MMs Proposition I states that
the firms 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.
ko
Debt
Cost
MM's Proposition I
MM Approach Without Tax: Proposition I
How arbitrage works?
According to M&M theory, levered firm may
have higher value in the short run but this
situation cannot remain for a long period
because of arbitrage process.
Arbitrage
Levered Firm ( ):
60, 000 50, 000 110, 000
interest rate 6%; NOI 10,000
shares held by an investor in 10%
Unlevered Firm ( ):
100, 000
NOI 10, 000
l l l
d
l
u u
L
V S D
k X
L
U
V S
X
o
= + = + =
= = = =
= =
= =
= =
Arbitrage
( ) ( )
( )
Return from Levered Firm:
10 110, 000 50 000 10% 60, 000 6 000
10% 10, 000 6% 50, 000 1, 000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
= = =
= = = (

=
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
=
=
=
= =
= =
= =
sh available 11,000 10,000 1,000 = =
Illustration
The following is the data regarding two companies A & B
belonging to the same equivalent risk class:
Co. A Co. B
No. of ordinary shares 100000 150000
8% debentures 50000 ---
MP per share Rs.1.30 Re.1
EBIT 20000 20000
Both companies follow 100% pay-out policy.
You are required to explain how under MM approach, an
investor holding 10% of shares in company A will be better off
in switching his holding to Company B.
MMs 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 firms 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
ko
kd
Debt
Cost
MM's Proposition II
MM Propositions I and II
/
o
o
d
e
e o o
d
MM Proposition I :
X
V
k
X
k
V
MM Proposition II :
X k D
k
S
k k (k k )D S
=
=

=
= +
MM Hypothesis With Corporate Tax
Under current laws in most countries, debt has an important
advantage over equity: interest payments on debt are tax
deductible, whereas dividend payments and retained
earnings are not. Investors in a levered firm receive in the
aggregate the unlevered cash flow plus an amount equal to
the tax deduction on interest. Capitalising the first
component of cash flow at the all-equity rate and the second
at the cost of debt shows that the value of the levered firm is
equal to the value of the unlevered firm plus the interest tax
shield which is tax rate times the debt (if the shield is
fully usable).
It is assumed that the firm will borrow the same amount of
debt in perpetuity and will always be able to use the tax
shield. Also, it ignores bankruptcy and agency costs.
MM Hypothesis with Corporate Tax
After-tax earnings of Unlevered Firm:
(1 )
Value of Unlevered Firm:
(1 )
After-tax earnings of Levered Firm:
( )(1 )
(1 )
Value of Levered Firm:
(1 )
T
u
T
d d
d
d
l
u d
u
u
X X T
X T
V
k
X X k D T k D
X T Tk D
Tk D X T
V
k k
V TD
=

=
= +
= +

= +
= +
Illustration
There are two firms X &Y which are exactly
identical except that X does not use any debt
in its financing. Both the firms have EBIT of
Rs.25000 and equity capitalisation rate is
10%. Assuming corporate taxation of 50% .
Calculate the value of the firm using M&M
approach.
Planning the capital structure
Capital structure planning aims at the
maximisation of profits and wealth of
shareholders, ensures the maximum value of
a firm or the minimum cost of capital. It is
very important for the financial manager to
determine the proper mix of debt and equity
of his firm. In principle, every firm aims at
achieving the optimal capital structure.
Essential features of a sound capital
mix
1. Maximum possible use of leverage
2. Flexibility
3. Undue financial risk associated with increase of
debt should be avoided
4. Use of debt should be within the capacity of the
firm
5. It should involve minimum possible risk of loss of
control
6. It must avoid undue restrictions in agreement of
debt


Factors determining the capital
structure
Financial leverage/Trading on equity
Growth and stability of sales
Cost of capital
Cash flow ability to service debt
Nature and size of the firm
Control
Flexibility
Requirements of investors
Factors determining the capital
structure
Capital market conditions
Asset structure
Purpose of financing
Period of finance
Costs of floatation
Abilities of management
Corporate tax rate
Legal requirements
Pecking Order Theory
The announcement of a share issue reduces the share
price because investors believe managers are more likely
to issue when shares are overpriced.

Firms prefer internal finance since funds can be raised
without sending adverse signals.

If external finance is required, firms issue debt first and
equity as a last resort.

The most profitable firms borrow less not because they
have lower target debt ratios but because they don't need
external finance.

Pecking Order Theory
Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is
better.

EBIT-EPS Analysis
To understand the implications of debt financing on
returns to shareholders, we compare the earnings
available to shareholders (EPS) with various
financing alternatives. The comparison of the
financing alternatives must be made at the expected
value of EBIT.EBIT-EPS analysis is a powerful
analytical tool that helps in evaluation of different
financing patterns and in establishing a target capital
structure
EBIT-EPS Analysis
As leverage increase, the change in EPS and
return on equity is steeper and steeper.
Therefore increased amount of debt makes
returns to shareholders higher and riskier.
With EBIT-EPS analysis the capital structure
can be planned with desired return on equity
or EPS and risk appetite.
Limitations of EBIT-EPS Analysis
1. Growth rate of EPS is ignored
2. The risk of EBIT is not considered
3. The time value of money is not considered
ROI-ROE analysis
The EBIT-EPS analysis is done with absolute
numbers available, where total earnings potential is
measured by EBIT and the return to shareholders is
measured in terms of EPS. Often the comparison is
more convenient in percentage terms. If EBIT is
replaced by ROI and EPS is replaced by ROE, and
both are expressed in percentage terms, we obtain a
relationship between ROI and ROE similar to that
between EBIT and EPS
Summary of ROI-ROE analysis
As long as ROI is greater than the cost of debt, the
excess of ROI over the cost of debt contributes to
enhancement of the ROE. Therefore it is more
beneficial to choose a capital structure favouring
leverage.
When ROI is not enough to meet the cost of debt, it
is advantageous to have the capital structure
oriented towards equity.
The point where ROI is equal to the cost of debt will
be the point of indifference from the point of view of
the capital structure.