Capital Structure

For UG Finance Class

Rilina Basu (Banerjee)
Department of Economics
Jadavpur University
 • The assets of a company can be financed either by
increasing the owners’ claims or the creditors’ claim.
• Owners’ claim : firm raises funds by issuing ordinary
shares or by retaining earnings
• Creditors’ claims: raise funds by borrowing
 Financial Structure

• Various means of financing of an enterprise

• Liabilities + equity : left hand side of balance sheet
gives the financial structure of a firm
• Capital structure: Long term claims : Debt + equity
(paid up share capital + share premium + reserves and
surplus)
• Capital structure can affect market value of companies
Measures of financial leverage
• Debt Ratio: , where V is the
value of total capital
D and E may be measured in terms of book
value. Book value of equity is called net
worth.
• Debt Equity Ratio :
• Interest Coverage :
Corollary:
Both these measures of financial
leverage will rank companies in same
order.

These two are static in nature and show

the borrowing position of the company at
a point of time.
These do not reflect the level of financial
risk.
 How much of debt and equity should an
enterprise opt for?
• Objective of a firm is to maximise its value
• Three theories:
• A) Net Income Approach
• B) Traditional Approach
• C) Modigliani –Miller Proposition
 Net Income approach
• A firm that finances its assets by equity and debt is
called a levered firm. On the other hand a firm that
uses no debt and finances its assets only by equity is
called Unlevered firm.
• Value of a firm = Sum of value of all securities
= Sum of all debts and equity
• Value of a firm’s shares (equity) E = Discounted value
of shareholders’ earnings, called net income.
• Net Income = Net Operating Income - Interest
Value of Equity = Discounted value of net income

Value of debt = Discounted value of Interest =

Value of firm = value of debt + Value of equity = D +E

Firm’s cost of capital = Net operating income / Value of the firm

= Weighted average cost of capital

WACC = k0 = Cost of equity x weight of equity + cost of

debt x weight of debt
• In a frictionless world, with no taxes and
transaction costs, debt is riskfree and
shareholders perceive no financial risk
arising from the use of debt, then ke and
kd will remain constant with financial
leverage.
• Since debt is a cheaper source of finance
than equity, the firm’s WACC will decline
as leverage increases.
i) Given constant ke and kd and kd < ke , WACC falls as leverage
increases
ii) where () = spread between cost of equity and debt)

So k0 = ke if D/V = 0
k0 = kd if D/V =1 For an unlevered firm
iii) second term is zero, so its
cost of equity is its WACC
and NOI = Expected Net
Income
So value of a firm increases
steadily as D/V increases
and WACC falls.
II. Traditional View
A judicious mix of debt and equity can
increase the value of the firm by reducing
WACC up to a certain level of debt.
WACC decreases only within the
reasonable limit of financial leverage and
reaching the minimum level, it starts
increasing with financial leverage
A firm has an optimal capital structure that
occurs when WACC is minimum.
Why does WACC fall?
• It declines with moderate level of leverage since
low cost debt is replaced by expensive equity
capital.
• Financial leverage means higher risk to share
holders and hence cost of equity increases.
• Traditional theory assumes that at moderate level
of leverage, the increase in the cost of equity is
more than offset by lower cost of debt
• Financial risk caused by the introduction
of debt may increase the cost of equity
slightly
WACC = k0 = Cost of equity x weight of equity + cost of
debt x weight of debt
• Example:
• Suppose the cost of capital for totally
equity financed firm is 12%. Say firm
replaces 40% equity by debt at the rate of
8% of cost of debt. With this cost of
equity increases to 13%, what is WACC?
• But as debt increases by a very large
proportion, then cost of equity also
magnifies until a point is reached at
which the advantage of lower cost of
debt is more than offset by more
expensive equity.
First Stage: Increasing value
• Ke remains constant or rises slightly with
debt
• Kd remains constant since the market
views debt as a reasonable policy.
• WACC falls with rise in D, so value of firm
increases
• V = (Net Operating Income) / WACC
Second Stage : Optimum value
• A certain threshold value of leverage is
attained.
• An increase in D will lead to negligible
effect on WACC and hence V
• So with a rise in D, cost of equity increases
Third Stage : Declining Value
• WACC increases by a greater amount as
Debt increases
• Value of the firm falls
• Investors perceive a high degree of
financial risk and hence demand a higher
equity capitalization rate.
Optimal capital structure
Criticism
• There does not exist sufficient justification
for the assumption that investors’
perception about risk of leverage is
different at different levels of leverage.
• Riskiness of shares is not accommodated.
 Modigliani Miller Proposition
Key assumptions:
• Perfect Capital markets
a) Investors are free to buy or sell securities
b) They can borrow without restriction at the
same terms as firms do
c) They behave rationally
d) No transaction costs
• Homogeneous risk classes
• Risk of investors depends on both the
random fluctuations of the expected Net
operating income and the deviation of
expected from actual.
• No corporate taxes.
• Firms distribute all net earnings to share
holders, i.e. 100% dividend payout.
Propositions:
• 2 aspects of the theorem
a) The total value of the firm is independent
of the financial structure.
b) The pay out structure i.e. dividend and
share repurchase has no effect on firm
value.
Proof of a)
Let X = value of the firm
To show that X is independent of debt and
equity.
X = VE + VD where VE is the value of equity and
VD is the value of debt.
VE = E max (0, R – D)
VD = E min (R, D)
Where R is the income of the firm, stochastic
• Beyond D, debt holders receive nothing
even if firm’s income increases
• If , equity holders receive
nothing
• If , entire income of firms
accrue to equity holder.
• If , no return to equity holders
• So if
• If

