Question based on AU Solved Assignment and other course
Answer:
There are four basic Capital Structure theories. They are:
- Net Income (NI) Approach
- Net Operating Income (NOI) Approach
- Modigliani-Miller (MM) Approach
- Traditional Approach
Generally, the capital structure theories have the following assumptions:
- The firms employ only two types of capital namely debts ad equity
- The firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms.
- The total assets are given which do not change and the investment decisions are assumed to be constant.
- Business risk is constant over time and it is assumed that it is independent of the capital structure and financial risk.
- The firm has a perpetual life.
- The firm’s operating earnings (EBIT) are not expected to grow.
- The corporate and personal income taxes do not exist. This assumption was relaxed later on.
- The firm’s total financing remains constant. The firm’s degree of leverage can be altered either by selling shares to retire debt or by raising more debt and reduce the equity financing.
- All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm.
Net Income (NI) Approach
Net Income theory was introduced by David Durand. According to this approach, there is a relationship between the capital structure and the value of the firm. The firm, by increasing the debt proportion in the capital structure can increase its market value or lower the overall cost of capital (WACC).
Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest, company has to pay less tax and thus it will decrease the over all cost of capital or weighted average cost of capital (WACC).
High debt content in the debt-equity mix is called financial leverage. Increasing of financial leverage will help in maximizing the firm’s value. For example, if the debt: equity mix is increased from 50:50 to 80:20, it will increase the market value of firm and its positive effect on the value of per share.
Assumptions of NI approach:
- There are no taxes.
- The cost of debt is less than the cost of equity ( i.e kd < ke )
- The use of debt does not change the risk perception of the investors, as a result the cost of equity(ke) and the cost of debt (kd) remains constant with the change in leverage.
- The overall cost of capital (ko) decreases with the increase in leverage.
Net Operating Income (NOI) Approach
According to this approach the market value of the firm is not affected by the capitalstructure changes. This theory, contrary to NI theory, does not accept the idea of increasing the financial leverage. It means change in the capital structure does not affect the overall cost of capital and the market value of the firm. Thus at each and every level of capital structure, market value of firm will be same.
The market value of the firm V = (D+E) = EBIT/Ko V= Value of firm
(D+E)= Debt + Equity
KO = Overall cost of capital
EBIT = Earnings before interest and tax.
The overall capitalisation rate (ko) depends on the business risk of the firm and is independent of financial mix. Therefore, the market value of firm will be a constant and independent of capital structure changes. Thus, according to Net Operating Income (NOI) Approach, any capital structure will be optimum.
The critical assumptions of the NOI approach are:
- The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important.
- The market uses an overall capitalisation rate to capitalize the net operating income. Overall cost of capital depends on the business risk. If the business risk is assumed to remain unchanged, overall cost of capital is a constant.
- The use of less costly debt funds increases the risk to shareholder. This causes the equity capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the increase in the equity-capitalisation rate.
- The debt capitalisation rate is constant.
- The corporate income taxes do not exist.
- Traditional Approach
Traditional Theory is an intermediate approach between the net income and net operating income theories. This gives the right combination of debt and equity and always leads to enhanced market value of thefirm. It states that a firm’s value increases to a certain level of debt capital, after which it tends toremain constant and eventually begins to decrease.
The traditional theory assumes changes in cost of equity (ke) at different levels of debt- equity rate and beyond a particular point of debt-equity mix, ke rises at an increasing rate, thus reducing the value of the firm.
The effect of change in capital structure on the overall cost of capital can be divided into three stages as follows:
Stage I – Introduction of Debt: Increasing Value – The overall cost of capital falls and the value of the firm increases with the increase in leverage. This leverage has beneficial effect as debts are less expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in sucha firm.
Stage II – FurtherApplication of Debt: Optimum Value – Astage is reached when increase in leverage has no effect on the value of the firm or the cost of capital. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the advantage of low cost debt. Stage wherein the value of the firm is maximum and cost of capital is minimum
-Optimum capital Structure
Stage III – FurtherApplication of Debt: Declining Value – Beyond a definite limit of leverage the cost of capital increases with leverage and the value of the firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher rate of return on equity shares. As a result the value of the firm reduces.
