Theories of Capital Structure

Presented by Dr. Monika Aggarwal

Post Graduate Govt. College, CHD

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 Objectives of the Study
• Understand the theories of the relationship
between capital structure and the value of the firm

• Highlight the differences between the

Modigliani –Miller view and the Traditional view
on the relationship between capital structure
and the cost of Capital and the value of the firm

• Focus on the Interest Tax shield advantage

of debt as well as its disadvantages in terms of
costs of financial distress

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 Capital Structure
Issues:

• What is capital structure?

• Why is it important?
• What is business risk and financial risk?
• What are the relative costs of debt and equity?
• What are the main theories of capital structure?
• Is there an optimal capital structure?
 Capital Structure
• Capital Structure -- The capital structure of a
firm is the mix of different securities issued by
the firm to finance its operations.
Securities
• Bonds, bank loans
• Ordinary shares (common stock), Preference shares
(preferred stock)
• Hybrids, eg warrants, convertible bonds

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 Capital Structure
• Raising of capital from different sources and
their use in different assets by a company is
made on the basis of certain principles that
provide a system of capital, so that the
maximum rate of return can be earned at a
minimum cost. This sort of system of capital is
known as capital structure.

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 What is “ Financial Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference Financial
Assets shares
Structure
Ordinary
shares

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 What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference
Assets shares

Ordinary Capital
shares Structure

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 Business Risk

• The basic risk inherent in the operations of a

firm is called business risk
• Business risk can be viewed as the variability
of a firm’s Earnings Before Interest and Taxes
(EBIT)

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 Financial Risk
• Debt causes financial risk because it imposes a
fixed cost in the form of interest payments.
• The use of debt financing is referred to as
financial leverage.
• Financial leverage increases risk by increasing
the variability of a firm’s return on equity or the
variability of its earnings per share.

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 Business risk and Financial risk

• Firms have business risk generated by what they

do
• But firms adopt additional financial risk when
they finance with debt

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 Capital Structure Theories

• Basic question
– Is it possible for firms to create value by
altering their capital structure?
• Major theories
• Net Income (NI)
• Net Operating Income (NOI) Theory
• Traditional Theory
• Modigliani-Miller (M-M) Theory
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 A Basic Capital Structure Theory

• There is a trade-off between the benefits of

using debt and the costs of using debt.
– The use of debt creates a tax shield benefit from the
interest on debt.

– The costs of using debt, besides the obvious interest

cost, are the additional financial distress costs and
agency costs arising from the use of debt financing.

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 Net Income (NI) Theory
• This theory was propounded by “David
Durand” and is also known as “Fixed ‘Ke’
Theory”.
• According to this theory a firm can increase
the value of the firm and reduce the overall
cost of capital by increasing the proportion of
debt in its capital structure to the maximum
possible extent.

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 Net Income (NI) Theory
• Assumptions of NI Theory :
• The ‘Kd’ is cheaper than the ‘Ke’.
• There are no taxes
• The risk perception of investors is not
changed by the use of debt.

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 Net Income (NI) Theory
• It is due to the fact that debt is, generally a
cheaper source of funds because: (i) Interest
rates are lower than dividend rates due to
element of risk, (ii) The benefit of tax as the
interest is deductible expense for income tax
purpose.

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 Net Income (NI) Theory
• Computation of the Total Value of the Firm :
• Total Value of the Firm (V) = S + D Where, S =
Market value of Shares and D = Market value of
Debt
• Market Value of Shares = EBIT-I = E/ Ke
• E = Earnings available for equity shareholders
• Ke = Cost of Equity capital or Equity
capitalization rate.
• D = Market value of Debt = Interest/kd

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 Net Income (NI) Theory
• Case :
• K.M.C. Ltd. Expects annual net income (EBIT) of
Rs. 80,000 and equity capitalization rate of 10%.
The company has Rs.200,000 ,8% Debentures.
There is no corporate income tax. (A)
• Calculate the value of the firm and overall
(weighted average) cost of capital according to the
NI Theory. (B)
• What will be the effect on the value of the firm and
overall cost of capital, if: (i) the firm decides to
raise the amount of debentures to Rs.3,00,000

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Calculation of the value of the firm

Net income 80000

Less : Interest on 8% debentures of Rs 16,000
200,000
Earnings available to equity shareholders 64000

Equity capitalization rate 10%

Market value of equity (s)= 6,40,000

64000*100/10
Market value of debentures (D) 200,000

Value of the Firm(S+D) 840,000

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 Calculation of the value
of the firm when debt
raised to Rs 300,000
• Net income • 80,000
• Less : Interest on 8% • 24000
debentures of Rs 300,000
• Earnings available to equity
shareholders • 56,000
• Equity capitalization rate
• Market value of equity (s)= • 10%
56000*100/10 • 5,60,000
• Market value of debentures • 300,000
(D)
• 860,000
• Value of the Firm(S+D)

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 Net Operating Income
Theory
• This theory was propounded by “David
Durand” and is also known as “Irrelevant
Theory”.
• According to this theory, the total market value
of the firm (V) is not affected by the change in
the capital structure and the overall cost of
capital (Ko) remains fixed irrespective of the
debt-equity mix.

