Study Note — 2 FINANCIAL MANAGEMENT DECISIONS 2.1 Capital Structure This Section includes : •
Theories of Capital Structure
INTRODUCTION: The capital structure of a company refers to a containation of the long-term finances used by he firm. The th eory of capital stru cture is closely closely related to th e firm’s firm’s cost of cap cap ital. The The d eciecision regarding the capital structure or the financial leverage or the financing wise is based on the objective of achieving the maximization of shareholders wealth. To design design capital structure, we should consider the foll following owing tw o prop ositons ositons : (i) Wealth maximinization is attained. (ii) Best approximation to the optimal capital structure.
Factors Determining Capital Structure (1) Minimiza structure mu st be consiste consistent nt w ith business business risk. risk. Minimization tion of Risk Risk : (a) Capital structure (b) It should r esult in a certain certain level of financi financial al risk. (2) Cont Contro roll : It should reflect the management’s philosophy of control over the firm. (3) Flexib Flexibili ility ty : It refers to the ability of the firm to meet the requirements of the changing situations. (4) Profitabi profitable from the equity shareholders p oint of view. view. Profitability lity : It should be profitable (5) Solve Solvenc ncy y : The use of excessive debt may threaten the solvency of the company.
Process of Capital Structure Decisions Capital Budgeting Decision
Long-term Long-te rm sour ce cess of fund s
Capital Structure Decision
Dividend Decision
Debt-Equity
Existing Capital Structure
Effect on Investors Risk
Effect on Cost of Capital
Effect on Earnings per sh are (EPS)
Value of the Firm
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Financial Management Decisions THEORIES OF CAPITAL STRUCTURE :
quity an bt capital ar th two major sourcs of long-trm funs for a firm. h thoris on capital structur suggsts th proportion of quity na bt in th capital structur. Assumptions i hr ar only two sourcs of funs, i.., th quity an th bt, having a fix intrt. ii h total assts of th firm ar givn an thr woul b no chang in th invstmnt cisions of th firm. iii B arnings Bfor ntrst & ax/NO Nt Oprating rofits of th firm ar givn an is xpct to rmain constant. iv Rtntion Ratio is NL, i.., total profits ar istribut as ivins. [100% ivin pay-out ratio] v h firm has a givn businss risk which is not affct by th financing wis. vi hr is no corporat or prsonal taxs. vii h invstors hav th sam subjctiv probability istribtuion of xpct oprating profits of th firm. viii h capital structur can b altr without incurring transaction costs. n iscussing th thoris of capital structur, w will consir th following notations : = Markt valu of th quity = Makt valu of th bt V = Markt valu of th Firm = + = otal ntrst aymnts = ax Rat B/NO = arnings Bfor ntrst an ax or Nt Oprating rofit A = rofit Aftr ax 0 = ivin at tim 0 i.. now 1 = xpct ivin at th n of Yar 1. o = Currnt Markt ric pr shar 1 = xpct Markt ric pr shar at th n of Yar 1. I (1 − T ) = Cost of bt aftr ax D D = Cost of quity 1 P 0 0 = Ovrall cost of capital i.., WACC D E + Ke = Kd D + E D + E = = 58
K d
D E + K e = V V
K d D V
+
K e E V
=
K d D
+ K e E V
EBIT V
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Different Theories of Capital Structure (1) Net Income (N I) ap poa rch (2) Net Operating Income (NOI) Approach (3) Traditional Approach (4) Mod igliani-Miller Mod el (a) without taxes (b) with taxes.
Net Inome Approach As suggested by David Durand, this theory states that there is a relationship between the Capital Structure an d the value of the firm.
Assumptions (1) Toal Capital requirement of the firm are given and remain constant (2) Kd < K e (3) Kd and Ke are constant (4) Ko decreases w ith the increase in leverage.
