Capital Structure PPT

2 ND

CAPITAL STRUCTURE THEORY

Chapter CAPITAL STRUCTURE

Copyright © 2008, Dr Sudhindra Bhat

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FINANCIAL MANAGEMENT, Dr. Sudhindra Bhat

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2 ND


Capital Structure Defined 

The term capital structure is used to represent the p roportionate relationship between debt and equity. equi ty.



The various means of financing represent the financial fi nancial structure of an enterprise. The left-hand side of the balance sheet (liabilities (liab ilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing finan cing the firm¶s capital expenditure.


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Questions while Making the Financing Decision 

How should the investment project be financed?

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How does financing affect the shareholders¶ risk, return and value?

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Does there exist an optimum financing mix in terms of the maximum value to the firm¶s shareholders?

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What factors in practice should a company consider in designing its financing policy?


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Features of An Appropriate Capital Structure 

capital structure is that capital structure at that level of debt ± equity proportion where the market value per share is maximum and the cost of capital is minimum.

Appropriate capital structure should have the fol lowing features 

Profitability



Solvency

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Flexibility



Control


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Determinants of Capital Structure 

Seasonal Variations

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Tax benefit of Debt

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Flexibility

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Control

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Industry Leverage Ratios

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Agency Costs

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Industry Life Cycle

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Degree of Competition

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Company Characteristics

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Requirements of Investors

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Timing of Public Issue

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Legal Requirements


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Definitions used in Capital Structure« E = Total Market Value of Equity. D = Total Market Value of Debt. V = Total Market Value of the Firm. I = Annual Interest payment. NI = Net Income. NOI = Net Operating Income. Ee = Earning Available to Equity Shareholder .


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Patterns / Forms of Capital Structure Following are the forms of capital structure: 

Complete equity share capital;

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Different proportions of equity and preference share capital;

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Different proportions of equity and debenture (debt) capital and

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Different proportions of equity, preference and debenture (debt) capital.


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Assumption of Capital Structure Theories There are only two sources of funds i.e.: debt and equity. 

The total assets of the company are given and do not change. [Investment decision is assumed to be constant].

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The total financing remains constant. [Total capital is same, but p roportion of debt and equity may be changed].

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Operating profits (EBIT) are not expected to grow. All the investors are assumed to have the same expectation about the future profits. Business risk is constant over time and assumed to be independent of its capital structure and financial risk.

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Corporate tax does not exit.

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The company has infinite life.

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Dividend payout ratio = 100%. Copyright © 2008, Dr Sudhindra Bhat

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A Conceptual Look --Relevant Rates of Return

kd = the yield on the company¶s debt

kd

=

I D

=

Annual interest on debt Market value of debt

Assumptions: Interest paid each and every year Bond life is infinite Results in the valuation of a perpetual bond No taxes (Note: allows us to focus on just capital structure issues.)


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A Conceptual Look --Relevant Rates of Return ke = the expected return on the company¶s equity Earnings available to E E common shareholders ke = S = Market value of common S stock outstanding Assumptions: Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm Copyright © 2008, Dr Sudhindra Bhat

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A Conceptual Look --Relevant 2 ND Rates of Return CAPITAL STRUCTURE THEORY

Ko = an overall capitalization rate for the firm O Earnings to all capital supplier Ko = Total V Market value of the firm Assumptions: V = B + S = total market value of the firm Earnings to all capital supplier or EBIT=Interest plus earnings available to common shareholders


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Debt-equity Mix and the Value of the Firm 

Capital structure theories: 

Traditional approach and Net income (NI) approach.

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Net operating income (NOI) approach

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MM hypothesis with and without corporate tax.

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Miller¶s hypothesis with corporate and personal taxes.

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Trade-off theory: costs and benefits of leverage.


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Net Income Approach« A change in the proportion in capital structure will lead to a corresponding change in Ko and V. Assumptions: (i)

There are no taxes;

(ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the risk perception of investors. (iv) Cost of debt and cost of equity remains constant;


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Net Income (NI) Approach 

According to NI approach

both the

Cost

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

ke, ko

ke

result, the overall cost of capital declines and the firm value increases

ko kd

kd

with debt. 

This approach has no basis in reality; the optimum capital structure would be

Debt

100 per cent debt financing under NI approach. Copyright © 2008, Dr Sudhindra Bhat

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Formula used for NI Approach « N et

Income [ NI ] = EBIT ± Debenture Interest.

Market Value of the Firm [V] = Market Value of Equ ity [E] + Market Value of Debt [D] Market Value of Equity [E] =

N et

Income [ N I] / Cost of Equity [Ke]

Market value of Debt [D] = Interest [I] / Cost of Debt [Kd] Cost of Capital [Ko or R] = EBIT / V * 100 or EBIT/ (E+D) * 100


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Net Operating Income Approach« There is no relation between capital structure and Ko and V. Assumptions:  Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. 

The market capitalizes the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity;

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The market value of equity is residue [i.e., Total value of the firm minus market value of debt)

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The use of debt funds increases the received risk of equity investors, there by ke increases The debt advantage is set off exactly by increase in cost of equity.

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Cost of debt (Ki) remains constant

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There are no corporate taxes.


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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 ost

firm¶s capital structure. 

e

In the absence of taxes, an individual holding

all

the

debt

and

equity

securities will receive the same cash flows

regardless

of

the

o

capital

d

structure and therefore, value of the company is the same. ebt


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Formula used for NOI Approach« Value of the Firm [V] = EBIT / Ko Market Value of Equity [E] = V ± D Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT ± I / V-D


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MM Approach Without Tax: Proposition I 

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.


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MM¶s 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.


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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 allequity 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).

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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.


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Features of an Appropriate Capital Structure 

P rofitability



Solvency



Return

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Risk



Flexibility

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Capacity

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Control

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Conservatism


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Capital Structure PPT

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