Capital Structure

Dr Richa Verma Bajaj

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Objective of a Firm
Maximization of the firms value.
The capital structure or financial leverage decision
should be examined from the point of view of its impact
on the value of the firm.


What is the relationship between cost of capital, capital
structure and value of the firm?

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Optimal Capital Structure
The capital structure that minimizes the firms cost of capital and
thereby maximize the value of the firm


What should be the proportion of debt and equity in the capital
structure?

How much financial leverage a firm should employ?


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Capital Structure Theories
Relationship between capital structure, cost of capital and value
of firm
Relevance of Capital Structure
Net income (NI) approach
Traditional approach
Irrelevance of Capital Structure
Net operating income (NOI) approach
Modigliani-Millar (MM) hypothesis without corporate tax
Relevance of Capital Structure: MM hypothesis under
corporate tax
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Net Income (NI) Approach
According to NI approach, firm is able to increase its total
valuation (V), and lower its cost of capital (ko), as it increases
the degree of leverage, (D/V).

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Assumptions
Firm operates in perfect market: No corporate taxes and
transaction cost, debt is risk free and shareholders perceive no
financial risk arising from use of debt.

- Both the cost of debt and the cost of equity are independent of
the capital structure, i.e. they remain constant regardless of how
much debt the firm uses. The cost of debt (kd) is less than cost
of equity (ke).

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The effect of leverage on the cost of capital under NI
approach

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The optimum capital structure is one at which the cost of capital
is the lowest and the value of the firm is the greatest and this
would be 100 per cent debt financing under NI approach.

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Point of argument
Can a company operate with 100% debt capital and zero
equity capital?

Conclusion
Thus, NI is not based on logical foundation.
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Illustration
There are two firms similar in all respect except in the degree of
leverage employed by them. The Financial data for both the firms
is as follows:
A B
EBIT 10000 10000
ke 10% 10%
kd 6% 6%
Debt - 50000

The ko under NI approach is..
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Traditional Approach
A theory of capital structure in which there exists an optimal
capital structure

Judicious mix of debt and equity capital reduces ko and increases
the value of the firm upto a certain level of debt

This implies that cost of capital is not independent of the capital
structure of the firm
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11
r
D
V
kd

ke

ko
WACC (traditional view)
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The traditional theory on the relationship between
capital structure and the firm value has three stages:
First stage: kd remains constant, ke remains constant or rises as
debt is added but does not rise fast enough to offset the benefit of
cheaper debt. As a result, firm value increases and ko decreases, as
the leverage increases.
Second stage: Once the firm has reached a certain degree of
leverage, the addition of debt will have an insignificant impact on
the ko and firm value. As a result, ko and V remains constant
within a range or upto a certain point. Infact, there are range of
capital structure in which ko is minimum and value is maximum.
Ke increases with leverage because of added financial risk offsets
the advantage of low cost debt
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Third stage: After a critical point, the addition of debt to a
firms capital structure causes an increase in ko and decline in
value of firm. This is because, both kd and ke rise at an
abnormal rate owing to a high degree of financial risk and
exceeds the advantage of low cost debt

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Illustration
EBIT 150000
No debt 5% debt 300000 8% Debt 600000
Ke 10% 11% 12%