Cost of Capital (%)
K
e
K K
0 d
O
Degree of Leverage
Illustration Earnings Before Interest of Tax (EBIT) Interest Equ ity Earnings (E) Cost of Equ ity (Ke) Cost of Debt (Kd ) E Market Value of Equity = Ke I Market Value of Debt = Ke Total Valu e of the Firm [E+D] Overa ll cost of capital (K 0)
=
EBIT E + D
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Firm A
Firm B
2,00,000 — 2,00,000 12% 10%
2,00,000 50,000 1,50,000 12% 10%
16,66,667
12,50,000
N IL
5,00,000
16,66,667
17,50,000
12%
11.43%
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Financial Managemen t D ecisions N et Ope rating Income (NO I) Approach
According to David Duran d, und er NOI approach, the total value of the firm will not be affected by the composition of capital structure. Assumptions
(1) K0 and Kd is constant. (2) Ke will change with the degree of leverge. (3) There is no tax. K
e
Cost of Capital (%)
K
o
K
d
O
Degree of Leverag e
Illustration
A firm ha s an EBIT of Rs. 5,00,000 an d belong s to a r isk class of 10%. What is t he cost o f Equity if it emp loys 8% d ebt to t he exten t of 30%, 40% or 50% of th e tota l capital fu nd of Rs. 20,00,000? Solution 30%
40%
50%
6,00,000
8,00,000
10,00,000
14,00,000
12,00,000
10,00,000
5,00,000
5,00,000
5,00,000
10%
10%
10%
50,00,000
50,00,000
50,00,000
44,00,000
42,00,000
40,00,000
36,000
48,000
60,000
N et Profit (EBIT–Int.) (Rs.)
4,64,000
4,52,000
4,40,000
Ke (N P/ E)
10.545%
10.76%
11%
Debt (Rs.) Equ ity (Rs. ) EBIT (Rs.) Ko Valu e of the Firm (V) (Rs.) (EBIT/ Ko) Valu e of Equ ity (E) (Rs.) (V–D) Interest @ 6% (Rs.)
Traditional Approach :
It takes a mid-way between the NI app roach and the NO I approach.
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Assumptions
(i) The value of the firm increases with the increase in financial leverage, up to a certain limit only. (ii) Kd is assum ed to be less than K e.
K
K
e
Cost of Capital (%)
e
K
K
o
o
K
K
d
O Optimal Capital Structure
Leverage (Degree)
(Part-I)
d
O
P
Range of optimal Capital Structure
Leverage (Degree)
(Part-II)
Traditional viewpoint on the Relationship between Leverage, Cost of Capital and the Value of the Firm
Modigliani – Miller (MM) Hypothesis
The Modigliani – Miller hypothesis is identical with the net operating Income approach. Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by th e changes in capital structure. In other w ords, capital structure decisions are irrelevant and value of the firm is ind epend ent of debt – equity m ix. Basic Propositions
M - M Hyp othesis can be explained in terms of two pr opositions of Modigliani and Miller. They are : i.
The overall cost of capital (K O ) and the valu e of the firm are independ ent of the capital stru cture. The total ma rket value of the firm is given by capitalising the expected n et operating income by the rate ap prop riate for that risk class.
ii. The financial risk increases with m ore debt content in the capital structure. As a result cost of equity (Ke ) increases in a manner to offset exactly the low – cost advantage of d ebt. H ence, overall cost of capital remains the same. Fianancial Management & international finance
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Financial Management Decisions Assumptions of the MM Approach
1. There is a perfect capital market. Capital markets are perfect when i)
investors are free to buy and sell securities,
ii)
they can borrow funds without restriction at the same terms as the firms do,
iii)
they behave rationally,
iv)
they are well informed, and
v)
there are no transaction costs.
2.
Firms can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk.
3.
All investors have the same expectation of a firm’s net operating income (EBIT).
4.
The dividend payout ratio is 100%, which means there are no retained earnings.
5.
There are no corporate taxes. This assumption has been removed later.
