capital structure theories n.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
CAPITAL STRUCTURE –THEORIES PowerPoint Presentation
Download Presentation
CAPITAL STRUCTURE –THEORIES

Loading in 2 Seconds...

  share
play fullscreen
1 / 43
oberon

CAPITAL STRUCTURE –THEORIES - PowerPoint PPT Presentation

599 Views
Download Presentation
CAPITAL STRUCTURE –THEORIES
An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

  1. CAPITAL STRUCTURE –THEORIES • INTRODUCTION- • Capital structure refers to the mix or proportions of a firm’s permanent long-term financing represented by debt, pref-shares, and equity capital. while taking any financial decisions, the firm must ensure the maximization of wealth of shareholders. So even the capital structure decision must be taken in the light of wealth maximization objective. That particular mix of debt and equity which maximises the value of the firm, is known as optimum capital structure.

  2. Cont- • According to one school of thought , capital structure decision is irrelevent,as it does not affect the value of the firm . According to them there is nothing like optimum capital structure . • According to the other school of thought, the capital structure decision is relevant to the valuation of the firm. • So by changing the debt equity mix, we change the value of the firm. The value of the firm will be maximum at the optimum capital structure. So every firm wants to have optimum capital structure.

  3. Assumption of capital structure theories • There are only two sources of funds i, e; debt and equity. • The total assets of the company are given and do not change. • The total financing remains constant. The firm can change the degree of leverage either by selling the shares and retiring debt or by issuing debt and redeeming equity. • Operating profits (EBIT) are not expected to grow. • All the investors are assumed to have the same expectation about the future profits.

  4. Cont- • Business risk is constant over time and assumed to be independent of its capital structure and financial risk. • Corporate tax does not exist. • The company has infinite life. • Dividend payout ratio = 100%.

  5. Definitions and symbols used. • S = total market value of equity shares. • B = total market value of debt. • I = total interest payments. • V = total market value of the firm. • Ni = net income available to equity shareholders. • V = S+ B. • Cost of debt (Kd) = I / B. • Value of debt(B) = I / kd. • Cost of equity capital (Ke) = D1/ p +g.

  6. Cont- • Because of assumption no 4 growth rate =0.so Ke = D/P and since payout ratio = 100 %, D = earnings or dividends. • Therefore Ke = E/ p . • Ke = net income available to the equity shareholders/total market value of equity shares. • Ko = W1*kd+ W2*ke (w1 and w2 are weights) B/V*(kd)+ S/V*(Ke) or B/B+S*(kd) + S/B+S*(ke) or Ko = I+NI/V = EBIT / V So V= EBIT/ Ko.

  7. FINANCIAL BREAK-EVEN POINT • Financial break-even point may defined as that level of EBIT which is just equal to pay the total financial charges,i,e interest and preference share divided. • At this point or level of earnings before interest and tax, the earning per share = o. • It is a critical point in planning the capital structure of a firm, if earning before interest and tax is less than the financial break-point, the EPS shall be negative and hence fixed interest bearing debt or pref share capital should be reduced in the capitalisation of the firm. • In case the level of EBIT exceeds the financial break-even point , more of such fixed cost funds may be inducted in the capital structure.

  8. Calculation of financial break-even point • When the capital structure consists of equity share capital and debt only and no pref-share capital is employed: Financial break-even- point= Fixed interest charges. When the capital structure consists of equity share capital, debt and preference share capital, thus: Financial break-even-point= i+ Dp/(1-t).ssss where, I = Fixed interest charges. Dp= pref-dividend t = Tax rate.

  9. Question • A firm has two alternative plans for raising additional funds of Rs 10,00,000. • (i) issue of 10,000 debentures of Rs 100 each bearing 10% interest per annum. • (ii) issue of 4000 debentures of Rs 100 each bearing 10% interest per annum and balance by the issue of 12% pref-shares. you are required to calculate the financial B.E.P for each plan assuming a tax rate of 50%.

  10. solution Plan I- as the firm employs only debt and not pref-share capital the financial B-E-P shall be equal to the fixed interest charges; or Financial B-E-P = Fixed interest charges = Rs 1,00,000 Plan II- as the firm employs both debt and pref-share capital, the financial B-E-P can be; Financial B-E-P = i+Dp/(1-t) = 40,000+72000/(1-0.5) = 40,000+1,44,000 = Rs 1,84,000.

