FINM551: Corporate Finance - II

Capital Structure Decisions

Course Instructor: Tajinder

Learning Outcomes
Define the types of securities usually used by firms to raise capital.

Describe the capital structure that the firm should choose.

Understand the theoretical controversy about capital structure and

the value of the firm

Focus on the interest tax shield advantage of debt as well as its

disadvantage in terms of costs of financial distress

Explain how beta is related to capital structure and the cost of

capital.
Highlight the differences between the Modigliani–Miller view and the
traditional view on the relationship between capital structure and the
cost of capital and the value of the firm
 1

Sources of Finance

A firm/ company can broadly raise finances only

through two sources, i.e., OWNERSHIP and
DEBTSHIP.
Ownership

Equity Capital

Debt-ship
Loans
Preference
Capital
Debenture
Retained
Earnings
 2

Levered Firm vs Unlevered Firm

Levered Firm is a firm that finances its assets

with both EQUITY and DEBT. It is also called
Geared Firm.

Unlevered Firm is a firm that finances its assets

solely from EQUITY. It is also called Ungeared
Firm.
 3

Capital Structure vs Financial Structure

Capital Structure is a combination of different

types of long-term sources of funds. The Capital
Structure is a part of the Liabilities section of the
Balance Sheet.

Financial Structure is a combination of different

types of long-term as well as short-term sources
of funds. Financial structure includes capital
structure in it.
 4

Capital Structure

The relative proportions of debt, equity, and

other long-term securities that a firm has
outstanding
 5

Features of a GOOD Capital Structure

Risk

Control Return

Capacity Flexibility
6 Replacement
Capital Budgeting Modernization
Decision Expansion
Diversification

Internal Funds
Need to Raise Debt
Capital
External Equity

Capital Structure
Decisions

Existing Capital Desired Debt

Payout Policy
Structure Equity Mix

Effect on Return Effect on Risk

Effect on Cost of
Capital
Optimum Capital
Structure
Value of the Firm
 7

Capital Structure and Value of Firm

Two schools of thoughts:

Capital Structure affects the VALUE of FIRM

Capital Structure does not affect the VALUE of FIRM

Value of Firm
Levered
Firm
Unlevered
Firm
 8

Capital Structure Approaches (Theories)

Net Income (NI) approach

Net Operating Income (NOI) approach

Traditional approach

MM hypothesis with and without corporate tax

Miller’s hypothesis with corporate and personal taxes

Trade-off theory: costs and benefits of leverage

 The Net Income Approach
David Durand first suggested this approach in 1952, and he
was a proponent of financial leverage.

He postulated that a change in financial leverage results in a

change in capital costs.

In other words, there is a relationship between capital

structure and value of the firm and therefore firm can affect its
value by increasing or decreasing the debt proportion in the
overall financing mix.
 Contd….
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.
 9

Net Income (NI) Approach

Thrives on the premises of
16%

INDEPENDENCE of Cost of 14%

Ke

DEBT and Cost of EQUITY 12%

from CAPITAL STRUCTURE. 10%

Cost of Capital
8%
Which further implies that
6%
Ko
Kd and Ke remain constant 4% Kd

irrespective of LEVEL of 2%

DEBT in the CAPITAL 0%

100 200 300 400 500 600 700 800 900 1000
Debt (Rs.)
STRUCTURE.
 10

Net Income (NI) Approach: Implications

Overall Cost of Capital declines with INCREASE

in the proportion of DEBT in the capital
structure
Decline in overall cost of capital increases Value
of Firm

It implies, Value of Firm would be MAXIMUM

with 100% DEBT in the capital structure
 11

Net Income (NI) Approach: Criticism

Only a philosophical idea, no basis in reality

In reality, an increase in the proportion of debt

increases both the Cost of Debt and Cost of
Equity due to increase in risk of both.
 12

NI approach: Value of Levered Firm

Value of Firm (V) = Value of Debt (D) + Value of Equity (E)

Where,

Value of Equity = Discounted Value of Net Income

Net Income Where,
E=
Cost of Equity (Ke) NI = NOI - Interest

Value of Debt = Discounted Value of Interest

Interest
D=
Cost of Debt (Kd)
 11

NI approach: Value of Levered Firm

Net Operating Income (NOI)

Firm’s Cost of Capital (Ko) =
Value of Firm (V)
 12

Net Income (NI) approach: Implications

Suppose NOI of Firm is 100,000 and its Equity Capitalization rate (Ke=10%).
Now Company decides to replace equity with debt to the tune of Rs. 300000/-
Cost of Debt is 5% Find the value of Levered, Unlevered firm along with Ko.

To Earn Rs 10 Investment = Rs100/-

To Earn Rs 1 Investment= Rs 100/10
To Earn Rs 100000 Investment= RS100/10*100000= Rs1000000/-

VE= NI/Ke
NI=NOI – Interest – Tax-Pref dividend
NI=NOI – Interest – Tax-Pref dividend
VE= NI/KE=100000/10% =100000/10*100= 1000000/-

VF=VE + VD + Vp + VR
VF =VE + VD + Vp + VR = Rs1000000/-
Ko= WACC=WeKe + WdKd + WpKp + WrKr

Ko= WACC=WeKe + WdKd + WpKp + WrKr

=100% * 10%
Ko= 10%
Levered Firm

Unlevered Firm value = Rs10,00,000

Equity = Total Cap- Debt

Rs1000000-300000
E=700000
Debt=300000
1.Calculate Interest
Debt*Kd
300000*5%= 15000

2. Calculate NI
NI = NOI-Intt
100000-15000 =85000
3. Calculate VD= Intt/Kd = 15000/5%= 300000

4. Calculate VE= NI/Ke= 85000/10%= 850000

5. Calculate VF= Vd+Ve= 300000 + 8500000 = 1150000

6. Calculate Ko = WdKd + WeKe

300000/115000*5% + 850000/1150000*10%
=8.70%
 9

Net Income (NI) Approach

Thrives on the premises of
16%

INDEPENDENCE of Cost of 14%

Ke

DEBT and Cost of EQUITY 12%

from CAPITAL STRUCTURE. 10%

Cost of Capital
8%
Which further implies that
6%
Ko
Kd and Ke remain constant 4% Kd

irrespective of LEVEL of 2%

DEBT in the CAPITAL 0%

100 200 300 400 500 600 700 800 900 1000
Debt (Rs.)
STRUCTURE.
 Illustration
(a) A company expects a income of Rs. 80,000. It has Rs. 2,00,000,
8% Debentures. The equity capitalization rate of the company is
10%. Calculate the value of the firm and overall capitalization 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 capitalization rate?
Solution
 Net Operating Income Approach

This theory as suggested by Durand and 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.
 Contd….
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.

Assumptions of NOI theory:

(i) The market capitalizes 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.

 Contd….
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.
 11

Net Operating Income (NOI) approach

Thrives on the premises of
20%
Ke
INDEPENDENCE of Overall 18%
16%
Cost of Capital (WACC) and 14%

Cost of Capital
12%
VALUE OF FIRM from Ko
10%

CAPITAL STRUCTURE. 8%
6%
Which further implies that 4% Kd

2%
Kd and Ko remain constant 0%
100 200 300 400 500 600 700 800 900 1000
irrespective of LEVEL of Debt (Rs.)

DEBT in the CAPITAL

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

(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