Top 4 Theories of Capital Structure

This article throws light upon the top four theories of capital structure. The theories are: 1. Net Income Approach 2. Net Operating Income Approach 3. Traditional Approach 4. Modigliani and Miller Approach.

Theory # 1. Net Income Approach: 

According to this approach, a firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. The theory propounds that a company can increase its value and decrease the overall cost of capital by increasing the proportion of debt in its capital structure.

This approach is based upon the following assumptions:

(i) The cost of debt is less than the cost of equity.

(ii) There are no taxes.

(iii) The risk perception of investors is not changed by the use of debt.

Degree of Leverage and Cost of Capital

The line of argument in favour of net income approach is that as the proportion of debt financing in capital structure increase, the proportion of a less expensive source of funds increases. This results in the decrease in overall (weighted average) cost of capital leading to an increase in the value of the firm.

The reasons for assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than dividend rates due to element of risk and the benefit of tax as the interest is a deductible expense.

On the other hand, if the proportion of debt financing in the capital structure is reduced or say when the financial leverage is reduced, the weighted average cost of capital of the firm will increase and the total value of the firm will decrease. The Net Income (NI) Approach showing the effect of leverage on overall cost of capital has been presented in the following figure.

The total market value of a firm on the basis of Net Income Approach can be ascertained as below:

V= S + D

Where, V= Total market value of a firm

S = Market value of equity shares

= Earnings Available to Equity Shareholders (NI)/Equity Capitalisation Rate

D = Market value of debt,

and, Overall Cost of Capital or Weighted Average Cost of Capital can be calculated as:

K0 = EBIT/v

Illustration 1:

X Ltd. is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4 lakhs in 10% debentures. The cost of equity capital or capitalisation rate is 12.5%.

You are required to calculate the total value of the firm according to the Net Income Approach:

Solution:

Calculation of the Value of the Firm

Illustration 2:

(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8% Debentures. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall capitalisation rate according to the Net Income Approach (ignoring income-tax).

(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value of the firm and the overall capitalisation rate?

Solution:

Solution

Solution

Thus, it is evident that with the increase in debt financing the value of the firm has increased and the overall cost of capital has decreased.

Theory # 2. Net Operating Income Approach:

This theory as suggested by Durand is another extreme of the effect of leverage on the value of the firm. It is diametrically opposite to the net income approach. According to this 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.

It implies that the overall cost of capital remains the same whether the debt-equity mix is 50: 50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and every capital structure is the optimum capital structure.

This theory presumes that:

(i) The market capitalises the value of the firm as a whole;

(ii) The business risk remains constant at every level of debt equity mix;

(iii) There are no corporate taxes.

Degree of Leverage and Cost of Capital

The reasons propounded for such assumptions are that the increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of debt remains constant with the increasing proportion of debt as the financial risk of the lenders is not affected.

Thus, the advantage of using the cheaper source of funds, i.e., debt is exactly offset by the increased cost of equity.

According to the Net Operating Income (NOI) Approach, the financing mix is irrelevant and it does not affect the value of the firm. The NOI approach showing the effect of leverage on the overall cost of capital has been presented in the following figure.

The value of a firm on the basis of Net Operating Income Approach can be determined as below:

V = EBIT/K0

Where, V = Value of a firm

EBIT = Net operating income or Earnings before interest and tax

k0 = Overall cost of capital

The market value of equity, according to this approach is the residual value which is determined by deducting the market value of debentures from the total market value of the firm.

S = V – D

Where, S = Market value of equity shares

V = Total market value of a firm

D = Market value of debt

The cost of equity or equity capitalisation rate can be calculated as below:

= EBIT – I/V – D

Illustration 3:

(a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000, 6% Debentures. The overall capitalisation rate is 10%.Calculate the value of the firm and the equity capitalisation rate (cost of equity) according to the Net Operating Income Approach.

(b) If the debenture debt is increased to Rs. 7,50,000. what will be the effect on the value of the firm and the equity capitalisation rate?