• So total value of the firm is independent

of the financial structure.
• Note: If D is very high, it implies that firm
is highly leveraged or under capitalised.
• Leverage factor =
2nd aspect of the theorem
• Value of the firm depends on investment
and firm’s income (fundamentals)
• We assume a 100% equity firm
• No arbitrage condition: Expected Capital
gain = expected dividend
• Suppose n is the number of shares and d
is the dividend. The arbitrage condition is
• , β is the discount factor
Accounting Relation:

new equity div pymnt Invt

Value of the firm = ntPt [since 100% equity]

Again,
• Forwarding by 1 period

Taking expectation

Multiplying by β,

Adding (i) and (ii)

Proceeding in the same way, we get

Therefore by induction

So fundamentals can affect the value of the firm

and not dividend or share repurchase.
This validates the second proposition.
Criticism of MM hypothesis
• Discrepancy in lending and borrowing rates: firms
and households can borrow or lend at the same
rate of interest does not hold in practise.
• It is assumed that personal leverage is a perfect
substitute for corporate leverage. The existence of
limited liability of firms vis-à-vis unlimited liability
of individuals make this inconsistent. It is more
risky to create personal leverage.
• Existence of transaction costs interferes
with the working of arbitrage.
• Institutional restrictions are there.
• Existence of corporate taxes.
MM hypothesis with corporate taxes
• If taxes exist interest payable by firms
saves taxes debt financing is
advantageous.
• Interest tax shield is a cash inflow to the
firm and therefore makes the firm valuable.
• PV of interest tax shield = (corporate tax
rate x interest)/cost of debt =
Value of unlevered firm = (After Tax
NOI)/Unlevered firm’s cost of capital

Value of levered firm = VU + PV of interest tax

shield

So if T>0, then VL >VU

So for T>0, VL increases as L increases with maximum at L =1.
Implications of MM hypothesis with
corporate tax
• “Tax corrected view” suggests that
because of the tax deductibility of interest
charges, a firm can increase its value with
leverage.
• So the optimum capital structure is
achieved when 100% debt is there.
 Why is it not true in reality?
2 possibilities:
1. We need to consider the impact of both
corporate and personal taxes for corporate
borrowing. Personal income tax may offset
the advantages of interest tax shield.
2. Borrowing may involve extra costs in
addition to interest charges. Costs of
financial distress may also offset the
advantages of the interest tax shield.
Financial Leverage and Taxes
Companies pay corporate tax on their
earnings. So earnings available to investors
are declining. Further investors are
required to pay personal income taxes. So
for investors, effect of taxes include both
corporate tax and personal taxes. Hence a
firm should try to minimise the total taxes
put on an investor while deciding about
borrowing.
How do personal taxes change investors’ return
and value?

Interest income after personal taxes = Interest

income – personal taxes on interest income.
Equity income for firms = Net operating income
– corporate tax on net operating income
Equity income for investors = Equity income –
personal tax on equity income
= NOI (1-corporate tax rate)(1-personal tax
rate)
• Example: Say expected NOI of a firm is
Rs.100. In case of interest, no corporate
taxes and debt holders receive Rs. 100.
Personal tax on interest income is 40%. If
firm’s expected NOI is not distributed as
interest, then it belongs to shareholders
after paying corporate tax @50%. Personal
tax on equity is 30%. What will be the
income to the investors in both the cases?
Ans. i) Interest income after personal taxes =
100 – (0.4 x 100) = 60
ii) Equity Income = 100 – (0.5 x 100) = 50
iii) Equity income after personal taxes = 100
(1-0.5)(1-0.3) = 35
Over all taxes = 50 + 15 = 65
Share holders receive = 35
• Suppose the expected NOI of a firm is Re 1
and it is distributed as interest. The
personal tax rate on interest is TPd . Debt
holders income after personal taxes will be
1- TPd.
• If the firm’s expected NOI is distributed as
equity income, then the firm will pay
corporate tax T and the equity income will
be = 1-T
• Suppose personal tax rate on equity income is
TPe. So equity income after personal income tax =
(1-T)- TPe (1-T) = (1-T)(1- TPe )
• Corporate borrowing will be advantageous if
• (1- TPd )> (1-T)(1- TPe )
• A firm will stop borrowing when
(1- TPd ) = (1-T)(1- TPe )
Net tax advantage of debt or the interest tax shield
after personal taxes = (1- TPd ) - (1-T)(1- TPe ) =
(T- TPd ) + TPe (1-T)
• When TPd = Tpe = 0, tax adjustment is
determined by T.
• Corporate tax and TPe favour debt and TPd
reduces tax advantage
• When TPe= 0, TPd reduces tax advantage
and it disappears if T = TPd .
• In presence of a single tax, T = TPd = Tpe .
• Tax advantage of debt = (T - TP )+Tp (1-T)
= T(1-TP )
• Tax advantage of debt ratio =

• If ratio > 1, then debt is advantageous

relative to equity
• If all tax rates are same, tax advantage of
debt ratio = 1/(1-T)
Levered firms income after all taxes
= Unlevered firms income after all taxes + net
tax advantage of debt

where
TPD is the personal tax on interest
TPE is the personal tax rate on equity
 i. If
ii. If present value of interest tax
shield < TD
iii. If present value of interest shield
depend on T and TPD . Interest shield value
declines as TPD rises. Interest tax shield = 0,
if T = TPD .
iv. If advantage of
leverage will be completely lost as the
present value of interest tax shield will be
zero.
Thank You