Theory of Capital Structure

Fatima Amin Sir . Tehseen Mohsin Mahwish Hameed Rabiya Raffique

Learning Objectives
Introduction to the Theory Modigliani-Miller Position Taxes and Capital Structure Effects of Bankruptcy Costs Other Imperfections Incentive Issues and Agency Costs Financial Signaling

What is Capital?
Capital is money that is used to generate income or make an investment.

For Example: The money you use to buy shares of a mutual fund is capital that you're investing in the fund.

What is Capital Structure?

The capital structure of a firm is the mix of different securities issued by the firm to finance its operations.

Capital Structure
CAPITAL

CAPITAL DEBT

CAPITAL EQUITY

BONDS/ TFCs

BORROWINGS

DEBENTURS etc

DEPOSITS

COMMON STOSKS

PREFERRED STOCKS

RETAIN EARNING

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Fixed Assets Preference shares

Financial Structure

Ordinary shares

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Fixed Assets Preference shares Ordinary shares

Capital Structure

Introduction to Theory

The affects of change in Financial mix on total valuation of firm and its required returns. The total valuation of the firm and its cost of capital varies with the change in debt to equity, or degree of leverage.

Leverage
To borrow money to finance the purchase of asset Measured by debt to equity ratio It tells how many assets are financed by debt and how many are financed by equity

DEBT/EQUITY 3000/12000 =0.25

Assumptions
There are no corporate and personal tax and bankruptcy cost. The ratio of debt or equity for a firm is changed by 1issuing debt to 2repurchase stock or 3issue stocks to pay off debt.

The firm has a policy of paying 100%of its earnings in dividends. Means all the capital requirement will be met either by debt or equity.
The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.

Cost / Returns on Capital Employed

Cost of Capital Debt ki Return on Capital Equity ke Overall Capitalization Rate ko

 Cost of Capital Debt ki = I = Annual Interest Charges B Market value of debt outstanding

Return on Capital Equity

ke= E = Earnings Available to CS holders S Market Value of Stock Outstanding Overall Capitalization Rate ko = O V = Net Operating Earnings Total Market Value of Firm

Total Market Value of Firm

V=B+S
ko is the overall capitalization rate. It is the weighted average cost of capital and is expressed as: ko = kI [B/(B+S)] + ke [S /(B+S)]

Firms Valuation Approaches

Net Operating Income Approach Traditional Approach Optimal capital structure:
The capital structure that maximizes the value of a company.

Net Operating Income Approach

Under this approach, with change in capital structure Total value of the firm remains the same Share price of stocks remains the same Return on equity increases with the increase in leverage Critical Assumption: ko remains constant There is no one optimal capital structure. Total valuation of firm and its cost of capital is independent of the capital structure.

Net Operating Income Approach Example:

Given: Market value of debt= B = Rs.1,000/ Cost of debt= ki = 10% or 0.10 Net operating earning= O= Rs.1,000/ Overall capitalization rate= ko = 15% Market Value of Stock= ? ke = ?

Effect of Change in Leverage on ke

O ko V B S E ke Net Operating Income Overall Capitalization Rate Total Value of Firm Market Value of Debt Market Value of Stock Earnings Available to CS E/S Number of Shares 1000 .15 6667 1000 5667 1000-100= 900 15.88% 100 1000 .15 6667 3000 3667 1000-300=700 19.90% 100-35.29=64.71

2000/56.67=35.29 Market Price of Share 5667/100=56.67 3667/64.71=56.67

Assumption 2 "The ratio of debt or equity for a firm is changed by issuing debt to repurchase stock or issue stocks to pay off debt". According to this assumption Debt increase to repurchase stock value Rs.2,000/ Value of stocks decrease from Rs.5,667/- to Rs.3,667/ Value of firm/company is unaffected by its capital structure i.e. Rs.6,667/ ke increases with the increase in leverage

Capital costs and the NOI Approach

25 Capital Costs (%) 20 ke (Required return on equity) ko (Capitalization rate) ki (Yield on debt)

15
10 5 0

Financial Leverage (B / S)

GRAPH: Capital Cost: Net Income Approach

x-axis y-axis Leverage Percentage Rates

From the graph, we can view that if the overall capitalization rate and cost of debt capital remain constant than with the increase in leverage the return on equity will also increase.

Traditional Approach
This approach to valuation and leverage assumes that there is an optimal capital structure that the firm can increase the total value of the firm through the well judged use of leverage. Approach suggests that the cost of capital lower by increasing the leverage and using cheaper debt funds.