Preposition I
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 = S + D =
Where,
X K o
NO I =
K o
V = the market value of the firm S = the market value of equity D = the market value of debt
According the proposition I the average cost of capital is not affected by degree of leverage and is determined as follows: K o
X =
V
According to M –M, the average cost of capital is constant as shown in the following Fiure.
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Y á
Cost of Leverage á
Ko
á
O
Average cost of Capital
X
Arbitrage Process
According to M –M, two firms identical in all respects except their capital structure, cannot have different market values or different cost of capital. In case, these firms have different market values, the arbitrage will take place and equilibrium in market values is restored in no time. Arbitrage process refers to switching of investment from one firm to another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. The use of debt by the investors is known as personal leverage or home made leverage. Because of this arbitrage process, the market price of securities in higher valued market will come down and the market price of securities in the lower valued market will go up, and this switching process is continued until the equilibrium is established in the market values. So, M –M, argue that there is no possibility of different market values for identical firms. Reverse Working Of Arbitrage Process
Arbitrage process also works in the reverse direction. Leverage has neither advantage nor disadvantage. If an unlevered firm (with no debt capital) has higher market value than a levered firm (with debt capital) arbitrage process works in reverse direction. Investors will try to switch their investments from unlevered firm to levered firm so that equilibrium is established in no time. Thus, M – M proved in terms of their proposition I that the value of the firm is not affected by debt-equity mix.
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Financial Management Decisions Proposition II
M – M’s prop osition II d efines cost of equity. Accord ing to them , for any firm in a given risk class, the cost of equity is equ al to the consta nt a verage 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 d ebt. Thus, cost of equity is: K e
= K o + (K o − K d ) =
D S
Where, K e = cost of equity D/ S = debt – equity ratio M – M argue that Ko will not increase with the increase in the leverage, because the low – cost ad van tage of debt cap ital will be exactly offset by the increase in the cost of equ ity as caused by increased risk to equity sh arehold ers. The cru cial part of the M – M Thesis is that an excessive use of leverage will increase the risk to the d ebt hold ers wh ich resu lts in an increase in cost of debt (Ko). How ever, this w ill not lead to a rise in Ko. M – M maint ain that in such a case Ke will increase at a decreasing rate or even it may d ecline. This is becau se of the reason th at at an increased leverage, the increased r isk will be shared by the debt holders. Hence Ko remain constant. This is illust rated in the Figur e given below:
Y
Ke
Cost of Capital (percent)
Ko Kd
X O
Leverage
M M H ypothesis and cost of capital
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Criticism Of M M Hypothesis
The arbitrage process is the behavioural and operational foundation for M M Hypothesis. But this process fails the desired equilibrium because of the following limitations. 1. Rates of interest are not the same for the individuals and firms. The firms generally have a higher credit standing because of which they can borrow funds at a lower rate of interest as compared to individuals. 2. Home – Made leverage is not a perfect substitute for corporate leverage. If the firm borrows, the risk to the shareholder is limited to his shareholding in that company. But if he borrows personally, the liability will be extended to his personal property also. Hence, the assumption that personal or home – made leverage is a perfect substitute for corporate leverage is not valid. 3. The assumption that transaction costs do not exist is not valid because these costs are necessarily involved in buying and selling securities. 4. The working of arbitrage is affected by institutional restrictions, because the institutional investors are not allowed to practice home – made leverage. 5. The major limitation of M – M hypothesis is the existence of corporate taxes. Since the interest charges are tax deductible, a levered firm will have a lower cost of debt due to tax advantage when taxes exist. M – M Hypothesis Corporate Taxes
Modigliani and Miller later recognised the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximising debt component in the capital structure. According to this approach, value of a firm can be calculated as follows: EBIT
Value of Unlevered firm (Vu) = Where, EBIT =
K o
( I − t )
Earnings before interest and taxes
Ko
=
Overall cost of capital
t
=
Tax rate.
I
=
Interest on debt capital
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