This theory follows that the cost of capital is a function of the degree of leverage. Hence, an optimum capital structure can be achieved by establishing an appropriate degree of leverage.
Modigliani- Miller (M-M) 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.
Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of thefirm are not affected by the changes in capital structure.
Assumptions of M-M Approach
- Capital markets are perfect. Thus investors are
- free to buy and sell securities
- able to borrow funds at the same terms as the firms do
- well informed and behave rationally
- All investors have the same expectation of the company’s net operating income (EBIT) for the purpose of evaluating the value of the firm.
- Within similar operating environments, the business risk is equal among all firms.
- Dividend payout ratio is 100% and therefore no retained earnings.
- No corporate taxes exist. This was removed later.
Basic Propositions – M-M approach- Without Taxes
M M Hypothesis can be explained in terms of two propositions of Modigliani and Miller
Proposition I: 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 anappropriate discount rate suitable for the risk undertaken.
According to M M, for the firms in the same risk class, the total market value is independent of capital structure and is determined by capitalising net operating income by the rate appropriate to that risk class.
Proposition I can be expressed as follows:
V = (D+E) = NOI/Ko
Where V = the market value of the firms,
E= market value of equity, D= market value of debt NOI= Net operating Income
Ko = capitalisation rate appropriate to the risk class of the firm.
It is evident from this figure that average cost of capital is constant and is not affected by leverage.
Arbitrage Process: Why should proposition I hold good? The simple principle of proposition 1 is that two firms identical in all respects except for the capital structures cannot command different market values nor have different cost of capital.
Arbitrage process 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 high. This will have an 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 price of these two firms become equal or identical. 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. Thus the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.
Proposition II: For any firm in a given risk class, the cost of equity is equal to the constant average cost of capital (Ko) plus a premium for the financial risk, which is equal to debt – equity ratio times the spread between average cost and cost of debt.
Therefore, cost of equity is defined as follows:
Ke= Ko+(ko-kd) (D/E)
- K is the required rate of return on equity or cost of equity
- K is the company unlevered cost of capital (ie assume no leverage).
- K is the required rate of return on borrowings, or cost of debt
- D/E is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).
M-M approach – With Taxes: Debt has an important advantage over equity, interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. The value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable).
The following assumptions are made in the propositions with taxes:
- corporations are taxed at the rate T on earnings after interest,
- no transaction costs exist, and
- individuals and corporations borrow at the same rate
It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency cost.
Proposition I
VL= VU+TCD
Where
- VL is the value of a levered firm
- VU is the value of an unlevered firm
- TCD is the tax rate TCxD the value of debt
- the term assumes debt is perpetual
Proposition II:
rE= ro+D/E (ro- rd) (1- Tc)
Where
- rE is the required rate of return on equity, or cost of levered equity=unlevered equity + financing premium
- ro is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0)
- rd is the required rate of return on borrowings, or cost of debt
- D/E is the debt to equity ratio
- Tc is the tax rate.
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.
Relaxing MM Assumptions: The scenarios presented by MM are not necessarily reflective of business reality. Additional factors for consideration include:
- Financial Distress: as a firm assumes more debt (i.e. increases its financial leverage), its bankruptcy risk increases. This increased risk should be factored in to any analysis.
- Agency Costs: these are the costs incurred by stockholders to monitor company managers; agency costs are increased when monitoring mechanisms fail and equity value losses are absorbed.
- Asymmetric Information: MM assumes perfect information, but company managers commonly know more about the firm than the investing public. This is asymmetric information.
Pecking Order Theory: This theory states that company management prefers to use internal financing (cash on hand, retained earnings) as these sources are not as readily visible to the public as stock and bond offerings, which invite scrutiny.
Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a last resort. Hence, internal financing is used first, when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if externalfinancing is required.
This model does assume asymmetric information – managers know more than investors, and will only issue equity, the most expensive form of financing, last in order to avoid transferring wealth from old shareholders to new shareholders.
Static Trade-Off Theory: Outside the MM construct, this theory views capital structure as a decision that balances costs and benefits. Under static trade-off, the company should continue to capitalize itself with debt until the increased costs associated with financial distress exceed the value of the tax shield.
