CAPITAL STRUCTURE THEORIES NOTES
Capital of a firm is a mix (or proportion) of a firm permanent long term
financing representing by debt, preferred stock and common stock Given
that is firm has a certain structure of assets, which offers net
operating earnings of given size and quality, and given a certain
structure of rates in the capital markets in there some specific degree
financing leverage at which the market value of firm’s securities will higher (or the cost of capital will be lower) than at other degrees of leverage? This question has been the basis of extensive work on capital structure and has resulted in a number of theories which we shall now focus on.
5.2 Assumptions and Definitions
In order to grasp the elements of the capital structure and the values
of the firm or the cost capital properly we make the following assumptions.
• Firms employ only two types of capital debt and equity
• The total assets of the firm are given and the degree of leverage can
be changed by selling debts to repurchase shares or selling shares to
retire debt.
• Investors have the same probability distribution of expected future
operating earnings for a given firm.
• The firm has policy of paying 100 per cent dividends.
• The operating earnings of the firm are not expected to grow.
• The business risk is assumed to be constant and independent of capital
structure and financial risk.
• The corporate and personal income taxes do not exist this assumption
is relaxed later on.
In our analysis of capital structure theories we shall use the following
basic definitions:
S= market value for ordinary shares
D= market value of debt
V= total market value of the firm (S+D)
= XNOI = expected net operating income i.e. earning before interest an
taxes (EBIT)
INT= interest charges DKei ).,.( d
= YNI = net income or shareholders earnings (EBIT-INT) when corporate
taxes do not
exist.
The capitalization rates or costs associated with the different earnings
stream and the value of different securities can be defined as follows:
The equation and definition described above are valid under any the
capital structure theories. The controversy is with behavior of the
variables like o k , e k and V etc.
5.3 Capital Structure Theories
5.3.1 Net Income Approach ……………. Capital Structure Matters
The essence of the net income (NI) approach is that the firm can
increase its or lower the overall cost capital by increasing the debt in
the capital structure the crucial assumptions of the approach are:
• The use of debt does not change the risk perception of investors as
result the equity capitalization rate and the debt capitalization rate , remain constant with changes in leverage.
• The debt capitalization rate is less than the equity capitalization
rate (i.e. < ) d k e k
• The corporate income taxes do not exist.
The first assumption implies that if and are constant increased use of
debt by magnifying the shareholders earnings will result in higher value
of the firm via higher values of equity consequently the overall or the
weighted average cost of capital will decrease. The overall cost of
capital is measured by equation
It is obvious from equation (4) that with constant annual net operating
income (NOI), the overall cost of capital would decrease as the value of
the firm V increases. The overall cost of capital can also be measured
by equation;
In equation (6) as per the assumption of the NI approach, and are
constant and is less than therefore will be equal to if the firm is
fully equity financed. V increases as the overall cost of capital
decreases or as D/V increases. Equation (6) also implies that the
overall cost of capital will be equal to if the firm does not use any
debt i.e. D/V = 0 and that will approach as D/V approach one.
5.3.2 The Net Operating Income Approach ………………. Capital Structure Does Not Matter
According to the net operating income (NOI) approach the market value of
the firm is not affected by the capital structure changes. The market
value of the firm is found not by capitalized the net operating income
at the overall or the weighted average cost of capital
which is a constant. The value of the firm V is determined by equation (8).
Where is the overall capitalization rate, which depends on the business
risk of the firm. It is independent of financial mix. If NOI and are
independent of capital structure changes, the critical assumptions of
the NOI approach are:
• The market capitalizes the value of the firm as a whole. Thus the
split between debt and equity is not important.
• The market uses an overall capitalization rate to capitalize the net
operating income and depends on the business risk. If the business risk
is assumed to remain unchanged is a constant.
• The use of less costly debt funds increases the risk of shareholders.
This causes the equity capitalization rate to increase. Thus the
advantage of debt is offset exactly by the increase in the equity –
capitalization rate . e k
• The debt – capitalization rate is a constant. d k
• The corporate income taxes do not exist.
As stated above under NOI approach the total value of the firm is found
out by out by dividing the net operating income by the overall cost of
capital . The market value of equity, S, can be determined by
subtracting the value of debt D, from total market value
of the firm V, (i.e. S = V – D). The cost of equity will be the measured
as follows:
Where, INT is the interest charges. Alternative the cost of equity can
be defined as follows.
Equation (7) indicates that if and are constant would increase linearly
with debt equity ratio D/S.
5.3.3 The Traditional View …………… The Existence of an Optimal Capital Structure
The traditional view which is also known as an intermediate approach is
a compromise between the net income approach and the net operating
approach and the net operating approach. According to this view the
value of the firm can be increased or he cost of capital can be reduced
by a judicious mix of debt and equity capital. This approach very
clearly implies that the cost of capital decrease within the reasonable
limit of debt and then the cost of capital increases with leverage.
Thus, an optimum capital structure exists and it occurs when the cost of
capital is minimum or the value of the firm is maximum. The cost of
capital declines with leverage because debt capital is cheaper than
equity capital within reasonable or acceptable limit of debt. The
statement that debt funds are cheaper than equity implies the weighted
average cost of capital will decrease with the use of debt.
According to the traditional position, the manner in which the overall
cost of capital reacts to changes in capital structure can be divided in
to three stages.
First stage: increasing value
In the first stage this rate at which the shareholders capitalization
their net income i.e. the cost of equity remains constant or rises
slightly with increase debt but it does not increase fast enough to
offset the advantage of low cost debt
During this stage the cost debt remains constant of rises negligibly
since market views the use of debt as a
Third stage: Declining value
Beyond the acceptable limit of leverage the value of this firm decreases
with leverage or the cost of the capital increases with leverage. This
happens because investors perceive a high degree of financial risk and
demand a higher equity capitalization rate which offset the advantage of
low cost debt. The overall effect of these three stages is to suggest
that the cost of capital is a function of leverage. In declines with
leverage and after reaching a minimum point or range starts rising. The
relation between costs of capital and leverage is graphically shown in
the figure below wherein the overall cost of capital curve is saucer
shaped with a horizontal range. This implies that there is a range of
capital structure in which the cost of capital is minimized. is assumed
to increase slightly in the beginning and then at a faster rate. In
figure below the cost of capital curve is shown to be U – shaped under
such a situation there is a precise point at which the cost of capital
would be minimum. This precise point defines the optimum capital structure.
Criticism of the traditional view
The validity of the traditional position has been questioned on the
ground that the market value of the firm depends upon its net operating
income and risk attached to it. The form of financing can neither change
the net operating income nor the risk attached to it. It simply changes
the way in which the income is distributed between equity holders and
debt- holders. Therefore, firms with identical net operating income and
risk, but differing in their modes of financing should have same total
value. The traditional view is criticized for implying that the totally
of risk incurred by all security – holders of a firm can be altered by
changing the way in which this totality of risks are distributed among
the various classes of securities. Modigliani and Miller also do not
agree with the traditional view. They criticized the assumption that the
cost of equity remains unaffected by leverage up to some reasonable
limit. They assert that sufficient justification does not exist for such
an assumption. They do not accept the contention that moderate amounts
of debt in “sound firms” do not really add very much to the “riskiness”
of the shares. However the argument of the traditional theories that an
optimum capital structure exists, can be supported on the two counts;
the tax deductibility of interest changes and market imperfections.
5.3.4 The Modigliani and Miller Hypothesis With Out Taxes …. Capital Structure is Irrelevant
The Modigliani-Miller (M-M) posits that in the absence of taxes a firm’s
market value and the cost of capital remain invariant to the structures
changes.
Assumptions
The M-M hypothesis can be explained in terms of their propositions I and
II whose assumption as described below.
• Prefect capital markets: securities (share and debt instruments) are
traded in the perfect capital market situation. This specifically means
that (a) investors are free to buy or sell securities (b) they can
borrow without same term as the firm do; and (c) they behave rationally.
It is also implied that the transaction costs i.e. the cost of buying
and selling securities do not exist
• Homogeneous risk classes: firm can be grouped in to homogenous risk
classes. Firms would be considered to belong to a homogenous risk class
if their expected earnings have identical risk characteristics. It is
generally implied under the M-M hypothesis that firms within same
industry constitute a homogenous class.
• Risk: The risk of investors is defined it terms of the variability of
the net operating income (NOI), the probability that the actual value of
the firm may turn out to be different than their best estimate.
• No taxes: In the original formulation of their hypothesis M-M assume
that no corporate income taxes exist.
• Full payout: Firms distribute all net earning to the shareholders
which means a 100 per cent payout.
5.3.4.1 Proposition 1: M-M (1)
Given the above stated assumptions M-M (1) argue that, for firms in the
same risk class the total market value is independent of debt equity mix
and is given by capitalization the expected net operating income by the
rate appropriate to that risk class. This is their
proposition 1 and can be expressed as follows:
Equation (5) expresses as the weighted average of the expected rate of
return of equity and debt capital of the firm. Since the cost of capital
is defined as the expected net operating income divided by the total
market value of the firm, M-M (1) conclude that the total the market
value of the firm is unaffected by the financing mix. It follows that
the cost of capital is independent of the capital structure and is equal
to the capitalization rate of a pure equity stream of its class. The
cost of capital function as hypothesized by M-M (1) shown in the figure
above is a constant and is not affected by leverage.
Arbitrage process
The simple principle of M-M (1) is that firms identical in all respects
except for capital structure can not command different market values or
have different cost of capital. M-M
(1) do not accept the NI approach as valid
Their opinion is that if two identical firms except for the degree of
leverage have different markets values arbitrage (or switching) will
take place to enables investors to engage in personal or home made
leverage as against the corporate leverage to restore equilibrium in the
market.
Equation (7) states that for firm in a given risk in a given risk class.
The cost of equity is equal to the constant average cost of capital plus
premium for the financial risk which is equal to debt – equity ratio
times the spread between the constant average cost of capital and the
cost of debt ( – ) D/S. The cost of equity is a linear function of a
leverage measured by the market value of debt to equity D/S. Thus
leverage will result not only in more earnings per share to shareholders
but also increased cost of equity. The benefit of leverage is exactly
taken off by increased cost of equity and consequently the firm’s market
value will remains unaffected.
It should however be noticed that the functional relationship = ( – )
D/S is valid irrespective of any particular valuation theory. For
example M-M (1) assume to be constant, while according to the more
popular traditional view is a function of leverage. The crucial part of
the M-M thesis that will not rise even if very excessive sure of
leverage is made. This conclusion could be valid of the cost of
borrowing remains constant for any degree of leverage.
But in practice, increases with leverage beyond a certain acceptable or
reasonable level of debt. However M-M maintains that even if the cost of
debt increase will increase at a decreasing rate and may even turn down
eventually. This is illustrated in the figure above. M-M insists that
the arbitrage process will work and that as increases with debt, will
become less sensitive to further borrowing. The reason for this that
debt holders in the extreme situations, own the firms assets and bear
some of the firm’s business risk. Since the risk of shareholders is
transferred to debt holders declines.
Criticism of the M-M hypothesis
The arbitrage process is the behavioral foundation for the M-M thesis.
The shortcoming of this thesis lie in the assumption of perfect capital
market in which arbitrage may fail to work and may give rise to
discrepancy between the market values of levered and unleveled firms.
The arbitrage process may fail to bring equilibrium in the capital
market for the following reasons.
Leading and borrowing rates discrepancy: The assumption that firms and
individual can borrow and lend at the same rate of interest does not
hold well in practice. Because of the substantial holding of fixed
assets firms have a higher credit standing. As a result they are able to
borrow at lower rates of interest that individual. Non- substitutability
of personal and corporate leverage: it is incorrect in assume that
personal (home made) leverage is a perfect substitute for “corporate
leverage”. The existence of limited liability of firms in contrast with
unlimited liability of individuals clearly places individuals and firms
on a different footing in the capital markets. If a levered firm goes
bankrupt all investors stand to lose to the extent of the amount of the
purchase price of their shares. But if an investors creates personal
leverage then in the event of the firm’s insolvency, he would lose not
only his principle in the shares of the unleveled company, but will also
be liable to return the amounts of his personal loan
Transaction costs: The existence of transaction costs also interferes
with the working of arbitrage.
Institutional restrictions: institutional also impede the working of
arbitrage because “home made” leverage is not particularly feasible as a
number of institutional investors would not be able to substitute
personal leverage for corporate leverage simple because they are not
allowed to engage in the “home made” leverage.
Existence of corporate tax: The incorporation of the corporate income
taxes will also frustrate M-M a conclusions interest charges are tax
deductible. This is fact, means. The very existence of interest chares
gives the firm a tax advantages. Which allows it to return to its equity
and debt holders a larger stream of income than it other wise could have.
5.3.5 The M-M Hypothesis under Corporate Taxes ……. Relevance of Capital Structure
M-M’s hypothesis that the value of the firms is independent its debt
policy is based on the critical assumption that corporate income taxes
do not exist in really, corporate income taxes exist and interest paid
to debt holders is treated as a deductible expense. Dividends paid to
shareholders on the other hand are not tax deductible. Thus unlike
dividends the return to debt holders is not subject to the taxation at
the corporate level. This makes debt financing advantages. In their 1963
article M-M 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 that of the unleveled firm.
5.3.6 Miller Hypothesis with Corporate and Personnel Taxes ……. Economy Wide
Optimum Capital Structure
Investors are required to pay personal taxes on the income earned by
them. Therefore, form investors point of view taxes will include both
corporate and personal taxes. A firm should thus aim at minimizing the
total taxes (both corporate and personal) while deciding about
borrowing. Note that the after tax income available to both shareholders
and debt holders is less by the tax rate on account of personal taxes.
This present value is same as obtained earlier when the personal taxes
were ignored. It is because both cash flows and discount rate have been
reduced by the personal tax rate of 40 per cent. Thus;
We can generalize the following from equation (24):
• If Tpe = Tpb = 0 then the present value of the interest tax shield is
equal to: TD (corporate tax rate T times the amount of debt D)
• If > then the present value of the interest tax shield will be less
than TD:
PVINTS<TD.
• If (1- ) = (1-T (1- ) then the advantage of leverage will be
completely lost. Tpb Tpe In terms of the corporate borrowing Miller
model (equation (24) indicates the following if the personal tax rate on
equity income is zero except the tax exempt debt holders nobody would be
interested in lending to the firm. Therefore to induce debt holders to
lend, the firm will have to offer a higher before tax interest rate.
This implies that if this rate on the firm of tax exempt investors is
say io then debt holders with a personal tax rate of will have to be at
least offered a rate of interest equal to i Tpb o/(1 – ) otherwise they
will not lend. Therefore, firms have to keep raising interest to attract
investors in high tax brackets. Firms will be motivated to keep the
interest rate rising if the corporate tax saving is greater than the
personal tax loss. Tpb They will stop borrowing once the corporate tax
rate T. equals the personnel tax rate . Thus in the equilibrium the
interest rate should be equal to i Tpb o / (1-T) to verify this point.
Assume that the personal tax rate on equity income is zero, = 0 then
equation (24) can be written as follows:
Miller’s model had two important implications
• There is an optimum amount of debt in the economy which is determined
by the corporate and personal tax rates. In others words. There is an
optimum debt equity ratio for all firms in the economy.
• There is no optimum debt equity ratio for a single firm. There are
hundreds of firms which have already induced tax except and low tax
brackets investors. Therefore a single firm can not gain or lose by
borrowing more or less.
