CAPITAL STRUCTURE: THEORY AND POLICY

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

disadvantage in terms of costs of financial distress
 Explain the impact of agency costs on capital structure
 Study the determinants of capital structure in practice
 Practical Considerations in Determining Capital Structure
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What is Capital Structure?

What are the advantages of equity?
What are the disadvantages of equity?
What are the advantages of debt?
What are the disadvantages of debt?
 INTRODUCTION
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 The objective of a firm should be directed towards

the maximization of the firm’s value.

 The capital structure or financial leverage decision

should be examined from the point of its impact on
the value of the firm.
 Modigliani and Miller“s
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Proposition : Key Assumptions
 Perfect capital markets
 Homogeneous risk classes
 Risk
 No taxes
 Full payout
 Modigliani and Miller“s
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Approach Without Tax:
Proposition I
 MM’s Proposition I is
that, for firms in the same
risk class, the total market
value is independent of
the debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to that
risk class.
 Net Operating Income (NOI)
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Approach
 According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firm’s capital structure. In the
absence of taxes, an individual holding all the debt
and equity securities will receive the same cash
flows regardless of the capital structure and
therefore, value of the company is the same.
 MM’s approach is a net operating income
approach.
 MM’s Proposition II
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 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.
 The cost of equity for a levered firm should be higher than the
opportunity cost of capital, ka; that is, the levered firm’s ke >
ka. It should be equal to constant ka, plus a financial risk
premium.
 Criticism of the MM Hypothesis
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 Lending and borrowing rates discrepancy

 Non-substitutability of personal and corporate
leverages
 Transaction costs
 Existence of corporate tax
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RELEVANCE OF CAPITAL
STRUCTURE:
MM HYPOTHESIS UNDER
CORPORATE TAXES
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 MM show that the value of the firm will increase

with debt due to the deductibility of interest
charges for tax computation, and the value of the
levered firm will be higher than of the unlevered
firm.
Example: Debt Advantage: Interest
Tax Shields
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 Suppose two firms L and U are identical in all respects except that firm L
is levered and firm U is unlevered. Firm U is an all-equity financed firm
while firm L employs equity and Rs 5,000 debt at 10 per cent rate of
interest. Both firms have an expected earning before interest and taxes (or
net operating income) of Rs 2,500, pay corporate tax at 50 per cent and
distribute 100 per cent earnings as dividends to shareholders.
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 You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered
firm L’s investors are ahead of the unlevered firm U’s investors by Rs 250.
You may also note that the tax liability of the levered firm L is Rs 250 less
than the tax liability of the unlevered firm U. For firm L the tax savings
has occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5 ×
(0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,
 Value of Interest Tax Shield
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 Interest tax shield is a cash inflow to the firm and therefore, it is

valuable.
 The cash flows arising on account of interest tax shield are less
risky than the firm’s operating income that is subject to business
risk. Interest tax shield depends on the corporate tax rate and the
firm’s ability to earn enough profit to cover the interest payments.
 The corporate tax rates do not change very frequently.
 Implications of the MM
Hypothesis with
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Corporate Taxes
 The MM’s “tax-corrected” view suggests that, because of the
tax deductibility of interest charges, a firm can increase its
value with leverage. Thus, the optimum capital structure is
reached when the firm employs almost 100 per cent debt.

 In practice, firms do not employ large amounts of debt, nor

are lenders ready to lend beyond certain limits, which they
decide.
 Why do companies not employ
extreme level of debt in practice?
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 First,we 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 distress—
that may also offset the advantage of the interest shield.
FINANCIAL LEVERAGE AND
CORPORATE AND PERSONAL
TAXES
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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.
 A firm should thus aim at minimizing the total taxes (both
corporate and personal) to investors while deciding about
borrowing.
 How do personal income taxes change investors’ return and value?
 It depends on the corporate tax rate and the difference in the personal
income tax rates of investors.
 Limits to Borrowings
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 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?

Corporate and Personal Tax Rates
in India
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 In India, investors are required to pay tax at a

marginal rate, which can be as high as 30 per cent.
 Dividends in the hands of shareholders are tax-
exempt.
 Capital gains on shares are treated favourably.
 In India, companies are required to pay dividend tax
at 15 per cent (as in 2010) on the amount distributed
as dividend.
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TRADE-OFF THEORY: COSTS OF

FINANCIAL DISTRESS AND AGENCY
COSTS
 Financial Distress
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 Financial distress arises when a firm is not able to meet its

obligations to debt-holders.
 For a given level of debt, financial distress occurs because
of the business (operating) risk . with higher business risk,
the probability of financial distress becomes greater.
Determinants of business risk are:
 Operating leverage (fixed and variable costs)
 Cyclical variations
 Intensity of competition
 Price fluctuations
 Firm size and diversification
 Stages in the industry life cycle
 Costs of Financial Distress
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 Financial distress may ultimately force a company

to insolvency. Direct costs of financial distress
include costs of insolvency.

 Financial distress, with or without insolvency, also

has many indirect costs. These costs relate to the
actions of employees, managers, customers,
suppliers and shareholders.
 Value of levered firm under
corporate
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taxes and financial distress
With more and more debt, the costs of
financial distress increases and therefore,
the tax benefit shrinks. The optimum point is
reached when the marginal present values
of the tax benefit and the financial distress
cost are equal. The value of the firm is
maximum at this point.
 Agency Costs
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 In practice, there may exist a conflict of interest among

shareholders, debt holders and management.
 These conflicts give rise to agency problems, which
involve agency costs.
 Agency costs have their influence on a firm’s capital
structure.
 Shareholders–Debt-holders conflict

 Shareholders–Managers conflict

 Monitoring and agency costs

PECKING ORDER THEORY
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 The “pecking order” theory is based on the assertion that managers

have more information about their firms than investors. This disparity
of information is referred to as asymmetric information.
 The manner in which managers raise capital gives a signal of their
belief in their firm’s prospects to investors.
 This also implies that firms always use internal finance/low interest
rate /high interest rate/ equity when available, and choose debt over
new issue of equity when external financing is required.
 The pecking order theory is able to explain the negative inverse
relationship between profitability and debt ratio within an industry.
 However, it does not fully explain the capital structure differences
between industries.
 Implications:
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 Internal equity may be better than external

equity.
 If external capital is required, debt is better.
CAPITAL STRUCTURE
PLANNING AND POLICY
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 Theoretically, the financial manager should plan an

optimum capital structure for the company. The optimum
capital structure is one that maximizes the market value
of the firm.
 The capital structure should be planned generally,
keeping in view the interests of the equity shareholders
and the financial requirements of a company.
 While developing an appropriate capital structure for its
company, the financial manager should inter alia aim at
maximizing the long-term market price per share.
 Elements of Capital Structure
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1. Capital mix
2. Maturity and priority
3. Terms and conditions
4. Currency
5. Financial innovations
6. Financial market segments
 Framework for Capital
Structure:
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The FRICT Analysis
 Flexibility
 Risk
 Income
 Control
 Timing
 APPROACHES TO ESTABLISH
TARGET CAPITAL STRUCTURE
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1. EBIT—EPS approach for analyzing the

impact of debt on EPS.
2. Valuation approach for determining the impact
of debt on the shareholders’ value.
3. Cash flow approach for analyzing the firm’s
ability to service debt.
 Practical Considerations in
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Determining Capital Structure
1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields
4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack –Commitment charges
7. Sustainability and Feasibility
8. Control
9. Marketability and Timing
10. Issue Costs
11. Capacity of Raising Funds