Solution:

Solution

Illustration 4:

H.B.P. Ltd. expects annual net operating income of Rs. 2,00,000. It has Rs. 5,00,000 outstaing debt, cost of debt is 10%. If the overall capitalisation rate is 12.5% what would be the total value of the firm and the equity capitalisation rate according to the Net operating Income approach.

What will be the effect of the following on the total value of the firm and equity capitalisation rate, if:

(i) The firm increases the amount of debt from Rs. 5,00,000 to Rs. 7,50,000 and uses the proceeds of the debt to repurchase equity shares.

(ii) The firm redeems debt of Rs. 2,50,000 by issuing fresh equity shares of the same amount.

Solution:

Solution

Theory # 3. 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. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt.

Thus, overall cost of capital, according to this theory, decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases or rises beyond a certain point. Even the cost of debt may increase at this stage due to increased financial risk.

The traditional view point on the relationship between the leverage, cost of capital and the value of firm has been shown in the figures below:

Degree of Leverage and Cost of Capital

Degree of Leverage and Cost of Capital

The figures above show that there can be a range of optimal capital structure or a particular level of optimal capital structure.

Illustration 5:

Compute the market value of the firm, value of shares and the average cost of capital from the following information:

Capital Structure with Illustration 14

Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.

Solution:

Computation of Market Value

Comments:

It is clear from the above that if debt of Rs. 4,00,000 is used the value of the firm increases and the overall cost of capital decreases. But, if more debt is used to finance in place of equity, i.e., Rs. 6,00,000 debentures, the value of the firm decreases and the overall cost of capital increases.

Illustration 6:

A company’s current net operating income (EBIT) is Rs. 8,00,000. The company has Rs. 20 lakhs of 10% debt outstanding. Its equity capitalisation rate is 15%. The company is considering to increase its debt by raising additional Rs. 10 lakhs and to utilise these funds to retire the amount of equity. However, due to increased financial risk, the cost of entire debt is likely to increase to 12% and the cost of equity it 18%.

You are required to compute the market value of the company using traditional model and also make recommendations regarding the proposal:

Solution:

Computation of Market Value of the Company

Computation of Market Value of the Company

Theory # 4. Modigliani and Miller Approach:

M&M hypothesis is identical with the Net Operating Income approach if taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net Income Approach.

(a) In the absence of taxes. (Theory of Irrelevance):

The theory proves that the costs of capital is not affected by changes in the capital structure or say that the debt-equity mix is irrelevant in the determination of the total value of a firm. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases.

This increase in cost of equity offsets the advantage of the low cost of debt. Thus, although the financial leverage affects the cost of equity, the overall cost of capital remains constant. The theory emphasises the fact that a firm’s operating income is a determinant of its total value.

The theory further propounds that beyond a certain limit of debt, the cost of debt increases (due to increased financial risk) but the cost of equity falls thereby again balancing the two costs.

In the opinion of Modigliani& Miller, two identical firms in all respects except their capital structure cannot have different market values or cost of capital because of arbitrage process.

In case two identical firms except for their capital structure have different market values or cost of capital, arbitrage will take place and the investors will engage in ‘personal leverage’ (i.e. they will buy equity of the other company in preference to the company having lesser value) as against the ‘corporate leverage’; and this will again render the two firms to have the same total value.

The M&M appraoch is based upon the following assumptions:

(i) There are no corporate taxes.

(ii) There is a prefect market.

(iii) Investors act rationally.

(iv) The expected earnings of all the firms have identical risk characteristics.

(v) The cut-off point of investment in a firm is capitalisation rate.

(vi) Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates.

(vii) All earnings are distributed to the shareholders.