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 Net Operating Income Theory
• Assumptions
• The split of total capitalization between debt
and equity is not essential or relevant.
• The market capitalizes the value of the firm
as a whole.
• The business risk at each level of debt-equity
mix remains constant. Therefore, overall cost
of capital also remains constant.
• The corporate income tax does not exist.
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 Required Rate of
Return on Equity
Calculating the required rate of return on equity

Total firm value = EBIT / ko = Rs1,350 / .15

= Rs 9,000
Market value =V-D = Rs9,000 - Rs1,800
of equity = Rs7,200 Interest payments
= $1,800 x 10%
Required return = E / S or EBIT-I/S
on equity* = (Rs1,350 - Rs180) / Rs7,200
= 16.25%
* D / S = Rs1,800 / Rs7,200 = .25
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 Required Rate of
Return on Equity
What is the rate of return on equity if D=Rs3,000?

Total firm value = O / ko = Rs1,350 / .15

= Rs9,000
Market value =V-D = Rs9,000 - Rs3,000
of equity = Rs6,000 Interest payments
= $3,000 x 10%
Required return = E / S on
equity* = (Rs1,350 - Rs300) / Rs6,000
= 17.50%
* D / S = Rs3,000 / Rs6,000 = .50
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 Required Rate of
Return on Equity
Examine a variety of different debt-to-equity ratios
and the resulting required rate of return on equity.

D/S ki ke ko
0.00 --- 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
Calculated in slides27 and 28 24
 Required Rate of
Return on Equity
Capital costs and the NOI approach in a graphical
representation.
.25
ke = 16.25% and
.20 17.5% respectively
ke (Required return on equity)
Capital Costs (%)

.15
ko (Capitalization rate)
.10
ki (Yield on debt)
.05

0
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B / S) 25
 Summary of NOI Approach
• Critical assumption is ko remains constant.
• An increase in cheaper debt funds is exactly offset by
an increase in the required rate of return on equity.
• As long as ki is constant, ke is a linear function of the
debt-to-equity ratio.
• Thus, there is no one optimal capital structure.
• Financing mix is irrelevant and it does not affect the
value of the firm .
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A Basic Capital Structure Theory
• Debt versus Equity
– A firm’s cost of debt is always less than its cost of
equity
• debt has seniority over equity
• debt has a fixed return
• the interest paid on debt is tax-deductible.

– It may appear a firm should use as much debt and as

little equity as possible due to the cost difference, but
this ignores the potential problems associated with
debt.
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 Traditional Theory

• This theory was propounded by Ezra Solomon.

• According to this theory, a firm can reduce the
overall cost of capital or increase the total
value of the firm by increasing the debt
proportion in its capital structure to a certain
limit. Because debt is a cheap source of raising
funds as compared to equity capital.

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 Traditional Theory

• Effects of Changes in Capital Structure on

‘Ko’ and ‘V’ :
• First Stage: Increasing value
• The use of debt in capital structure increases
the ‘V’ and decreases the ‘Ko or WACC’.
Because ‘Ke’ remains constant or rises slightly
with debt, but it does not rise fast enough to
offset the advantages of low cost debt.
• ‘Kd’ remains constant or rises very negligibly.
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 Traditional Theory

• Second stage : Optimum Value

• After certain degree of leverage , increase in
leverage have a negligible effect on WACC
and hence on the value of the firm .
• Optimal Capital Structure -- The capital
structure that minimizes the firm’s cost of
capital and thereby maximizes the value of the
firm.

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 Traditional Theory
• Effects of Changes in Capital Structure on
‘Ko’ and ‘V’ :
• Effects of Changes in Capital Structure on
‘Ko’ and ‘V’ Second Stage: During this Stage,
there is a range in which the ‘V’ will be
maximum and the ‘Ko’ will be minimum.
Because the increase in the ‘Ke’, due to
increase in financial risk, offset the advantage
of using low cost of debt.

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 Traditional Theory

• Third stage – Declining Value

• Beyond the acceptable limit of leverage , the
value of the firm decreases with leverage as
WACC increases with leverage . As financial
risk increases , exceeding the advantage of low
cost debt.

