INTRODUCTION
Capital structure refers to the combination of debt and equity sources of financing in the business. Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm.
Debt and Equity are used in business operations, asset acquisitions, financing projects and other investments. The debt-equity mix reflects the capital structure and there are always trade-offs between the use of debt and equity in the business.
There are basically four theories on Capital Structure:
- Net Income (NI) Approach
- Net Operating Income (NOI) Approach
- Traditional Theory Approach
- Modigilian-Miller (MM) Approach
Net Income (NI) Approach
Net Income (NI) Approach suggests that the value of the firm changes with the change in cost of capital. Use of debt instruments will reduce the cost of capital increasing the value of the firm. Debt is considered as a cheaper source of financing.
Assumptions
- Debt is the cheaper source of funds.
- There is no corporate tax.
- Investors are indifferent to the use of debt.
*For solved numerical problem CLICK HERE
Value of the Firm (V) = Market Value of Equity Share (S)+ Market Value of Debt (D) S = Earnings Market to Equity Shareholders/ Equity Capitalization Rate
S = (EBIT -I)/Ke
Cost of Capital = EBIT/V
Net Operating Income (NOI) Approach
Net Operating Income (NOI) Approach advocates that the debt-equity mixer is not important as the market itself capitalizes the value of the firm as a whole. It means that the advantage of using debt instruments to lower the cost of capital is offset by the increased risk perception due to the use of debt instruments i.e. increased the required rate of return by Equity investors.
NOI approach suggests that every capital structure is optimal capital structure.
Assumptions
- Market capitalizes the value of the firm as a whole.
- The business risk remains constant at every level of debt-equity mix
- There are no corporate taxes.
Value of the Firm (V) = Market Value of Equity Share (S)+ Market Value of Debt (D)
Value of the Firm (V) = EBIT/Ko
Equity Capitalization Rate = ( EBIT -I)/(V-D) , Market Value of the debt
*For solved numerical problem CLICK HERE
Traditional Theory Approach
Traditional Theory Approach is also considered as an intermediate Approach as this approach explains the capital structure and the value of firm remaining in the ground between the NI approach and NOI approach.
The basic idea about the value of firm in this approach is that, at a certain point, the debt-equity mix will positively impact the value of firm i.e. debt instrument will reduce the cost of capital. Once the optimum level of debt equity-mix is attained, any additional debt will cause decrease in the market value and increase the cost of capital. After the optimum level of the mix, the risk factor of debt is more evident than the benefit of using the debt instrument.
Assumptions
- Cost of capital remains more or less constant for a certain level and rises thereafter.
- Cost of equity remains more or less constant for a certain level and rises rapidly thereafter.
- Average cost of capital decreases for a certain level, remains unchanged and rises thereafter.
*For solved numerical problem CLICK HERE
Modigliani-Miller (MM) Approach
Modigilian-Miller builds the relationship among the cost of capital, capital structure and the valuation of the firm. MM approach generally advocates that the market value of any firm is irrelevant to its capital structure. For the same level of business risk, the market value of the levered firm is indifferent from the market value of the levered firm. The valuation of any form is irrelevant to its capital structure.
VU=VL= (EBIT/Keo)
VU is the value of an unlevered firm and VL is the value of a levered firm. Keo is the required rate of return on equity of an unlevered firm.
Assumptions
- There are no taxes.
- Transaction costs for buying and selling securities and bankruptcy is zero.
- There is a symmetry of information.
- The cost of borrowing is the same for investors and companies.
- There is no corporate dividend tax.
*For solved numerical problem CLICK HERE
MM Approach: (With NO Taxes)
Proposition I
Proposition I suggests that with an assumption of “no taxes”, the capital structure doesn’t influence the valuation of the firm. The future cash flows determine the value of a company, therefore, capital structure doesn’t affect it. Also, we assume the market to be perfect which means companies do not pay any taxes i.e. company doesn’t have any tax benefit.
VU=VL
Proposition II
Proposition II suggests that financial leverage and cost of equity are in direct proportion which means increasing the debt component increases the risk perception to the company for the equity shareholders. For the use of extra debt, equity shareholders expect higher returns as risk increases.
- Re= Ra + (D/E) (Ra-Rd)
- Re= Cost of Levered Equity
- Ra= Cost of Unlevered Equity
- Rd= Cost of Debt, D/E =Debt-Equity Ratio
MM Approach: (With Taxes)
Proposition I
Proposition I suggests that the tax shields from deductible interest payments make the value of the levered firm higher than the market value of the unlevered firm. The tax deductibles positively reflect the value of the firm.
- VL=VU + Tc*D
- Tc = Tax Rate
- D= Debt
Proposition II
Proposition II under MM Approach under tax-consideration states that the cost of equity has a direct proportional relationship with the leverage level. Consideration of tax shield affects the relationship by making the cost of equity less sensitive to the leverage level. This proposition also suggests that additional debt increases the chance of the company’s default but investors are more prone to gain the benefit from the tax-shield than the negative impact of taking additional leverage, hence, increasing the value of the firm.
- Re= Ra + (D/E) (Ra-Rd)(1-Tc)
- Re= Cost of Levered Equity
- Ra= Cost of Unlevered Equity
- Rd= Cost of Debt
- D/E =Debt-Equity Ratio
- Tc= Tax rate
References: