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Capital Structure

Analysis
 How do we want to finance our firm’s assets?
 Distinguish between financial structure and
capital structure.
Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’ Financial
Equity
Structure
Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Capital
Structure
Why is Capital Structure Important?

 1) Leverage: higher financial leverage


means higher returns to stockholders,
but higher risk due to interest
payments.
 2) Cost of Capital: Each source of
financing has a different cost. Capital
structure affects the cost of capital.
 3) The Optimal Capital Structure is the
one that minimizes the firm’s cost of
capital and maximizes firm value.
Designing the capital structure – EBIT & EPS
Analysis
A company is likely to face six possible consequences because of
economic conditions. The EBIT likely to range from Rs500 to
Rs400,000. the company has an option to decide on its financing
mix by employing no debt, 25% debt, 50% debt or 75% debt. The
company’s capital structure consists of 1 lakh ordinary shares of
Rs10 each. Tax rate applicable is 35%. If the company uses debt
the interest rate is likely to be 10%.

Calculate the impact of raising debt and varying EPS under


different economic conditions like very poor (EBIT-Rs500), poor
(Rs25000), Regular (Rs100000), Normal (Rs200000),
Good(Rs300000), very good(Rs400000)
Conditions EBIT 0,Debt 25% Debt 50% Debt 75% Debt
EPS EPS EPS EPS

Very Poor 500 0.00 -0.21 -0.64 -1.94

Poor 25000 0.16 0.00 -0.33 -1.30

Regular 100000 0.65 0.65 0.65 0.65

Normal 200000 1.30 1.52 1.95 3.25

Good 300000 1.95 2.38 3.25 5.85

Very Good 400000 2.60 3.25 4.55 8.45


EPS with all equity option 1

EPS = [(1-T) EBIT] / number of shares in plan 1 (N1)

Second option with debt and equity


EPS = [(1-T)(EBIT -Interest]/ Number of shares in plan 2 (N2)

Break even point in both the options to get the EBIT will be:
[(1-T) EBIT] / number of shares in plan 1 (N1) = [(1-T)(EBIT -Interest]/ Number
of shares in plan 2 (N2)
Capital Structure Theory:
•Excess financial risk put the firm into
bankruptcy cost and to use little financial
leverage results in an undervaluation of
the firm’s shares in the marketplace.
•Financial manager must know how to
find the optimal financial leverage use
What is the Optimal Capital
Structure?
 In a “perfect world” environment
with no taxes, no transactions
costs and perfectly efficient
financial markets, capital
structure does not matter.
 This is known as the
Independence Hypothesis of
capital structure: firm value is
independent of capital structure.
Analytical Setting:
•Investment policy and dividend policy are
held constant throughout the discussion
•Firm retains none of its current earnings
•Corporate income is not subject to any
taxation (removed later)
•Capital structure consists of only debt and
equity. Degree of financial leverage is by
retiring the debt or repurchase of equity
(More…)
•The expected values of EBIT of all investors
are identical for each firm
•Securities are traded in perfect or efficient
financial markets
Theories:
1) Extreme Positions View
• Independence Hypothesis (NOI Theory by D. Durand)
• Dependence Hypothesis (NI Theory by D. Durand)

2) Moderate View
This is not to say that the markets really
behave in strict accordance with either
position.
The point is to identify polar positions on
how things might work.
1) Independence Hypothesis
 Firm value does not depend
on capital structure.
Firm’s composite cost of capital and
common stock price are both independent
of the degree of financial leverage.
•Independence hypothesis- if the capital
structure has no impact on the total market
value of the firm, then the value of the firm is
arrived by capitalizing (discounting) the
firm’s operating income (EBIT) . Therefore
this hypothesis is called Net Operating
Income.
•Value of equity is the residual value
Independence Hypothesis

Cost of
Capital kc = cost of equity
kd = cost of debt
ko = cost of capital

kc .
0% debt financial leverage 100%debt
Independence Hypothesis

Cost of
Capital
If we have an all-equity
financed firm, what is
the cost of capital?
kc .
financial leverage
Independence Hypothesis

Cost of
Capital
If we have an all-equity
financed firm, the cost of
capital is just the cost of
ko=kc . equity.

financial leverage
Independence Hypothesis
Suppose we begin adding debt
Cost of financing at a cost of kd.
Capital

kc
kd

financial leverage
Independence Hypothesis
Suppose we begin adding debt
Cost of financing at a cost of kd.
Capital
kd is lower than kc, so what
should happen to the cost
of capital?
kc
kd kd

financial leverage
Independence Hypothesis

Cost of It should go down.