Traditional Approach
25 Capital Costs (%) ke ko

20
15 10 5 0

ki Optimal Capital Structure

Financial Leverage (B / S)

Modigiliani-Miller Position
Two economists who demonstrated that with perfect financial markets capital structure is irrelevant. MM in their original position advocate that the relationship between leverage and the cost of capital is explained by the net operating income approach. They take the position that the cost of capital, ko, remain constant throughout all degrees of leverage

Modigiliani-Miller Position
The total pie does not change as it is divided into debt, equity, and other securities. MM assume that capital structure changes are not a thing of value in the perfect capital market world.
Value of Fim Value of Firm

Debt Edquity

Debt Edquity

Homemade Leverage
Consider two firms identical in every respect except company A is not levered, while company B has Rs.3,000,000/- of 12% bonds outstanding. According to traditional position, company B may have a higher total value and lower average cost of capital than company A.

COMPNAY A O F Net Operating Income Interest on Debt Rs.1,000,000

COMPNAY B Rs.1,000,000 Rs.360,000 (Rs.3,000,000x 0.12) Rs.640,000

Earning Available to CS Rs.1,000,000

ke
S B

Required Equity Return 0.15

Market Value of Stock Market Value of Debt Rs.6,666,667

0.16
Rs.4,000,000 3,000,000

V
ko B/S

Total Value of Firm

Rs.6,666,667

Rs.7,000,000
14.3% 75.0%

Implied Overall Capt. 15% Rate Debt-to-equity Ratio 0

 Arbitrage- Buying one asset in one market at a lower price and simultaneously selling an identical asset in another market at a higher price.

MM maintain that this situation cannot continue (i.e; different returns for different companies), for arbitrage will drive the total values of the two firms together. Company B cannot command a higher total because of financing mix different from company A's.

Arbitrage Steps
1.

2. 3. 4. 5.
6.

If a rational investor owns 1% of the stocks of company B, the leverage firm, worth Rs.40,000/- (1% of Rs.4,000,000). Sell the stock in company B for Rs.40,000/-. Borrow Rs.30,000/- @12% interest. Buy 1% of shares of company A (1% of 6,666,667) the unleveraged firm, for Rs.66,666.67. The expected return on investment in company B's stock was 16% on a Rs.40,000/-, or Rs.6,400/-( i.e; Rs.40,000 * 0.16) The expected return on investment in company A is 15% on a Rs.66,666.67 investment or Rs10,000/- (i.e; Rs.66,667 * 0.15). Return on investment in company A Less: Interest (Rs.30,000 * 0.12) Net Return Rs.10,000/3,600/Rs. 6,400/-

Irrelevance in a CAPM Framework

If the assumptions of the Capital Asset Pricing Model (CAPM) hold, as they would in perfect capital market, the irrelevance of capital structure can be demonstrated using the CAPM. Systematic Risk- Any risk that affects a large number of assets, each to a greater or lesser degree. Also called market risk or common risk.

Irrelevance in a CAPM Framework

Consider the expected return and systematic risk of a leverage company: ko = kI [B /(B+S)] + ke [S /(B+S)]

By rearranging the equation

ke = [ko- kI] B/S + ko

Irrelevance in a CAPM Framework

As described by beta, the systematic risk of the overall firm is simply a weighted average of the betas of the individual securities of firm: firm = debt [B /(B+S)] + stock [S /(B+S)] Beta stocks can be obtained by rearranging: stock = [ firm- debt] B/S + firm It can be observed that an increase in the debt- to equity ratio increases not only the expected return on of a stock but also its beta.

Taxes and Capital Structure

Nothing is lost or gain in the slicing between debt and equity, the sum of the parts is always the same. To the extent that there are capital market imperfections, however, changes in the capital structure of a company may affect the total size of the pie.
The firm's valuation and cost of capital may change with changes in its capital structure. Tax is one of the most important factors which have impact on firm's valuation. Here, we will examine the valuation impact of corporate taxes in the absence of personal taxes and then the combined effect of corporate and personal taxes.

 Interest payment against debt is deductible as an expense. Whereas dividends or retained earnings associated with stocks are not deductible by the corporation for the tax purposes. For Example: Suppose the EBIT are Rs.4,000,000/- for company X and Y and they are alike in every respect except in leverage. Company Y has Rs.5,000,000/- in debt at 12% interest, whereas company X has no debt.

Company X
EBIT Interest Income debt holder Profit before tax to Rs.2,000,000 0 Rs.2,000,000

Company Y
Rs.2,000,000 600,000 Rs.1,400,000

Taxes @40%
Income available to stockholders Income available to stock & debt holders

800,000
Rs.1,200,000 Rs.1,200,000

560,000
Rs.840,000 Rs.1,440,000

 It can be viewed that the total income for the leverage company Y is greater than the unleveraged company X. Reason behind it is that in case of Leverage Company for the use of debt, total income to all investor's increases by the interest payment times the tax rate. It amounts to Rs.600,000 x 0.40= Rs.240,000/- represent a tax shield that government provides the leverage company as compare to unleveraged company.

