Capital Structure

Debt versus Equity

 Introduction
Capital structure of a company refers to the
composition or make up of its
capitalisation and includes all long term
capital resources viz: loans, reserves,
shares and bonds.
Refers to permanent financing of a firm.
Composed of long term debt, preference
share capital and equity.
 Capital structure
Capitalisation- quantitative aspect, refers to
the total amount of securities issued by the
company
Capital structure-qualitative aspect, refers to
the proportionate amount that makes up
capitalisation
Financial structure- Entire liabilities side of
the balance sheet
 Importance of Capital structure
Refers to the relationship between the various
long term forms of financing.
The use of long term fixed interest bearing
debt and preference share capital along
with equity shares is called financial
leverage or trading on equity.
Capital structure cannot affect the total
earnings of a firm but it can affect the share
of earnings available for equity share
holders.
 The Choices in Financing
There are only two ways in which a business can
make money.
• The first is debt. The essence of debt is that you
promise to make fixed payments in the future
(interest payments and repaying principal). If you
fail to make those payments, you lose control of
your business.
• The other is equity. With equity, you do get
whatever cash flows are left over after you have
made debt payments.
 Advantages of Debt
• Interest is tax deductible (lowers the
effective cost of debt)
• Debt-holders are limited to a fixed return –
so stockholders do not have to share
profits if the business does exceptionally
well
• Debt holders do not have voting rights
 Disadvantages of Debt
• Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)
 What is the optimal debt-equity
ratio?

• Need to consider two kinds of risk:

– Business risk
– Financial risk
 Optimal capital structure
“ The capital structure that leads to the
maximum value of the firm”.
Maximizes the value of the company and
hence the wealth of its owners and
minimizes the company’s cost of capital.
Every firm should aim at achieving the
optimal capital structure.
V= D + S
 Considerations for achieving the optimal
capital structure
If the ROI> fixed cost of funds, company
should make maximum possible use of
leverage
Firm saves considerable amount called tax
leverage
Avoid undue financial risk as it will reduce
the market price of the shares
The capital structure should be flexible
 Risk and Return trade off
Financial Risk- Arises
on account of use of
debt or fixed interest
bearing securities
Non employment of
Debt capital risk-
Higher the Debt
Equity ratio or
leverage, lower is this
risk.
 Business Risk
• Standard measure is beta (controlling for
financial risk)
• Factors:
– Demand variability
– Sales price variability
– Input cost variability
– Ability to develop new products
– Foreign exchange exposure
– Operating leverage (fixed vs variable costs)
 Financial Risk
• The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
 Example of Business Risk
• Suppose 10 people decide to form a
corporation to manufacture disk drives.
• If the firm is capitalized only with common
stock – and if each person buys 10% --
each investor shares equally in business
risk
Example of Relationship Between
Financial and Business Risk
• If the same firm is now capitalized with
50% debt and 50% equity – with five
people investing in debt and five investing
in equity
• The 5 who put up the equity will have to
bear all the business risk, so the common
stock will be twice as risky as it would
have been had the firm been all-equity
(unlevered).
 Business and Financial Risk
• Financial leverage concentrates the firm’s
business risk on the shareholders because
debt-holders, who receive fixed interest
payments, bear none of the business risk.
 Financial Risk
• Leverage increases shareholder risk
• Leverage also increases the return on
equity (to compensate for the higher risk)
 Question?
• Is the increase in expected return due to
financial leverage sufficient to compensate
stockholders for the increase in risk?
 Theories of capital structure