Capital
But how should increasing
leverage affect kc?

kc
kd kd

financial leverage
Independence Hypothesis

Cost of According to the


Capital
Independence Hypothesis,
the increase in debt will cause
kc to rise.
kc
kd kd

financial leverage
Independence Hypothesis
Increasing leverage causes the
kc
Cost of cost of equity to
Capital rise.

kc
kd kd

financial leverage
Independence Hypothesis
Increasing leverage causes the
kc
Cost of cost of equity to rise.
Capital
What will
be the net effect
on the overall cost
kc of capital?

kd kd

financial leverage
Independence Hypothesis
The cost of capital does kc
Cost of not change. Leverage has
Capital no effect on the cost
of capital and
therefore,

kc ko
kd kd

financial leverage
Independence Hypothesis
The cost of capital does kc
Cost of not change. Leverage has
Capital no effect on the cost
of capital and
therefore, it has no effect on
the value of the firm.
kc ko
kd kd

financial leverage
Independence Hypothesis

 In a “perfect markets”
environment, capital
structure is irrelevant. In
other words, changes in
capital structure do not
affect firm value.
The EBIT of the firm is expected to be Rs1 lakh and
the company has debt of Rs3 lakhs in its capital
structure. The cost of debt is 10% and the over all cost
of capital is 12.5%.
If the company change the debt equity ratio and now
increased the debt capital to Rs5 lakhs. Find the value
of firm under IH/NOI approach
Mv of debt 300000 Mv of debt 500000
cost of capital 12.50% cost of capital 12.50%
cost of debt 10.00% cost of debt 10.00%
EBIT 100000 EBIT 100000
interest 30000 interest 50000
EACS 70000 EACS 50000
mv of firm 800000 mv of firm 800000
mv of debt 300000 mv of debt 500000
mv of equity 500000 mv of equity 300000
cost of equity 0.14 cost of equity 0.166667
•Firm’s cost of equity will rise at precisely the
same rate as the earnings and dividends do.
•Use of financial leverage brings a change in the
cost of common equity large enough to offset the
benefits of higher dividends to investors. This will
keep the composite cost of funds constant.
•Independence Hypothesis says, one capital
structure is as good as any other, the financial
officers should not waste time searching for an
optimal capital structure.
Dependence Hypothesis
(NI Theory)

 Since debt is less expensive


than equity, more debt
financing would provide a
lower cost of capital.
 A lower cost of capital would
increase firm value.
 Debt financing have a
favorable effect on the
company’s stock price
It is the net income (earnings available to
common shareholders) that is capitalized
to arrive at the market value of common
equity. Because of this, the dependence
hypothesis is also called Net Income
approach to valuation.

The explicit and implicit costs of debt are


one and the same. The use of more debt
does not change the cost of equity.
Dependence Hypothesis
Cost of debt is lower
Cost of than cost of equity
Capital as leverage increases and both
are not affected by leverage.

kc kc

kd kd

financial leverage
Dependence Hypothesis

because
Cost of of the tax benefit
Capital associated with
debt financing.
kc kc

kd kd

financial leverage
Dependence Hypothesis
So, what will happen to the
Cost of cost of capital as leverage
Capital increases?

kc kc

kd kd

financial leverage
Dependence Hypothesis

The low cost of debt


Cost of
reduces the cost of
Capital
capital.

kc
kc
ko
kd kd

financial leverage
The EBIT of the firm is expected to be Rs1 lakh and the
company has debt of Rs3 lakh in its capital structure.
The cost of debt is 10% and cost of equity is 13%.
If the company wants to change the debt equity ratio by
increasing debt capital to Rs5 lakhs, what will happen to
the value of the firm

