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Capital Structure Theories There are broadly four approaches in this regard. These are: a. Net Income Approach (N.I. approach) b. Net Operating Income Approach (N.O.I. approach) c. Traditional Theory d. Modigliani and Miller Approach
Net Income Approach (N.I. approach) Net Income Approach is based on the following three assumptions: (i) There are no corporate taxes (ii) The cost of debt is less than cost of equity or equity capitalization rate (iii) The use of debt content does not change the risk perception of investors as a result both the Kd (debt-capitalization rate) and Ke (equity-capitalization rate) remains constant
Where,
Net Income Approach (N.I. approach) Contd.. Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising the cost of capital. The N.I. Approach can be illustrated with help of the following example, The overall cost of capital under this Approach is Overall cost of capital =
Net Income Approach (N.I. approach) Contd.. Illustration ABC, Ltd., is expecting an annual Earnings before the payment of Interest and Tax of Rs.2 lacs. The company in its capital structure has Rs.8 lacs in 10% debentures. The cost of equity or capitalisation rate is 12.5%. You are required to calculate the value of firm acording to NI Approach. Also compute the overall cost of Capital. Solution: Statement showing the value of firm and overall cost of capital Rs. Earnings before interest and tax (EBIT) 2,00,000 Less: Interest on debentures (10% of Rs.8,00,000) 80,000 Earnings available for equity shareholders (NI) 1,20,000 Equity Capitalisation rate (Ke) 12.5% Market value of equity (S) = {NI/Ke} 9,60,000
Market value of debt (D) Total value of the firm (V) Overall cost of capital = =
__8,00,000 _17,60,000
The value of equity can be detrmined by the following equation Value of equity (S) = V (Market value of firm) D (Market value of debt)
Statement showing value of firm and cost of equity capital (Contd..) 20% Debt Rs. 4,00,000 Rs.36,00,000 Ko = ------------------ x 8% + ----------------- x 10.22% Rs.40,00,000 Rs.40,00,000 = 0.008 + 0.092 = 0.10 or 10% 35% Debt Ko Rs. 7,00,000 Rs.33,00,000 = ------------------ x 8% + ----------------- x 10.42% Rs.40,00,000 Rs.40,00,000
= 0.014 + 0.0859 = 0.0999 or10% 50% Debt Ko Rs. 10,00,000 = ------------------ x 8% + Rs.40,00,000 Rs.30,00,000 ----------------- x 10.66% Rs.40,00,000
Traditional Approach The Traditional Approach is also called anintermediate approach as it takes a midway between NI approach (that the value of the firm can be increased by increasing financial leverage) and NOI approach (that the value of firm is constant irrespective of the degree of financial leverage). As per the Traditional Approach the cost of capital is a function of financial leverage and the value of the firm can be affected by the judicious mix of debt and equity in capital structure.
Traditional Approach(Contd..)
Illustration: XYZ Ltd., is expecting an EBIT or Rs.3,00,000. The company presently raised its entire fund requirement of Rs.20 lakhs by issue of equity with equity capitalisation rate of 16%. The firm is now contemplating to redeem a part of capital by introducing debt financing. The firm has two options-to-raise debt to the extent of 30% or 50% of total funds. It is expected that for debt financing upto 30% the rate of interest will be 10% and equity capitalisation rate is expected to increase to 17%. However, if firm opts for 50% debt then interest rate will be 12% and equity capitalisation rate will be 20%. You are required to compute value of firm and its overall cost of capital under different options. Solution ___________________________________________ 0% 30% Debt 50% Debt___ Total debt -Rs. 6,00,000 Rs. 10,00,000 Rate of Interest -10% 12% Earning before Interest & tax(Rs.) 3,00,000 3,00,000 3,00,000 Less : Interest -60,000 1,20,000 Profit after interest before tax 3,00,000 2,40,000 1,80,000 Equity capitalisation rate, Ke 16% 17% 20% Value of equity (E) 18,75,000 14,11,176 9,00,000 Value of debt (D) -6,00,000 10,00,000 Total value of firm (V) = (E) + (D) 18,75,000 20,11,176 19,00,000 Overall cost of 16% 14.91% 15.78% Capital (EBIT / Total value of firm) ____________________________________________
Traditional Approach(Contd..)
It is apparent from above computations that value of firm increases from Rs.18,75,000 to Rs.20,11,176 if firm increase its debt content from 0% to 30%. The overall cost of capital fall from 16% to 14.91%. However, if the debt content increase from 30% to 50% the value of the firm reduces from Rs.20,11,176 to Rs,19,00,000 and its overall cost of capital incrses from 14.91% to 15.78%
Modigliani and Miller Approach The net income Rs.1,656 is higher than the net income of Rs.1,440 forgone by selling 10% equity of Company X. This shows that the investor will be better off in switching his holding to Company Y. It may be noted that when the investor sells equity in Company X and buys equity in company Y with personal leverage, the market value of equity of Company X tends to decline and the market value of equity of Company Y tends to rise. This process will only end when the market values of both the companies are the same.
TAXATION AND CAPITAL STRUCTURE Thus the present value of the interest tax shields is independent of the cost of debt. It is simply the corporate tax rate times the amount of permanent debt. For Firm B the present value of tax shield works out to : 0.5(Rs.80,00,000) = Rs.40,00,000. This represents the increase in its market value arising from Financial Leverage. The value of unleveraged firm is : EBIT (l t) Vu = ---------------Ko And the value of leveraged firm: Vl = Vu + Debt (t) From the above it is evident that greater the leverage, greater the value of the firm, other things being equal. This implies that the optimal strategy of a firm should be to maximize the degree of leverage in its capital structure.