Capital Structure Theory by edutap

Summary Sheet Capital Structure Theories

Important Points

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1 Summary Points  Capital Structure: Combination of capital of a firm from different sources of finance i.e. equity share

holders’ fund, preference share capital and long term external debts  The ultimate objective of ay firm is to maximize the value of the company through optimal capital structure  Capital Structure Theories Classification:

 Capital Structure Relevance Theory: Says that composition of capital structure i.e. amount of debt

and equity influence the Value of Firm and Cost of Capital  Capital Structure Irrelevance Theory: Says that composition of capital structure has no effect on the value of the firm  Basic assumptions implied in Capital Structure Theories: 1. There are only 2 kinds of funds used by a firm i.e. debt and equity 2. The total assets of the firm are constant 3. Taxes Taxes are not considered 4. The payout ratio is 100% 5. The firm’s total financing remains constant 6. Business risk is constant over time 7. The firm has perpetual life  Net Income Approach (NI): According to this approach, capital structure decision is relevant to the

value of the firm. It says, 1. Increase in financial leverage (Debt)  decline in the weighted average cost of capital (WACC) (WACC) and increase in value of the firm as well as market price of ordinary share 2. Suggests the firm to employ as much debt as a s possible to maximize its value by minimizing the cost of capital

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Assumes Ke and Kd don’t change with leverage  Basic Formul ae used in NI approach:

Where, S = Market value of equity D = Market value of debt

Where, NI = Earnings available for equity shareholders Ke = Equity Capitalization rate

Where, Interest = Interest charged on Debt Kd = Cost of Debt

Where, EBIT = Earnings before Interest and Tax  Example: In the following table, 3 scenarios have been given to observe a change(decrease) in WACC

with increase in debt employed in the capital www.edutap.co.in


 Under the NI approach, approach, the firm will have the maximum value and minimum WACC when it is 100

per cent debt-financed  Traditional Approach: Approach favours that as a result of increase in financial leverage cost of

capital comes down and value of firm increases up to some point but beyond that point, reverse trends emerge  Says that there is an optimal capital structure occurs at the point where value of the firm is highest, and the cost of capital is the lowest  Cost of capital is a function of leverage

 Net Operating Income Approach (NOI): According to this approach, capital structure decisions of

the firm are irrelevant. It says, www.edutap.co.in


 Any change in the leverage will not lead to any change in the total value of the firm

and the market price of shares  Increase in the use of debt (which is cheaper) is offset by increase in the equity capitalization rate

 Modigliani-Miller Approach (MM): Approach provides behavioural justification for constant overall

cost of capital and therefore, total value of the firm

 MM Approach-1958 without Tax: This approach describes, in a perfect capital market where there

is no transaction cost and no taxes , the value and cost of capital of a company remain unchanged irrespective of change in the capital structure taxes):  Further assumptions made in MM Approach(without taxes): 1. Capital markets are perfect 2. All investors are rational 3. Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk 4. Non-existence of corporate taxes  Propositions made by MM: 1. Total market value of a firm is equal to its expected net operating income divided by the discount rate appropriate to its risk class decided by the market. That is,

2. A firm having debt in capital structure has higher cost of equity than an unlevered firm

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3. The structure of the capital (financial leverage) does not affect the overall cost of capital

operational justification of Modigliani-Miller hypothesis is explained through the functioning of  The operational justification the arbitrage process and substitution of corporate leverage by personal leverage  Arbitrage: Refers to buying asset or security at lower price in one market and selling it at a higher price in i n anoth a nother er market mar ket.. As a result, equilib equilibrium rium is attained in different different markets markets  Investors of the firm whose value is higher will sell their shares and instead buy the shares of the firm whose value is lower  They will be able to earn the same return at lower outlay with the same perceived risk

or lower risk  There is a conservation of investment value. That is, total investment value of a

corporation depends upon its underlying profitability and risk, it is invariant with respect to relative changes in the firm ’s financial capitalization  This process will be continued till both the firms will ha ve same market value  Example: Suppose there are two firms, viz., Firm- ‘A’ and Firm-‘B’. They are similar in all respects except in the composition of capital structure. Assuming that Firm- ‘A’ is financed only by equity whereas Firm-‘B’ is financed by a debt-equity mix. Following are the details:

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Process would be as: The Arbitrage Process If an equity shareholder, has 1% equity of firm-‘B’. He will do the following: 1. First, he will dispose of his equity of firm- ‘B’ for Rs. 3,333 2. He will take a loan of Rs. 2,000 at 5% interest from personal account 3. He will purchase by having Rs. 5,333 (i.e., Rs. 3,333 + Rs. 2,000) 1.007% of equity from the firm ‘ A’ 4. With this, his net income will be = Return from firm ‘A’ ‘A’ – – Interest @ 5% = 533 – 100 = 433 5. Whereas, his old net income was = Return from firm ‘B’ = 1 %(Equity Earnings) = 1% (50000 – 5%(20000)) = 400 6. Thus, Net Arbitrage earned by the investor = 433-400 = 33  MM Approach- 1963: with tax: Recognizes that the value of the firm will increase, or cost of capital

will decrease where corporate taxes exist  Value of levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate  The effective cost of debt will be less than the explicit rate of interest because of tax benefits, also known as tax shield  Important formulae in MM Approach (With Taxes):

Where Vl= Value of Levered Firm Vu= Value of Unlevered Firm D= Amount of Debt www.edutap.co.in


t= Tax Rate

 Trade off theory:

1. 2. 3. 4.

Entails off setting setting the costs of debt against the benefits of debt Deals with the two concepts - cost of financial distress and agency costs States that there is an advantage to financing with debt, the tax benefits of debt And disadvantage of cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy non -bankruptcy costs 5. Optimizing overall value of the firm will focus on this trade-off when choosing how much much debt and equity to use for financing 6. Agency costs: Costs occurring due to dispute of interests among the management of the firm, debt holders and shareholders  Pecking Order Theory: 1. Based on Asymmetric information, which refers to a situation in which different parties have different information 2. States that firms prefer to issue debt when they are positive about future earnings 3. According to it, there are two kind of equity internal and external 4. Suggests that managers may use various sources for raising of fund by following below rules:  Use internal financing first  Issue debt next  Issue of new equity shares at last

Worksheet Click the next green button on the bottom of your screen to view the Work sheets Worksheets on this topic. Work sheet consists of 1. Fill in the blanks 2. True /False www.edutap.co.in


3. MCQs 4. Match the column This will give new dimensions to your learning and will test how much you can apply

So do not forget and attempt this Worksheet. Happy Learning!!!

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Capital Structure Theory by edutap

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