If initially there are 2500 number of shares. When


company increased debt to 5 lakhs means repay the
shareholders Rs200000 at market price
Mv of debt 300000
cost of equity 13.00%
cost of debt 10.00%
EBIT 100000
interest 30000
EACS 70000
mv of equity 538461.5
mv of firm 838461.5
cost of capital 0.119266
Alternative approach to
Cost of capital
Wd 0.357798
We 0.642202
WACC 0.119266
no of shares 2500
market price per share 215.3846
mv of debt 500000
cost of equity 13.00%
cost of debt 10.00%
EBIT 100000
interest 50000
EACS 50000
mv of equity 384615.4
mv of firm 884615.4
cost of capital 0.113043
Alternative approach to Cost of
capital
Wd 0.565217
We 0.434783
WACC 0.113043
share price per share calculation:
share capital paid back 200000
at market price 215
no of shares reduced 930.2326
shares remaning 1569.767
take it as 1570
market price per share 244.978
Dependence Hypothesis

 The more debt financing used,


the greater the tax benefit, and
the greater the value of the firm.
 So, this would mean that all
firms should be financed with
100% debt, right?
 Why are firms not financed with
100% debt?
Why is 100% debt not optimal?

Bankruptcy costs: costs of financial


distress.
 Financing becomes difficult to get.

 Customers leave due to uncertainty.

 Possible restructuring or liquidation

costs if bankruptcy occurs.


Why is 100% debt not optimal?
Agency costs: costs associated with
protecting bondholders.
 Bondholders (principals) lend money to

the firm and expect it to be invested


wisely.
 Stockholders own the firm and elect the

board and hire managers (agents).


 Bond covenants require managers to be

monitored. The monitoring expense is an


agency cost, which increases as debt
increases.
3) Moderate Position
 The previous hypothesis
examines capital structure in a
“perfect market.”
 The moderate position examines

capital structure under more


realistic conditions.
 For example, what happens if we

include corporate taxes?


Tax effects of financing with debt

with stock with debt


EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
Tax effects of financing with debt

with stock with debt


EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
Moderate Position with Bankruptcy
and Agency Costs
The cost of debt increases as the
Cost of
proportion of debt increases.
Capital

kc

kd
kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
The cost of debt increases as the
Cost of
proportion of debt increases. At
Capital
some point, the capital markets
will consider any new debt
kc excessive, and therefore much
kd
riskier.
kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Increasing debt also increases
Cost of
the cost of equity since the
Capital
equity becomes
riskier.
kc kd

kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Increasing debt also increases kc
Cost of
the cost of equity since the
Capital
equity becomes
riskier.
kc kd

kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
At first, the cost of capital falls. kc
Cost of
Why?
Capital

kc kd
ko
kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Because the cost of equity is not kc
Cost of
rising enough to offset the
Capital
low after-tax cost of
debt.
kc kd
ko
kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs
At higher debt levels, the higher kc
Cost of
costs of debt and equity cause
Capital
the cost of capital to
increase. ko
kc kd

kd

financial leverage
Moderate Position with Bankruptcy
and Agency Costs

Cost of At some point, there will be a kc


Capital minimum cost of
capital!
ko
kc kd

kd

financial leverage
Modigliani-Miller Approach:

This approach is a kin to NOI approach and


it is based on research work by Modigliani
&Miller (the cost of capital, corporation
finance and the theory of investment),
American Economic review XL VIII, June
1958
Assumptions:

1. Perfect capital market- securities are infinitely divisible,


investors are free to buy/sell securities, investors can borrow
without restrictions on the same terms and conditions as firms,
there are no transaction cost, each investor has the same
information and it is readily available without any cost, investors
are rational and they behave rationally
2. All investors have the same expectation of the firm’s operating
income (EBIT)
3. Business risk is equal among all the firms within the similar
operating environment
4. Dividend payout ratio is 100%
5. There is no taxes (removed later)
6.MM propositions prove that if all the assumption are met the
market value of the firms is equal irrespective of leverage
MM Approach without tax:
Here analyzed the impact of leverage under
the assumption that there is no corporate or
personal tax on the basis of two propositions:

Proposition I: the value of the firm is established by


capitalizing its expected net operating income (EBIT) at a
constant over all cost of capital
V(L) = V(U) = EBIT/WACC = EBIT/K0
Here L is the levered and U is unlevered firm
Here as per the proposition I, both L and U
firms have the same business risk and the
standard deviation is the same
Proposition II:
The cost of equity to a levered firm is equal to the cost of
equity to an unlevered firm in the same risk class plus a
risk premium whose size depends on both the differentials
between an unlevered firm’s cost of debt and equity and
the amount of debt used.
K0(L) = K0(U) +Risk premium
= Ke(U) +(Ke(U) –Kd)(D/S)
Here D is the market value of debt and S is the market
value of equity and Kd is the cost of debt
Taken together the two MM propositions
imply that the inclusion of more debt in the
capital structure will not increase the value
of the firm, because the benefit of cheap debt
will be exactly offset by an increase in the
riskiness, hence the cost of equity will move
up. So MM argues that in the world of no
tax, both firms value and its WACC would
be unaffected by its leverage decision
MM’s Arbitrage proof:
MM used an arbitrage proof to support their
propositions. They proved that if the two
firms’ value is different and they way of
financing is different, the investors can sell
the shares of over valued firm and buy the
shares of under valued firm continuously
than the value of both the firms will be the
same
Example on Arbitrage:
There are two firms A and B, where A is a
levered firm and employs debt equity ratio of
60:40. firm B is a equity financed firm.
Capital requirement of both the companies is
Rs10 lakh. EBIT of both the companies is
assumed to be Rs2 lakh. The debt is 10% and
the cost of equity for A is 18% and for B is
12%.

Find first the value of the two firms


Firm A Firm B
Total capital employed 1000000 1000000
Ratio of debt in capital structure 0.6 0
Debt 600000 0
Equity 400000 1000000
Cost of debt 0.1 0.1
Cost of equity 0.13 0.12
EBIT 200000 200000
Interest on debt 60000 0
EBT 140000 200000
Value of shareholders 1076923.08 1666666.67
Value of debt 600000 0
Value of firm 1676923.08 1666666.67
Cost of capital 0.1192661 0.12

From the above it is clear that the value of firm A


(levered firm) is more that firm B(unlevered). To
make the value equal we should follow arbitrage
process suggested by MM
Arbitrage process-
Let us say an investor holds 20% shares of the levered firm:
Means holding Rs215384.6 worth of equity in the company A. this
means his share in EBT/PAT will also be 20% which works out to
be Rs28000.
If he sells his holding in firm A and invests in firm B which is
unlevered, the financial risk of the investor will be less because
firm B is debt free. Under recession even profit will be there

Now if he wants to hold 20% in firm B


he requires Rs333,333 (20% of equity value of B)
He already has Rs215384.6 and rest Rs117,949 he will borrow
As the lending rate for the corporate and the individual is same so
he can borrow at 10%.
As now he is holding 20% in firm B, his share of EBT/PAT will be
20% which is Rs40,000
Out of this Rs40,000 if he pays a interest on
his loan of Rs11,794.9(10% of 117949), he
is left with Rs28205.1(40000 – 11794.9)

Which means that by shifting his investment


from A to firm B he can able to earn an extra
profit of Rs205.1 (Rs28205.1 – Rs28000)
and also reduce his risk level
Reverse Arbitrage Process:
In the above example if the cost of equity of
the levered firm is 18%, we will suddenly
find that the total value of the levered firm
is less than the unlevered firm.
In this type of situation, the investor will
sell the shares of unlevered firm and buy
shares of levered firm until the two firms
value are equal
MM Approach with Corporate Tax:
MM’s original work, published in 1958,
assumed zero taxes. In 1963, they published a
second article that incorporates corporate
taxes.
With corporate taxes, they conclude that
leverage would increase a firm’s value. This
is because interest is tax-deductable expenses,
hence more of a leveraged firm’s operating
incomes flows through to investors
Proposition I:

The value of a levered firm is equal to the


value of an unlevered firm in the same risk
class plus the gain from leverage. The gain
from the leverage is the value of the tax
savings, found as the product of the
corporate tax rate (T) times the amount of
debt the firm used (D):
V(L) = V(U) + TD
When the corporate taxes are introduced, the
value of the levered firm exceeds that of the
unlevered firm by the amount TD. Since the gain
from leverage increases as debt increases, the
firm’s value is maximum at 100 percent debt
financing.
As all cash flows are assumed to be perpetuity ,
the value of the unlevered firm can be found by
V(U) = EBIT(1-T)/Ke(U)…….
With zero debt the value of the firm is its equity
value
Proposition II:
The cost of equity to a levered firm is equal to
1.The cost of equity to an unlevered firm in the
same risk class plus
2.A risk premium whose size depends on the
differential between the cost of equity and debt
to an unlevered firm, the amount of financial
leverage used, and the corporate tax rate

Ke(L) = Ke(U) +(Ke(U) –Kd)(1-T)(D/S)