Where will be the optimum capital structure?
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Net Operating Income (NOI) Approach
A theory of capital structure in which the weighted average cost
of capital and the total value of the firm remains constant as
financial leverage is changed (independent of leverage)
Why total valuation of the firm is unaffected by its capital
structure??
As both EBIT and capitalization rate applied to income remain
constant in the face of changing capital structure
This approach implies that there is no one single optimum
capital structure as the ko cannot be changed through leverage.
Under this approach, the ke increases linearly with leverage
but the Kd, Ko and Value of the firm, all remain constant as
the leverage is changed.
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Assumptions
The ko does not vary with leverage, but is constant for all degree of
leverage. An increase in the use of supposedly cheaper debt capital,
(kd) is exactly offset by an increase in the cost of equity (ke). Thus,
the weighted average cost of capital (ko) remains unchanged for all
degree of leverage.
The value of the firm (V) is found by capitalising net operating income
(EBIT) at the overall cost of capital, (ko), Thus, V = EBIT/ko. As
both EBIT and ko are constant and independent of leverage, V does
not change as leverage changes.
The value of equity (S) is found as a residual by subtracting the value
of the debt (D) from the (constant) value of the firm (V).
The cost of debt (kd) is constant. The cost of equity is (Ke = EBIT-
I/S). The use of cheaper debt capital increases the risk to shareholders.
This raises the cost of equity (Ke).
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Cost of
Capital (%)
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0 20 40 60 80 100
Debt/Value
Ratio (%)
k
e
ko
k
d
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Illustration
Assume that a firm has 1000 in debt at 10% interest, the
expected annual EBIT is 1000 and ko is 15%. Given this
calculate the value of the firm and ke. What happened to
the value of the firm and ke, when firm increase the
amount of debt from 1000 to 3000.
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MM Hypothesis
MM developed a theoretical argument which supports NOI
approach.
MM argue that, in the absence of corporate tax, the cost of capital
and the market value of the firm remain invariant to the changes in
the capital structure (degree of leverage)
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Assumptions
Capital markets are perfect.
There is no corporate tax.
There are no transaction costs
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This is identical to NOI hypothesis.
According to MMs Proposition I, the total market value of the
firm and its cost of capital, are independent of its capital
structure, for firms in the same risk class.
The total market value of the firm is established by capitalizing
the expected net operating income (NOI=EBIT) by the
capitalization rate (i.e., the opportunity cost of capital)
appropriate to firms risk class.

MM Approach Without Tax: Proposition I
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The cost of capital under MM proposition I
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MM Proposition II
Financial leverage causes two opposing effects: it increases the
shareholders return but it also increases their financial risk.
Shareholders will increase the required rate of return (i.e., the cost
of equity) on their investment to compensate for the financial risk.
The higher the financial risk, the higher the shareholders required
rate of return or the cost of equity.

Proposition II states that the firms Ke increase in a manner to
offset exactly the use of cheaper debt capital. In other words, as
the firms use of debt increases, the cost of equity also rises.

This proposition of MM hypothesis implies a linear relationship
between ke and debt equity ratio.
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MMs Proposition II
MM argue that the Ke is equal to a constant average
cost of capital (Ko) plus a risk premium that
depends on the degree of leverage, i.e.
Ke = Ko + Risk premium

To determine the levered firm's cost of equity, k
e
:


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Illustration
Ricardo corporation has WACC (ignoring taxes) of 12%. It can
borrow at 8%. Assuming that Ricardo has a target capital structure
of 80 percent equity and 20 percent debt, what is the cost of
equity? What is the cost of equity if target capital structure is 50
percent equity? Calculate WACC using your answers to verify that
it is the same.
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Interpretation of MM hypothesis
When both propositions are combined, MM hypothesis implies
that though debt is less expensive than equity, the inclusion of
more debt in the capital structure of a firm will not increase its
value because the benefits of cheaper debt capital are exactly
offset by the increase in the cost of equity. In other words, value
of the firm is completely unaffected by its capital structure.
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MM Hypothesis with Taxes
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With the introduction of corporate taxes, MM recognize that
the value of the firm will increase or the cost of capital will
decrease with an increase in the leverage as the interest on debt
is a deductible expense for tax computation
Interest payable by firms saves taxes and makes debt financing
advantageous. Thus, the value of the levered firm will be
higher than of the unlevered firm, by an amount equal to Ls
debt multiplied by the tax rate. VL = VUL + T*Debt
Interest Tax shield or tax advantage of debt= T*kd*D
(Corporate tax rate * Interest)
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Relevance of Capital Structure:
The MM Hypothesis Under Corporate Taxes
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MM: Proposition I
Without Taxes
- The Value of levered Firm = Value of Unlevered Firm
- Implications of Proposition I
(i) Firms Capital Structure is Irrelevant
(ii) The firms ko is same, no matter what debt and equity is used to finance
the firm
With Taxes
- VL = VUL+TD
- Implications of Proposition I
(i) Debt Financing is advantageous and in extreme, firms optimal capital
structure is 100 percent debt
(ii) Firms ko decrease, as firm relies more on debt financing

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Illustration
EBIT: 100000
Firm A: Debt 0
Firm B: 6% debt 500000
Tax Rate 35 %