 Present value of tax shield = tc r B/ r = tc B= 0.40x 5,000,000= Rs.2,000,000/Where, B is market value of debt.

Tax shield is a thing of value and that the overall value of company will be Rs.2,000,000/- more if debt is employed than if the company has no debt.

 Present value of Rs.240,000 discounted at 12%= Rs.240,000/0.12= Rs.2,000,000/ Value of Firm = Value of unleveraged + Value of Tax Shield = Rs.7,500,000 + 2,000,000= 9,500,000/COMPNAY X EBIT INTEREST ON DEBT EARNING AVAILIABLE TO CS TAX @40% INCOME AVAILABLE TO STOCKHOLDERS Rs.2,000,000 800,000 Rs.1,200,000 Rs.2,000,000 COMPNAY Y Rs.2,000,000 *600,000 Rs.1,400,000 560,000 Rs.840,000

INCOME AVAILABLE TO DEBT & STOCKHOLDERS TAX SHIELD

RETURN ON EQUITY @ 16% VALUE OF FIRM

Rs.1,200,000
0 0.16 Rs.7,500,000

Rs.1,440,000
2,000,000

Rs.9,500,000

It means that tax shield is the difference in the value of firm, which is the sum of value of unleveraged firm plus tax shield. i.e; Rs.7,500,000 + Rs.2,000,000= Rs.9,500,000/-

Debt=

6,000, 000 at 12%

Company A EBIT
Interest Income on Debt Profit before tax Tax @35% Income available Stockholders to 2600000

Company B 4000000
720000 3280000 1148000 2132000

4000000
0 4000000 1400000

Income Debt & Stockholders

2600000

2852000

Tax shield to leverage company 6000000* 0.35 = 2,100,000 Value of Firm = Value of unleveraged + Value of Tax Shield = Rs.17,333,333 + 2,100,000= 19,433,333/If the return on equity on unleveraged company is 15%, it means that tax shield is the difference in the value of firm, which is the sum of value of unleveraged firm plus tax shield. i.e; Rs.2,600,000/0.15=17,333,333 + Rs.2,100,000= Rs.19,433,333/-

 Redundancy is another argument. The notion here is that companies have ways other than interest on debt to shelter income- leasing, foreign tax shelters, investment in intangible assets etc. Uncertainty of Tax Shield- if the reported income is consistently low or negative, the tax shield on debt is reduced or even eliminated. It is expressed as Value of firm= Value if unlevered + Pure value of corporate tax shield value lost through tax shield uncertainty.

Corporate plus Personal Taxes

The presence of taxes on personal income may reduce or possibly eliminate the corporate tax advantage associated with debt. However, the corporate tax advantage remains, if returns on debt and on stock are taxed at the same personal rate.

Company X Debt Income Less: Personal Taxes of 30% Debt income after personal taxes Income available to stockholders Less: personal taxes of 30% Shareholder income after personal taxes Income available to stock & debt holders after personal taxes.

Company Y Rs.0 Rs.600,000 0 180,000 0 420,000

Rs.1,200,000
-360,000

Rs.840,000
-252,000

Rs.840,000
Rs.1,200,000

588,000
Rs.1,008,000

Present Value of Corporate Tax Shield in the presence of personal tax

Present Value of Tax Shield

Where B= Market value of debt tc= Corporate Tax tps =Personal income tax rate applicable to CS tpd = Personal income tax rate applicable to debt income If tps= tpd Present Value of Tax Shield= tcB

= [1- [(1 tc)(1 tps)] (1- tpd )]B

Dividend versus Capital Gain

Again investment in stocks, we have two types of returns: Dividend Income- taxed at personal rate, in Pakistan charge 10% WHT as final discharge.

Capital Gain Income- charge at lower rate, in Pakistan there is no CGT if an investment period exceed three years.

Debt or Stock Income

The company decision to finance either with debt or with equity is based with tax benefit. If a rupee of operating earnings is paid out as interest to debt holders, the company pays no corporate tax on it because interest is deductible as an expense. Therefore, the income to the investor after personal taxes are paid is: After tax income for debt holders =Rs.1(1- tpd)

Bankruptcy Costs
The presence of bankruptcy costs is another imperfection effecting capital structure decisions. Bankruptcy Costs are dead weight loss to suppliers of capital.