As in the above equation the (1-T) is less
than 1, so the corporate taxes cause the cost
of equity to rise less rapidly with leverage
than it would in the absence of taxes.
Proposition II, together with the fact that
taxes reduce the effective cost of debt, is
what produces the proposition I result the
firm’s value increases as its leverage
increases.
Example:
To illustrate the MM model, assume the following data of XYZ
company an old established firm that supplies electricity to
residential customers in several cities of India
1.XYZ currently has no debt, it is an all-equity company
2.Expected EBIT =240000. EBIT is not expected to increase over
time, so XYZ is in a no growth situation
3.XYZ pays out all of its income as dividends as it does not require
funds
4.If XYZ begin to use debt, it can borrow at 8%. This borrowing rate
is constant, does not increase regardless of debt used. Any amount
raised by selling debt would be used to repurchase shares, so the
assets would remain constant
5.The business risk is inherent in XYZ assets and thus in its EBIT
required rate of return Ke(U) is 12%, if no debt is used
Under no tax-Find out if value of the firm,
cost of equity and over all cost of capital if
the company started using the debt as;
Debt- 0 5 10 15 20
Equity- 20 15 10 5 0
With no tax:
Assume that tax is 0, at any level of debt, proposition I can be
used to find the value of the firm

V(L) =V(U) = EBIT/Ke(U)


= 2.4/0.12 = 20 lakhs

If the firm uses 10 lakhs of debt, stock value will be also 10


lakhs
We can find the cost of equity Ke(L) and its WACC at a debt
level of 10lakhs.
First use the proposition II to find the leveraged cost of equity
= 12 + (12% - 8%)(10/10) = 16%
Now to calculate the WACC= (D/V)Kd(1-T) + (S/V)Ke
= (10/20)(8%)(1)+(10/20)(16) = 12%
Now For different levels of debt and value,
cost of equity and WACC
Debt Equity Value Kd Ke WACC

0 20 20 8 12 12

5 15 20 8 13.33 12

10 10 20 8 16 12

15 5 20 8 24 12

20 0 20 8 - 12
With corporate tax;
Suppose the tax rate is 40% and the all other
things are constant only the EBIT is changed
from 2.4 to 4 lakhs
When the firm has 0 debt but it pays tax, so its value will be:

V(U) = EBIT(1-T)/Ke(U)

= 4(.6)/.12= Rs20 lakhs

Now if the firm uses 10 lakhs of debt in the world of tax we see by
proportion I that the total market value rises to 24
V(L)=V(U)+TD
= 20+(10*.4)= Rs24 lakhs So the value of equity = 24-10=14
We can also find the cost of equity of the firm and the WACC at a
debt level of 10 lakhs.

First we should find the cost of equity under proposition II

Ke(L) = Ke(U) +(Ke(U) –Kd)(1-T)(D/S)

= 12+(12%-8%)(1-.4)(10/14) = 13.71%

The WACC = (D/V)(Kd)(1-T) +(S/V)Ke

= (10/24)(8%)(1-.4) + (14/24)13.71% = 10%


Now calculate the value of the firm, cost of equity,
WACC with tax under different levels of debt used
by the firm. Start with all equity value 20, and
increase debt further to 5,10,15,20,25,30,33.33

Debt Equity Value D/V Kd Ke WACC


0 20 20 0 8 12 12
5 17 22 22.73 8 12.71 10.91
10 14 24 41.67 8 13.71 10
15 11 26 57.69 8 15.27 9.23
20 8 28 71.43 8 18 8.57
25 5 30 83.33 8 24 8
30 2 32 93.75 8 48 7.5
33.33 0 33.33 100 12 - 12
Limitations of MM approach:

1.Personal leverage impractical


2.No transaction cost not in reality
3.Personal and corporate borrowing rate is
different in the practical market place
The Hamada Equation:
Increase in debt will also increase the risk of the shareholders and
has an impact on the cost of equity.
This equation developed by Robert Hamada (portfolio analysis,
market equilibrium and corporation finance, Journal of finance,
March 1969)

He says that the beta increases with the financial leverage


β= β (U) [1+(1-T)(D/E)]
This shows how increase in debt/equity ratio increase the beta. Here
β (U) is the beta of unlevered firm
β(U) = β / [1+(1-T)(D/E)]

This beta is to be used in CAPM to get the cost of equity and that the
over all cost of capital is to be calculated taking the weight and
component costs

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