Compute total income to equity holders and
debt holders and Interest Tax Shield.
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Present Value of Interest Tax Shield
Interest tax shield is a cash inflow to the firm and therefore, it is
valuable.
What discount rate to use, that reflects the riskiness of these
cash flows??
Tax shield is generated by paying interest, thus, it has the same risk
as debt, hence, kd is the appropriate discount rate
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Value of the levered firm
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MM: Proposition II
Without Taxes
- Cost of Equity is
- Implications of Proposition II
(i) ke rises as firm increases use of debt financing
(ii) Risk of equity depends on: the riskiness of firms operations and
degree of financial leverage
With Taxes
- Cost of Equity is ke = ko+( ko-kd)(D/E)(1-Tc)
- Implications of Proposition II: Same
- Ko declines

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Illustration
EBIT = 151.52
Corporate Tax = 34%
Debt = $500
Cost of capital of Unlevered firm = 20%
Cost of debt capital = 10%
Compute- Value of equity, Value of Firm, Cost of equity capital
and WACC
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Implications of MM Hypothesis with Corporate Taxes
Corporate tax laws favor debt financing over equity financing.
With corporate taxes, the benefits of financial leverage exceed
the risks: More EBIT goes to investors and less to taxes when
leverage is used.
Because of deductibility of interest charges, a firm can increase
its value with leverage
Thus, the optimum capital structure is reached when a firm
employs almost 100% debt to maximize value

Is this holds in Reality??
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Why do companies not employ extreme level of
debt in practice?
First, Firms need to consider the impact of both corporate and
personal taxes for corporate borrowing. Personal income tax
may offset the advantage of the interest tax shield.

Second, borrowing may involve extra costs (in addition to
contractual interest cost)costs of financial distressthat may
also offset the advantage of the interest shield.
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Financial Leverage and Corporate and
Personal Taxes
Companies everywhere pay corporate tax on their earnings. Hence,
the earnings available to investors are reduced by the corporate tax.
Further, investors are required to pay personal taxes on the income
earned by them.
Therefore, from investors point of view, the effect of taxes will
include both corporate and personal taxes.
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Corporate and Personal Taxes
Debt tax advantage over equity at the Corporate level might be
partially or fully offset by a tax disadvantage at the individual
level (Millers Argument)
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing.
Advantage of borrowing reduces, when CT and Tpe
decreases and Tpd increases
Use of debt financing remains advantageous, but benefits are
less than under only corporate taxes.
Firms should still use 100% debt.
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EBIT 15000
10% Debt 80000
Ke 12.5%
CT Tpe Tpd
Base Case 50 30 40
Scenario 1 30 20 44
Scenario 2 50 30 30
Scenario 3 50 25 40
Scenario 4 30 20 50
Scenario 5 50 20 60
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When Firm Value
Tpe = Tpd VL = VUL+ TcD
Tpe < Tpd
But (1-Tpd) > (1-Tc)(1-Tpe)
VL < VUL+ TcD but greater
than VUL
(1-Tpd) = (1-Tc)(1-Tpe)

VL = VUL (MM argument in Tax
free world)
(1-Tpd) < (1-Tc)(1-Tpe) VL < VUL
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CT Tpe Tpd ITS Vul Vl
Base
Case
50 30 40 2000

42,000.00

75,333.33
Scenario
1
30 20 44 0

67,200.00

67,200.00
Scenario
2
50 30 30 2800

42,000.00

82,000.00
Scenario
3
50 25 40 1800

45,000.00

75,000.00
Scenario
4
30 20 50 (480)

67,200.00

57,600.00
Scenario
5
50 20 60 0

48,000.00

48,000.00
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Limits to Borrowings
The attractiveness of borrowing depends on corporate tax rate,
personal tax rate on interest income and personal tax rate on equity
income.
The advantage of borrowing reduces when corporate tax rate
decreases, or when the personal tax rate on interest income
increases, or when the personal tax rate on equity income decreases.
When will a firm stop borrowing?
A firm will stop borrowing when (1 T
pd
) becomes equal to (1 T
pe
)
(1 T). Thus, the net tax advantage of debt or the interest tax shield
after personal taxes is given by the following:
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