Miller’s model has the following limitations
• It implies that tax exempt persons or institutions will invest only in
debt securities and high tax bracket investors in equities. In practice
investors hold portfolio of debt and equity securities.
• The personal tax rate on equity income is not zero. Firms do pay
dividends if is positive more investors can be induced to invest in debt
securities Tpe
• Investors in high tax brackets can be induced to invest in debt
securities indirectly, they can invest in the corporate bonds.
M-M and Miller’s model can be summarized as follow
Under M-M’s model the existence of the corporate taxes provides a strong
incentive to borrow. In fact it is ideal for a firm to have 100 per cent
debt in its capital structure. They ignore personal taxes. Miller’s
model considers both the corporate both the corporate as well as the
personal taxes. It concludes that the advantage of corporate borrowing
is reduced by the personal tax loss. The crucial implication of model is
that there is no optimum capital structure for a single form a single
but for the economy as a whole there exists an equilibrium amount of
aggregate debt.
From a single firm’s point of view therefore, the capital structure does
not matter Miller’s model is based on some controversial assumptions and
therefore most people still believe that in balance, there is a tax
advantages to corporate borrowing.
5.4 Financing Distress
It is difficult believe that a firm should have 100% debt because of tax
advantage. Why don’t firm in practice borrow 100% or what is the
offsetting disadvantage of debt? The offsetting disadvantage is grouped
under the term financial distress. Financial distress occurs when the
firm finds it difficult to honor the obligation of creditors. The
extreme form of financial distress is insolvency. Insolvency could be
very expensive. It involves legal costs. The firm may have to sell its
needed assets at distress prices. More important the consideration is
the inflexibility of raising funds if the firm has already used heavy
amount of debt. Non availability of funds on acceptable terms could
adversely affect the operating performance of the firm. Creditors lose
patience when a firm is financially distressed they force the firm in to
liquidation to realize their claims. They the value of levered firms is
given as follows:
The figure above shows how the capital structure of the firm is
determined as a result of the tax benefits and the costs of financial
distress. The present value of the interest tax shield increase with
borrowing but so does the present value of the cost of financial
distress. However, the cost of financial distress are quite
insignificant with moderate level of debt and therefore the value of eh
firm increase with debt. With more and more debt and the cost of
financial distress increases and therefore the tax benefit shrinks. The
optimum point reached when the present value of the tax benefits equal
to the present value of the costs of financial distress. The value of
the firm is maximum at this point.
5.5 Agency Theory
The theory posts that equity holders and debt holders incur costs
associated with monitoring management to ensure that it behaves in ways
consistent with the firm’s contractual agreement. Regardless of who
makes the monitoring express the cost is ultimately borne by the
shareholders. Debt holders anticipating high monitoring costs charges
higher interest rates which lower the value of the firm to its
shareholders. The presence monitoring cost acts as a disincentive to the
insurance of debt monitoring costs like insolvency costs tend to
increase at an increasing with leverage.
5.6 Signaling Theory
The theory contends that signal provided by capital structure changes
are credible in providing the trend of future cash flows. Actions that
increase have been associated with positive equity returns while actions
that decrease leverage have been assonated with negative equity reruns,
therefore when a firm makes any capital changes it must be mindful of
the signal that the proposed transaction will transmit to the market
place regarding the firm’s present and future earnings prospects and the
intentions of its managers. The theory is based on the assumption of
information asymmetry between the management and shareholders.
5.7 The Pecking Order Theory
The pecking order theory implies that firms prefer to finance internally
and if external financing is required, they will tend to use the safest
securities first. Debt tends to be the first security issued and
external equity the last resort. The preference of internal financing is
based on the desire to avoid the discipline and monitoring that occurs
when new securities are sold publicly.
DIVIDEND THEORIES AND POLICY NOTES
CAPITAL BUDGETING AND RISK- Risk Analysis NOTES
CAPITAL BUDGETING (INVESTMENT DECISIONS) NOTES
