# Capital Structure Theories

##### CS LLB Pulkit Gupta View Profile My Other Post

Friends I have found this file on facebook and found it very useful and easy to understand. There is a probability that it has been posted before too but I am posting it again for my friends who are finding Capital Structure a bit difficult to understand.

Pls don't thank me for this post as this is not my write-up

The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases.

Example:

Let us consider an example where a company has 20% debt and 80% equity in its capital structure. The cost of debt for the company is 9% and the cost of equity is 14%. According to the traditional approach the overall cost of capital would be:

The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases.

WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity)

⇒ (20% x 9%) + (80% x 14%)

⇒ 1.8 + 11.2 ⇒ 13%

If the company wants to raise the debt portion in the capital structure to be 50%, the cost of debt as well as equity would increase due to the increased risk of the company. Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost of capital would be:

WACC = (50% x 10%) + (50% x 15%)

⇒ 5 + 7.5 ⇒ 12.5%

In the above case, although the debt-equity ratio has increased, as well as their respective costs, the overall cost of capital has not increased, but has decreased. The reason is that debt involves lower cost and is a cheaper source of finance when compared to equity. The increase in specific costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a cheaper source, namely debt.

Now, let us assume that the company raises its debt percentage to 70%, thereby pushing down the equity portion to 30%. Due to the increased and over debt content in the capital structure, the firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be:

WACC = (70% x 15%) + (30% x 20%)

⇒ 10.5 + 6 ⇒ 16.5%

This decision has increased the company's overall cost of capital to 16.5%.

The above example illustrates that using the cheaper source of funds, namely debt, does not always lower the overall cost of capital. It provides advantages to some extent and beyond that reasonable level, it increases the company's risk as well the overall cost of capital. These factors must be considered by the company before raising finance via debt.

Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

Assumptions of NI approach:

• There are no taxes
• The cost of debt is less than the cost of equity.
• The use of debt does not change the risk perception of the investors

View Source: http://bit.ly/NI_approach

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Net Operating Income Approach

Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:

• At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.
• The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:

Value of Equity = Total value of the firm - Value of debt
• Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

Example:

Let us assume that a firm has an EBIT level of \$50,000, cost of debt 10%, the total value of debt \$200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate).

Solution:

EBIT =         \$50,000

WACC (overall capitalization rate) =         12.5%

Therefore, total market value of the firm = EBIT/Ko ⇒ \$50,000/12.5% ⇒ \$400,000

Total value of debt =\$200,000

Therefore, total value of equity = Total market value - Value of debt

⇒ \$400,000 - \$200,000 ⇒ \$200,000

Cost of equity capital = Earnings available to equity holders/Total market value of equity shares

Earnings available to equity holders = EBIT - Interest on debt

⇒ \$50,000 - (10% on \$200,000) ⇒ \$30,000

Therefore, cost of equity capital = \$30,000/\$200,000 ⇒ 15%

Verification of WACC:

10% x (\$200,000/\$400,000) + 15% x (\$200,000/\$400,000) ⇒ 12.5%

Effect of change in Capital structure (to prove irrelevance)

Let us now assume that the leverage increases from \$200,000 to \$300,000 in the firm's capital structure. The firm also uses the proceeds to re-purchase its equity stock so that the market value of the firm remains the same at \$400,000.

EBIT = \$50,000

WACC = 12.5% (overall capitalization rate)

Total market value of the firm = \$50,000/12.5% ⇒ \$400,000

Less: Total market value of debt ⇒ \$300,000

Therefore, market value of equity = \$400,000 - \$300,000 ⇒ \$100,000

Equity-capitalization rate = (\$50,000 - [10% on \$300,000)/\$100,000 ⇒ 20%

Overall cost of capital =

10% x \$300,000/\$400,000 + 20% x \$100,000/\$400,000 ⇒ 12.5%

The above example proves that a change in the leverage does not affect the total value of the firm, the market price of the shares as well as the overall cost of capital.

View Source: http://bit.ly/NOI_approach

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Modigliani Millar Approach

Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for independence of the company's cost of capital.

Basic Propositions of MM approach:

• At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.
• The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.
• The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.

Assumptions of MM approach:

• Capital markets are perfect.
• All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.
• Within similar operating environments, the business risk is equal among all firms.
• 100% dividend payout ratio.
• An assumption of "no taxes" was there earlier, which has been removed.

Arbitrage process

Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is higher. This results in restoration of equilibrium in the market price of a security asset. This process is a balancing operation which implies that a security cannot sell at different prices. The MM hypothesis states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation. Generally, investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's price is higher. This process or this behavior of the investors will have the effect of increasing the price of the shares that is being purchased and decreasing the price of the shares that is being sold. This process will continue till the market prices of these two firms become equal or identical. Thus the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

Limitations of MM hypothesis:

• Investors would find the personal leverage inconvenient.
• The risk perception of corporate and personal leverage may be different.
• Arbitrage process cannot be smooth due the institutional restrictions.
• Arbitrage process would also be affected by the transaction costs.
• The corporate leverage and personal leverage are not perfect substitutes.
• Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.View Source: http://bit.ly/MM_approach

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##### Arniv Sharda View Profile My Other Post
CA Final

good work done pulkit

well done

cheers

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(Guest)

very halping notes shared for the fellow students

will help many of the students

cheers

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