If there is a possibility of bankruptcy and if the administrative and other costs associated with the bankruptcy are significant; a leveraged firm may be less attractive then an unlevered one.
In Perfect Capital Markets: - Bankruptcy costs are zero. - If the firm goes bankrupt presumably the assets can be sold at their economic value with no liquidating or legal costs involved.

Less Than Perfect Markets: - Their are administrative costs to bankruptcy. - Assets may have to be liquidated at least than their economic value.

Bankruptcy Costs
Relationship to Leverage:
A levered firm is a less attractive investment option as opposed to a unlevered firm. The expected cost of bankruptcy increases at an increasing rate beyond a certain point and has a negative effect on the overall value of the firm and on its cost of capital. Ex Post cost of bankruptcy is beard by creditors. Ex ante cost is passed on to stockholders. Even thought the market equilibrium process is assumed to be efficient, the investors are unable to diversify the bankruptcy costs since they represent a dead weight loss. The investors penalize the price of the stock as leverage increases. Here the required rate of return for investors, k is divided into its components parts. There is the risk free rate Rf plus a premium for business risk.

ke When Bankruptcy Costs Exist But There Are No Taxes

REQUIRED RATE OF RETURN ON EQUITY, ke ke with bankruptcy costs

Premium for Financial Risk

ke without bankruptcy costs Premium for Business Risk Risk-free rate LEVERAGE B/S

ke with no leverage

Bankruptcy Costs
Taxes and Bankruptcy Costs:
As the company increases its leverage the present value of the tax shield increase at least for a while.

The net tax effect will have a positive influence on value at least for moderate amounts of leverage, bankruptcy costs and tax-shield uncertainty exert a negative influence.

Value of Firm With Taxes and Bankruptcy Costs

Net tax effect alone Bankruptcy costs

VALUE OF FIRM

With taxes and bankruptcy costs

Optimal capital structure LEVERAGE B/S

Bankruptcy Costs
Increasing leverage and the consequent increase in chances of bankruptcy cause the value of the firm to increase at a decreasing rate and eventually to decline. This can be expressed as:

Value of the firm =

value as unlevered firm

present value of net tax shield on debt

present value of bankruptcy costs

The optimal capital structure is the point at which the value of the firm is maximized. Thus we have a trade-off between the tax effects and bankruptcy costs.

Bankruptcy Costs
Other Imperfections:
Other imperfections also exists that impede the equilibrium of security prices with respect to their expected risks and returns. These imperfections must be material and one-directional.

Corporate and Homemade Leverage not Being Perfect Substitutes:

Homemade Leverage:
The perceived risks of personal and corporate risks differ. If investors borrow personally and pledge their stock as collateral. They are then subject to margin calls.

Bankruptcy Costs
Homemade leverage involves certain inconveniences: 1. Stockholders who other wise have limited liability with stocks have unlimited liability with personal leverage. The costs of borrowing will be higher for a person than fore corporations.

2.

Arbitrage:
Arbitrage may occur without the individual actually borrowing.

Financial intermediaries may also replicate financial claims of ether the levered or unlevered company and buy the stock of the other if chances for profit exist.

Bankruptcy Costs
Institutional Restrictions:
Certain restrictions may retard the arbitrage process. Regulatory bodies restrict stock and bond investment to a list of companies that fulfill certain standards such a only safe amount of leverage. With such restrictions the point at which the firm's value lie turns down with leverage comes sooner than depicted.

Incentive Issues and Agency Costs:

Capital structure decisions lead to incentive issues between equity holders, debt holders, management and other stake holders. These considerations influence the choice of security used in financing, as well as whether to finance or invest at all.

Debt Holders Versus Equity Holders

The equity of a firm may be taken as a call option on a firms total value, the value being the underlying asset of the option.

In this case the writers of the option are the debt holders.

If we assume that debt is represented by discount bonds that pay only at maturity. We can then view the firm as been sold to debt holders by the stockholders with an option to buy it back at a specified price.

The option has and exercise price equal to the face value of the debt and its expiration date is the maturity of the debt.

Value of Debt and Equity At The Debts Expiration Date

VALUE OF EQUITY, V0

VALUE OF DEBT, Vd

Vd = Vf

Vd = D
VALUE OF THE FIRM, Vf

V0 = 0

V0 = Vf - D

Debt Holders Versus Equity Holders

The value of the option at expiration date is:

V0= max (Vf - D, 0)

Where, Vf is the value of the firm at expiration date D is the face value of the debt and max means the maximum value of Vf - D or zero. The value of the debt at expiration is: Vd= min (Vf - D) If Vf is greater than D, the debt holders are entitled to the face value of the debt and the stock holders exercise heir option. If Vf is less than D the debt holders as owners of the firm are entitle to its full value. The value of their option can not be negative since they have limited liability.