  11. Important to note- • The long-term source of finance, which a company may use for investments,maybe broadly classified into 2 types. • They are debt capital and equity capital. The finance manager must determine the proportion of debt and equity and financial leverage. • Understanding the relationship between financial leverage and cost of capital is extremely important for taking capital structure decisions. • Theoretically the value of a firm can be maximised when the cost of capital is minimised. • The capital structure where the cost of capital is minimum is known as optimum capital structure.

  12. Cont- • There are 4 major theories explaining the relationship between capital structure, cost of capital and valuation of the firm. They are— • Net income approach (NI) • Net operating income approach (NOI) • Traditional approach • Modigliani-Millar approach.

  13. Net income approach • According to this approach, capital structure decision is relevant to the valuation of the firm and it is possible to change the cost of capital by changing the debt-equity mix. • A change in the capital structure causes a change in the overall cost of capital as well as the value of the firm. • Assumptions of the theory. • (i) the use of debt does not change the risk of investors and therefore cost of debt(Kd) and cost of equity(Ke) remain same irrespective of the degree of leverage. • Cost of debt is less than the cost of equity. • The corporate income tax does not exist.

  14. Cont- • According to the theory, cost of debt is assumed to be less than the cost of equity. Therefore when the financial leverage is increased (proportion of debt in the total capital), the overall cost of capital will decline and the value of the firm will increase. • The overall cost of capital will be minimum when the proportion of debt in the capital structure is maximum. • So optimum capital structure exists when the firm employs 100% debt or maximum debt in the capital structure.

  15. Question • A company’s expected net operating income(EBIT) is Rs 1,00,000. the company has issued Rs 5,00,000, 10% debentures of Rs 100 each. The cost of equity is 12.5%, assuming no taxes find out overall cost of capital and the value of the firm, according to NI approach.

  16. Solution- • Net operating income Rs 1,00,000 • Less: int on debentures 50,000 • EAESH (NI) 50,000 • Cost of equity(Ke) 12.5% • S= value of equity shares(NI/Ke) 4,00,000 • Value of debt (B) Rs 5,00,000 • Total value of the firm(S+B=V) Rs 9,00,000 • Overall cost of capital (EBIT/V) 11.1% • Alternatively Ko=w1(Kd)+w2(Ke)

  17. Cont- • 5,00,000/9,00,000*(0.10)+4,00,000/9,00,000*(0.125)=11.10% • Assuming that the above company increases the debt from Rs 5,00,000 to Rs 6,00,000 and the cost of debt and equity remains at the same level. Calculate the overall cost of capital, value of the firm and the market value of equity shares.

  18. Important point- • To sum up, according to NI approach as the debt content is increase in the capital structure, Ko falls, value of the firm increases and the market value of the equity shares also increases.

  19. NOI approach. • According to NOI approach, the capital structure decision is irrelevant and there is nothing like optimum capital structure. All the capital structures are optimum. • According to this theory, the market value of the firm is affected by the capital structure changes. • The market value of the firm is find out by capitalising (dividing) the net operating income by the overall cost of capital, which is constant. • The market value of the firm= V=NOI/Ko

  20. Cont- • The overall cost of capital depends on the business risk of the firm, which is assumed to be constant, NOI depends on the investments made by the company and not on the capital structure decision. So if NOI and Ko are constant, the value of the firm must remain same regardless of leverage. • Assumptions:- • (i) the market capitalises the value of the firm as a whole .thus the split between debt and equity is not important. • the value of the firm is obtaining by capitalising NOI by the ko, which depends on the business risk. If business risk is constant, ko is also constant.

  21. Cont- • The use of debt increases the risk of shareholders. So Ke increases with the leverage and eats completely the advantage of low cost debt. • Cost of debt remains same regardless of leverage. • Corporate income tax does not exist. • The critical assumptions of this approach are that Ko remains same regardless of the degree of leverage. • The market capitalises the value of the firm as a whole and split between debt and equity is unimportant. • So Ke is the linear function of the debt equity ratio, since overall cost of capital remains same at all the degrees of leverage, there is no optimum capital structure according to the theory.