Net Income Approach

Net operating Income Approach
The Traditional Approach
Modigliani and Miller Approach
Relationship – Capital structure, Ko, Value of
the firm
 Theories
Relevance Irrelevance
Cap structure effects CS does not effect
Ko-variable Ko- constant
Value of the firm NOI
NI MM
Traditional
Net Income Approach
Firm can minimize WACC and increase
its value by increasing the
proportion of debt in capital
structure.
When Financial Leverage is reduced,
the WACC will increase and the
total value of the firm will decrease.
V= S+D
V= Total market value of the firm
S= Market value of equity shares
Earnings (NI)/Equity capitalisation
rate
D= Market value of Debt
WACC K0 =EBIT/V
Net Operating Income Approach (NOI)
Suggested by Durand. Diametrically
opposite to NI approach.
Change in the capital structure of a
company does not affect the market
value of the firm and the overall cost of
capital remains constant irrespective of
the method of financing.
There is nothing as an optimal capital
structure and every capital structure is
the optimal one.
V = EBIT/K0
V= value of the firm
K0= Cost of capital
S= V-D
S= Market value of equity shares
D= Market value of Debt
The Traditional Approach
A compromise between two extremes of
NI and NOI approaches
Overall cost of capital decreases upto a
certain point, remains more or less
unchanged for moderate increase in debt
thereafter, and increases or rises beyond
a certain point.
Even cost of debt may increase at this
stage due to increased financial risk.
K0= EBIT/V
V= value of the firm
Modigliani and Miller Approach
MM hypothesis is similar to NOI approach
K0is not affected by changes in the
capital structure or D/E ratio is irrelevant
in the determination of total value of a
firm.
Although, the financial leverage affects
the cost of equity, the overall cost of
capital remains constant.
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Operating income is the determinant of
total value.
Beyond a certain limit of debt, Kd
increases but the cost of equity falls
thereby balancing the two costs.
Two identical firms cannot have different
market values or K0 because of arbitrage
process.
 MM- Theory of irrelevance
In the absence of taxes When taxes exist
D/E mix is irrelevant in Value of the unlevered firm
determination of total value of the Vu=EBIT(1-t)/Ko
firm Value of levered firm VL=Vu+D(t)
With increased use of debt the cost D
ke = WACC + (WACC − kd) × (1 − t) ×
of equity increases E

Although financial leverage affects The implication of M&M theory

the cost of equity, the overall cost of with tax is that the capital
capital remains constant. structure is no longer irrelevant.
The value of a company with
D E
WACC = kd ×
V
+ ke ×
V debt is higher than the value of
ke = WACC + (WACC − kd) ×
D a company with no or lower
E debt.
 VL=Vu+D(t)
Tax shield for a levered firm = Interest (tax)
D= MV of Long term debt
Tax savings= Dx Rf x t
PV of tax savings = (D*Rf*t)/(1+Rf)^n
PV of perpetuity = A/Rf
D*Rf*t = D*t
Rf
 Modigliani and Miller
• Any combination of securities is as good
as any other.
• Example:
– Two Firms with the same operating income
who differ only in capital structure

• Firm U is unlevered: VU=EU

• Firm L is levered: EL= VL-DL

 Modigliani and Miller Revisited
• M&M proposition 1: A firm’s total value is
independent of its capital structure
• Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by
capital structure
3. Corporate and personal taxes are not affected by
capital structure
4. The firm’s choice of capital structure does not
convey important information to the market
 Modigliani and Miller Revisited
• M&M Proposition 2: The return on equity
will rise as the debt-equity ratio rises in
order to compensate equity holders for the
additional (financial) risk.
• Note: Proposition 2 does not rely on
default risk – rE rises because of the rise in
financial risk
 WACC (M&M view)
r
rE

WACC

rD
D
E
 Capital Structure
D x rD x Tc
PV of Tax Shield = = D x Tc
rD
(assume perpetuity)

Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

 Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield

Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400

 Factors Determining The Capital
Structure
Financial leverage or trading on equity
Growth and stability of sales
Cost of capital
Cash flow and ability to service debt
Nature and size of the firms
Floatation costs
Corporate tax rate
Legal requirements
 Degree of Financial Leverage
Measures the impact of change in operating
income (EBIT) on change in earning on
equity capital.
DFL= % Change in EPS
% Change in EBIT
DFL= EBIT
EBIT-I
DFL 2 shows that 1% change in company’s
leverage will change company’s operating
income by 2%.
 Financial Leverage

Significance Limitations
Double edged weapon
Planning of Capital Benefits only to
structure companies having
Profit planning stability of earnings
Increases risk and rate
of interest
Restrictions from
financial institutions
 Operating Leverage

Operating Leverage results from the presence of

fixed costs in magnifying net operating income
fluctuations.
The fixed cost is fulcrum or leverage
Fixed costs remaining the same, the % change in
operating revenue will be more than the %
change in sales.
OL= sales –Variable costs = contribution
Sales-VC- FC Operating Profit
 Operating and Combined Leverage

DOL= % change in profits

% change in sales
Example: If DOL is 3 means, 10% increase
in sales will result in a 30% increase in
operating income.
Measures the sensitivity of operating income
to its sales.
Operating leverage affects the income
FL is the result of financial decisions
CL focuses on the entire income of the
concern.
DCL= % change in EPS or OL x FL
% change in sales
Break Even Point = Fixed cost
p/v ratio
P/v ratio = Contribution/ sales