Effect of Variance and Riskiness of Assets

The greater the variance in the value of underlying asset, the greater the value of the option, all other things the same. It is in the interest of the stockholders to increase the variance of the firm. It works to the disadvantage of debt holders because there will be a corresponding decrease in the value of their investment. By increasing the riskiness of the company stockholders are able to increase the value of their stock. Reason: Reason for this occurrence is that stockholders have an option on the total value of the firm and with increased variance of the underlying asset the options value increases.

Changing the Proportion of Debt

With the perfect market assumption of option pricing model, changing the proportion of debt in the capital structure will not affect the total value of the firm. Such a change will affect relative valuation of the debt and of equity. By comparing values for different proportions of debt we are able to determine the relationship between the proportion of debt and valuation.

Changing the Proportion of Debt (Cont.)

Increasing the face value of debt is accompanied by a smaller percentage increase in the value of the debt, holding constant the total value of the firm. Reason: Reliability of default has increased and with greater default risk, the value of debt (per $ of face value) is reduced. In context of option pricing model, issuing debt and retiring stock will result in a decline in the price of the existing debt. Only the old debt holders suffer. Wealth transfers from old debt holders to the stockholders.

Protective Covenants
A part of an indenture or loan agreement that limits certain actions a company may take during the term of the loan to protect the debt holders interests. These covenants may be used to restrict the stockholders ability to increase the asset riskiness of the company and/or its leverage. Reputation of the buyer may affect the terms of the loan. New borrowers with short track records generally face more restrictions than does a company with a long standing, high credit raring.

Me-first rule
Me-first rule is defined as a prior arrangement to protect bondholders from uncompensated shifts of wealth from bondholders to stockholders through a change in the capital structure of the firm. Me- first rule ensures that one party cannot gain at the expense of the other. To the extent that me-first rules are not effective, capital structure decisions may be relevant even in the absence of taxes and bankruptcy costs.

The Underinvestment Problem

Underinvestment problem is the result of equity holders not wishing to invest when the rewards favor debt holders. An important agency problem is the potential for underinvestment. Debt increases risk of financial distress.

Therefore, managers may avoid risky projects even if they have positive NPVs. A possible remedy for stock holders is to own both stocks and bonds in the company. If the incentives of both debt holders and stock holders can somehow be brought together by this means or by contracting between the to parties, the underinvestment problem disappears.

Agency Costs More Broadly Defined

Debt holders monitor the actions of equity holders. Monitoring requires the expenditure of resources, and the costs and the costs involved are one form of agency costs. Regardless of who makes the monitoring expenditures, the cost is borne by stockholders. Debt holders, anticipating monitoring costs, charge higher interest. The higher the probable monitoring costs, the higher the interest rate and lower the value of the firm to its stockholders, all other things the same. There is a trade-off between agency costs and higher interest rates.

Stockholders Bear Monitoring costs

Monitoring costs are not bad for owners of a company, it is that monitoring needs to be efficient. An optimal balance need to be struck between monitoring costs and interest rate charged on a debt instrument at the time it is sold. Some activities of the firm are relatively inexpensive to monitor, others are expensive. The relative costs of monitoring need to be taken into account in determining protective covenants that should be used. Like bankruptcy costs, monitoring costs may limit the amount of debt that is optimal for firm to issue.

 Relationships among taxes, bankruptcy costs and firm values need to be modified.

Bankruptcy Costs, Agency Costs, and Taxes

Tax effect alone Tax and bankruptcy costs

Value of The Firm

All three factors

Leverage B/S

Signaling Theory
Signal: An action taken by a firms management that provides clues to investors about how management views the firms prospects MM assumed that investors and managers have the same information. But, managers often have better information.

69

Symmetric Information: Investors and managers have identical information about the firms prospects. Asymmetric Information: Informational Asymmetry is based on the idea that insiders (managers) know something about the firm that outsiders (security holders) do not. Financial Signaling: A manager may use capital structure changes to convey information about the profitability and risk of the firm.

Asymmetric Information and Signaling

Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Changing the capital structure to include more debt conveys that the firms stock price is undervalued. This is a valid signal because of the possibility of bankruptcy. They will issue stock if they think stock is overvalued. They will issue debt if they think stock is undervalued. But outside investors are not stupid. They view a common stock offering as a negative signal--managers think stock is overvalued.

From Where Does Value Cometh?

What does capital structure changes tell us? It is the signal conveyed by the change that is significant. This signal pertains to the underlying profitability and risk of the firm.