  22. Question • A company’s expected annual net operating income (EBIT) is Rs 1,00,000. the company has 5,00,000, 10% debentures. The overall cost of capital is 12.5%. Calculate the value of the firm and value of equity , according to NOI approach. • If the company increases the debt from Rs 5,00,000 to 6,00,000, the Ke and the value of the firm ,calculate—the value of the firm and cost of equity.

  23. Solution: • Net operating income(EBIT) Rs 1,00,000 • Overall cost of capital(Ko) 0.125 • Total value of the firm(V=EBIT/Ko) 8,00,000 • Market value of the debt (B) 5,00,000 • Total market value of the equity(S=V-B) 3,00,000 • Cost of equity (Ke) NI/S =EAESH/market value of shares. = 1,00,000-50,000/3,00,000 • = 16.67%

  24. Traditional Approach. • The traditional approach, also known as Intermediate approach, is a compromise between the two extremes of net income approach and net operating income approach. • According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity, thus, optimum capital structure can be reached by a proper debt-equity mix.

  25. Question: • Net operating Income Rs 2,00,000 • Total Investment 10,00,000 • Equity capitalisation rate :- • (a) If the firm uses no debt 10% • (b) If the firm uses Rs 4,00,000 debentures 11% • (c ) If the firm uses Rs 6,00,000 debentures 13% • Assume that Rs 4,00,000 debentures can be raised at 5% rate of interest where as Rs 6,00,000 debentures can be raised at 6% rate of interest.

  26. Modigliani-Miller Approach(MM). • MM theory relating to the relationship between cost of capital and valuation is similar to the NOI approach. According to this approach, the value of the firm is independent to its capital structure. However, there a basic difference between the two is : • the NOI approach is purely definitional or conceptual without behavioral justification. • MM theory provides analytically sound, logically consistent, behavioral justification in favour of the theory and reject any other theories of capital structure as incorrect.

  27. Assumptions of MM theory- • (i)Capital markets are perfect. This means: • investors are free to buy and sell securities. • investors can borrow and lend money on the same terms on which a firm can borrow and lend. • there are no transaction costs. • they behave rationally. • there is a perfect knowledge on the part of investors. • (ii) Firms can be classified into homogeneous risk classes. All the firms within the same class will have the same degrees of business risk. • (iii) All the investors have the same expectation of a firm’s NOI with which to evaluate the value of any firm. • (iv) Dividend payout ratio is 100% and there are no retained earnings. • (v) There are no corporate income taxes. This assumption is removed later.

  28. The basic propositions of MM approach. • The overall cost of capital(Ko) and the value of the firm (V) are independent of leverage. The Ko and V are constant for all the degrees of leverage. The total value of the firm is obtained by capitalising the EBIT at a discount rate appropriate for its risk class. • Cost of equity (Ke) is equal to capitalisation rate of a pure equity stream plus a premium for financial risk. The financial risk increases with the leverage and therefore Ke increases in a manner to offset exactly the benefit from the use of low cost debt. • Ke = Ko+(Ko-Kd) B/S.

  29. Cont- • The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. This is true because cost of capital remains same regardless of the degree of leverage. So both investment decision and financing decision are independent.

  30. Proof of MM argument: • The value of a firm depends on its profitability and risk. It is invariant with respect to relative changes in the firm’s capitalisation. Similarly according to the theory, cost of capital and market value of the firm must be same regardless of the degree of leverage. • The operational justification for the MM hypothesis is the “Arbitrage Argument”. • The term Arbitrage refers to an act of buying a security in one market where the price is less and simultaneously selling it in another market where the price is more to take advantage of the difference in price prevailing in two different markets. Arbitrage process helps to bring equilibrium in the market, because of arbitrage, a security cannot be sold at different prices in different markets.

  31. Cont- • MM approach illustrates the arbitrage process with reference to valuation in terms of two firms, which are exactly similar in all the respects except with leverage so that one of them has debt in the capital structure while other does not. • Such homogeneous firm’s are, according to MM are perfect substitutes. • If the market value of the two firms which are exactly same in all the respects except with the leverage are not equal, investors of the overvalued firm would sell their shares, borrow additional funds on their personal account and invest in undervalued firm in order to obtain the same return on smaller investment amount. • The use of debt by the investor for arbitrage is termed as home-made of personal leverage. • So investor undertaking arbitrage would be better off.