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 Optimal Capital Structure:
Traditional Approach
Traditional Approach

ke
.25
ko
.20
Capital Costs (%)

.15
ki
.10
Optimal Capital Structure
.05

0
Financial Leverage (D / S)
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 Summary of the Traditional
Approach
• The cost of capital is dependent on the capital structure
of the firm.
– Initially, low-cost debt is not rising and replaces
more expensive equity financing and ko declines.
– Then, increasing financial leverage and the
associated increase in ke and ki more than offsets the
benefits of lower cost debt financing.
• Thus, there is one optimal capital structure where ko is
at its lowest point.
• This is also the point where the firm’s total value will
be the largest (discounting at ko).
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Modigliani and Miller (MM)

• Basic theory: Modigliani and Miller

(MM) in 1958 and 1963
• Old - so why do we still study them?
– Before MM, no way to analyze debt
financing
– Won the Nobel prize in 1990
• Most influential papers ever published
in finance
• Very restrictive assumptions
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Miller and Modigliani (M&M) theories
of capital structure
• Miller and Modigliani’s (M&M) seminal work on
capital structure earned them Nobel prizes in
Economics.

• They assume that a firm can separate the investing

(capital budgeting) decision from the financing
decision.

• The financing decision seeks to increase the value of

the firm by selecting the best borrowing pattern for
the firm.
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 M&M’s first theory: No Taxes
• Assumptions
• M&M’s first theory assumes no taxes.
• Perfect market
• Investors act rationally

• In this world, M&M conclude in Proposition I

that capital structure is irrelevant (Theory of
Irrelevance)
• It does not matter how you finance your
operations, the value of the firm is unchanged
regardless and is based only on the investing
choices of the firm.
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 Total Value Principle:
Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

 Total market value is not altered by the capital structure (the

total size of the pies are the same).
• M&M assume an absence of taxes and market imperfections.
• Investors can substitute personal for corporate financial
leverage.
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 Arbitrage Example
Consider two firms that are identical in every
respect EXCEPT:
 Company NL -- no financial leverage
 Company L -- Rs30,000 of 12% debt
 Market value of debt for Company L equals its par
value
 Required return on equity
-- Company NL is 15%
-- Company L is 16%
 NOI for each firm is Rs10,000
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 Arbitrage and Total
Market Value of the Firm
Two firms that are alike in every respect
EXCEPT capital structure MUST have the same
market value.
Otherwise, arbitrage is possible.

Arbitrage -- Finding two assets that are

essentially the same and buying the cheaper and
selling the more expensive.
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 Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to =E =O–I
common shareholders = Rs10,000 - Rs0
= Rs10,000
Market value = E / ke of equity
= Rs10,000 / .15
= Rs66,667
Total market value = Rs66,667 + Rs0
= Rs66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
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 Arbitrage Example:
Company L
Valuation of Company L
Earnings available to =E =O–I
common shareholders = Rs10,000 - Rs3,600
= Rs6,400
Market value = E / ke of equity
= Rs6,400 / .16
= Rs40,000
Total market value = Rs40,000 + Rs30,000
= Rs70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
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 Completing an Arbitrage
Transaction
Assume you own 1% of the stock of
Company L (equity value = Rs400).
You should:
1. Sell the stock in Company L for Rs400.
2. Borrow Rs300 at 12% interest (equals 1% of debt for
Company L).
3. Buy 1% of the stock in Company NL for Rs666.67.
This leaves you with Rs33.33 for other investments
(Rs400 + Rs300 - Rs666.67).
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 Completing an Arbitrage
Transaction
Original return on investment in Company L
Rs 400 x 16% = Rs64

Return on investment after the transaction

 Rs666.67 x 16% = Rs100 return on Company NL
 Rs300 x 12% = Rs36 interest paid
 Rs64 net return (Rs100 - Rs36) AND Rs33.33 left over.

This reduces the required net investment to Rs366.67 to

earn Rs64.
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 Summary of the Arbitrage
Transaction
 The investor uses “personal” rather than corporate
financial leverage.
• The equity share price in Company NL rises based
on increased share demand.
• The equity share price in Company L falls based
on selling pressures.
• Arbitrage continues until total firm values are
identical for companies NL and L.
• Therefore, all capital structures are equally as
acceptable. 45
 M&M’s first theory: no taxes
• This proof can be summarized with the following graph:

Cost of capital

Re = RA + (RA – Rd ) x (D/E)

WACC = RA

Rd

Debt-equity ratio, D/E

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 M&M’s second theory: with taxes
• The proof, Proposition II, shows that because interest
payments are tax-deductible, the value of a levered
firm (VL) increases with debt:

VL = VE + TC * D

where VE is the value of an all-equity firm and tc is the

corporate tax rate and TC * D represents the tax
shieldor quantum of debt used in the mix .

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•Thanks

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Summary
• A firm’s capital structure is the proportion of a firm’s long-
term funding provided by long-term debt and equity.

• Capital structure influences a firm’s cost of capital through

the tax advantage to debt financing and the effect of capital
structure on firm risk.

• Because of the tradeoff between the tax advantage to debt

financing and risk, each firm has an optimal capital structure
that minimizes the WACC and maximises firm value.

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Is there magic in financial leverage?

• … can a company increase its value simply by

altering its capital structure?

• …yes and no

• …we will see….

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Capital Structure Determination

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