MM approach in the absence of corporate taxes, i.e., the theory of irrelevance of financing mix has been presented in the following figure:

Degree of Leverage and Cost of Capital

Illustration 7:

The following information is available regarding Mid Air Enterprises:

(i) Mid Air currently has no debt, it is an all equity company;

(ii) Expected EBIT = Rs. 24 lakhs. EBIT is not expected to increase overnight, so Mid Air is in no growth situation;

(iii) There are no taxes, so T = O per cent;

(iv) Mid Air pays out all its income as dividends;

(v) If mid Air begins to use debt, it can borrow at the rate kd = 8 per cent. This borrowing rate is constant and it is independent of the amount of debt. Any money raised by selling debt would be used to retire common stock, so Mid Air’s assets would remain constant;

(vi) The risk of Mid Air’s assets, and thus its EBIT, is such that its shareholders require a rate of return ke = 12 per cent, if no debt is used.

Using MM Model without corporate taxes and assuming a debt of Rs. 1 crore, you are required to:

(a) Determine the firm’s total market value;

(b) Determine the firm’s value of equity;

(c) Determine the firm’s leverage cost of equity.

Solution:

Solution

(b) When the corporate taxes are assumed to exist. (Theory of Relevance):

Modigliani and Miller, in their article of 1963 have recognised that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum capital structure can be achieved by maximising the debt mix in the equity of a firm.

According to the M & M approach, the value of a firm unlevered can be calculated as.

where, Vu is value of unlevered firm

and, tD is the discounted present value of the tax savings resulting from the tax deductibility of the interest charges, t is the rate of tax and D the quantum of debt used in the mix.

Value of levered and unlevered firm under the MM model (assuming that corporate taxes exist) has been shown in the following figure.

Illustration 8:

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 Miller-Modigliani theory:

Capital Structure with Illustration 17

Solution:

Solution

Illustration 9:

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 tax of Rs. 25,000 and the equity capitalisation rate is 10%. Assuming the corporation tax of 50% calculate the value of the firm using M & M approach:

Solution:

Solution 

How does the Arbitrage Process Work?

We have noticed in Illustration 18 that the market value of the firm Y, which uses debt content in its capital structure, is higher than the market value of firm X which does not use debt content in its capital structure. According to M & M theory, this situation cannot remain for a long period because of the arbitrage process.

As the investors in company Y can earn a higher rate of return on their investment with lower financial risk, they will sell their holding of shares in company Y and invest the same in company X.

Further, as company X does not use any debt in its capital structure, the financial risk to the investors will be less, thus, they will engage in personal leverage by borrowing additional funds equivalent to their proportionate share in firm Y’s debt at the same rate of interest and invest the borrowed funds also in company X.

The arbitrage process will continue till the prices of shares of company Y fall and that of company X rise so as to make the market value of the two firms identical. However, in the arbitrage process, such investors who switch their holdings will gain. Illustration 19, given below, illustrates the working of arbitrage process.

Illustration 10:

The following is the data regarding two companies ‘A’ and ‘B’ belonging to the same equivalent risk class:

Capital Structure with Illustration 19

All profits after paying debenture interest are distributed as dividends.

You are required to explain how under Modigliani and Miller approach, an investor holding 10% of shares in company ‘A’ will be better off in switching his holding to company ‘B’

Solution:

Solution

As the net income of the investor in company ‘B’ is higher than the loss of income from company ‘A ‘ due to switching the holdings, the investor will gain in switching his holdings to company ‘B’.

Illustration 11:

Companies A and B belong to the same business-risk class. Average net operating income before interest of each company is 7 100 lakhs. Other related information is given below:

Capital Structure with Illustration 20

Rate of interest on debentures is 15% p.a. and the same is considered to be certain by all the investors:

(a) In case the total market value of the two companies is not in equilibrium, explain the process by which equilibrium is restored to according to Modigliani and Miller theory.

(b) If the cost of equity is 27.78% for company A in equilibrium, what will it be for company B?

Solution:

Solution

Illustration 12:

Compute the equilibrium values and capitalization rates of equity (Ke) of the companies A and B on the basis of the following data. Assume that:

(i) There is no income tax, and

(ii) The equilibrium value of average cost of capital (P) is 8.5%.

Capital Structure with Illustration 21

Solution:

Solution

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