  32. Cont- • This behaviour of arbitrageurs will have the effect of increasing the value of under-valued firm and decreasing the value of over-valued firm. • Arbitrage would be continuing till the market prices of two identical firms become identical.

  33. Cont- • Assume that there are two firms L and U which are identical in all the respects except that the firm L has 10% Rs 5,00,000 debentures. The EBIT of both the firms are Rs 80,000. the cost of equity of the firm L is higher at 16% and firm U is lower at 12.5%. The total market values of the firms are computed as below:

  34. Solution- • Firm L Firm U • EBIT 80,000 80,000 • Less ; Interest 50,000 ---- • EAESH (NI) 30,000 80,000 • Cost of equity(Ke) 0.16 0.125 • Market value of equity 1,87,500 6,40,000 • Market value of debt 5,00,000 nil • Total value of the firm 6,87,500 6,40,000 • Ko =EBIT/V 11.63% 12.5%

  35. Cont- • Thus, the total value of the firm which employed debt is more than the value of the other firm. • According to MM, when this situation prevails arbitrage would start and continue till the equilibrium is restored.

  36. Working of the arbitrage process. • Suppose there is an investor X, who holds 10% of the outstanding shares in the firm L. this means his holding amounts to Rs 18,750/- and his shares in the earnings which belongs to equity shareholders is Rs 3,000(10% of 30,000). • Mr X, will sell his holding in the firm L and invest money in firm U. • The firm U has no debt in the capital structure and hence, the financial risk to Mr X would be less in firm U then firm L. • In order to have the same degree of financial risk in firm U, X will borrow additional funds which is equal to his proportionate share in firm L’s debt on his personal account(Rs 50,000 at 10%).so he has substituted personal leverage in the place of corporate leverage.

  37. Cont- • The position of Mr X is summarized as below: • Firm L • Investment amount (10% holdings) Rs 18,750 • Dividend income (10% of 30,000) 3,000 • Return on funds 3000/18750 = 16% • Firm U • Investment amount (18,750+50,000) = 68,750 • (50,000 borrowed at 10%) • Total income 68,750/6,40,000*80,000=8593.75

  38. Cont- • Total income 68,750/6,40,000*80,000= 8,593.75 • Less – interest on loan(10% on 50,000)= 5,000 • Return on investment = 3,593.75 • ROI = 3593.75/18750 = 19.16% • So Mr X gets higher income after shifting his investment to firm U from firm L . His ROI increases from 16% to 19.16%. • Other investors will also start to make more profit out of arbitrage. This increases the demand for securities of firm U and will lead to increase in its price. At the same time the price of the security of the firm ‘ L’ will decline due to selling pressure. This will continue till the prices of the securities of the two firms become identical.

  39. Cont- • Taxes:- if the corporate taxes are taken into consideration, MM argue that value of the firm will increase and cost of capital will decrease with leverage. Interest paid on debt is tax deductible and therefore effective cost of debt is less than the coupon rate of interest. Therefore , levered firm would have a greater market value than an unlevered firm (cost of capital of levered firm would be lower). • Symbolically:- VL= Vu + Bt • VL= value of levered firm • Vu= value of unlevered firm • B= amount of debt • T= tax rate

  40. Cont- • Value of unleveraged Firm (Vu)= EBIT/Ko*(1-t) • Value of Leveraged Firm (VL)= Vu+Bt. • Question:- • A company has earnings before interest and Taxes of Rs 1,00,000. it expects a return on its investment at a rate of 12.5%. You are required to find out the total value of the firm according to the MM theory.

  41. Solution. • According to MM theory- • Value of the firm=EBIT/Ko • V= 1,00,000/12.5%= 8,00,000.

  42. Question- • There are two firms X and Y which are exactly identical except that X does not use any debt in its financing, while Y has Rs 1,00,000. 5% Debentures in its financing. Both the firms have earnings before interest and Taxes of Rs 25,000 and the equity capitalisation rate is 10%. Assuming the corporation tax of 50%. Calculate the value of the firm using MM approach.

  43. Solution- • Vu= EBIT/Ko*(1-t) = 25,000/0.10*(1-0.5) • = 250000*0.5= Rs 1,25,000. • VL= Vu+Bt= 1,25,000+1,00,000*0.50 • = 1,25,000+50,000= Rs 1,75,000.