What are the theories of Capital structure and its assumptions ?

What are the theories of Capital structure and its assumptions ?

A firm needs to have such sources in the right proportion. Short-term funds keep varying and hence, their proportions cannot be laid down in a rigid manner. However, a more definite policy is required for the composition of the long-term funds. This forms the capital structure of the firm. Thus, the capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company.

More important areas of the policy are the debt-equity ratio and the dividend decision. The latter affects the building up of retained earnings which is an important component of long-term owned funds. Since the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision, the term financial structure is often used to mean the capital structure of the firm.

According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.

With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firm’s objective.

The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firm’s value through the earnings available to the shareholders.The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the company’s market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the Earnings Per Share (EPS).

Theories of Capital Structure

As we are aware, equity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and equity in a firm’s capital structure has to be independently decided case to case.

A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits.What proportion of equity and debt should be taken up in the capital structure of a firm? The answeris tricky and is based on the understanding and interpretation of the relationship between the financial leverage and firm valuation or financial leverage and cost of capital. Many theories have been propounded to understand the relationship between financial leverage and firm value.

Assumptions

The following are some common assumptions made:

 The firm has only two sources of funds, debt and ordinary shares

 There are no taxes, both corporate and personal

 The firm’s dividend payout ratio is 100%, that is, the firm pays off the entire earnings to its equityholders and retained earnings are zero

 The investment decisions of a company are constant, that is, the firm does not invest any further in its assets

 The operating profits/EBIT are not expected to increase or decrease 

 All investors shall have identical subjective probability distribution of the future expected EBIT

 A firm can change its capital structure at a short notice without the incurrence of transaction costs

 The life of the firm is indefinite

Based on the assumptions regarding the capital structure, we derive the following formulae:

Cost of Debt

 Debt capital being constant, Kd is the cost of debt which is the discount rate at which the  discounted future constant interest payments are equal

 to the market value of debt, that is,

Kd = I/B

where, I refers to total interest payments and B is the total market value of debt.

Therefore value of the debt B = I/Kd

Cost of Equity

As mentioned above, it is assumed that there is a 100% dividend payout and constant earnings. Such being the case, the cost of equity is the discount rate at which the discounted future dividend/earnings are equal to the market value of equity.

 Cost of equity capital Ke = (D1/P0) + g

where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate.

 Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g

being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares.

Firm Value

The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 +  W2 K2.

That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S is the market value of equity and V is the total market value of  the firm and can be given as (B+S).

The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt component and Ke being the equity component) which can be expressed as:

K0 = I + NI/V or EBIT/V

or in other words, net operating income/market value of firm.

Net income approach

Net Income (NI) approach is suggested by Durand. He is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the Weighted Average Cost of Capital (WACC) declines and market value of firm increases. According to this approach, a firm can minimise the overall WACC and maximise the value of a firm by increasing the proportion of debt in its capital structure.

The NI approach is based on 3 assumptions. They are:

 no taxes

 the cost of debt is less than the cost of equity and remains constant

 use of debt does not change the risk perception of investors

We know that,

K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

Where, B is the market value of Debt and S, the market value of equity.

The following graphical representation of NI approach may help us understand this better.

It can be understood from the given graphical representation that as the market value of debt-to equity ratio (B/S) increases, K0 decreases. This is because the proportion of debt, the cheaper source of finance, increases in the capital structure.

Net operating income approach

Net Operating Income (NOI) approach is also propounded by Durand and is totally opposite to the NI approach. Durand says that any change in leverage will not lead to any change in the total value of the firm, market price of shares, and overall cost of capital. The overall capitalisation rate and the cost

of debt is the same for all degrees of leverage.

We know that:

K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

As per the NOI approach, the overall capitalisation rate remains constant for all degrees of leverage.

The market values the firm as a whole and the split in the capitalisation rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus, K0 and Kd remaining constant for all degrees of leverage, the cost of equity is:

Ke = K0 +[ (K0 – Kd)(B/S)].

Cost of debt

The cost of debt has two parts Explicit cost and Implicit cost Explicit cost can be considered as the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can result to a conclusion that the increasing proportion of debt does not affect the financial risk of lenders, and they do not charge higher interest.

Implicit cost is the increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralised by the implicit cost resulting in Ke and Kd being the same.

The below figure depicts the behaviour of Kd, Ke and K0, in response to changes in B/S.

Traditional approach

The traditional approach has the following propositions:

Kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate

Ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very  sharply

As a sequence to the above 2 propositions, K0 decreases till a certain level, remains constant for moderate increases in leverage thereafter and rises beyond a certain point

Below figure depicts the graphical representation based on the propositions made on the traditional approach.

The approach primarily implies that the cost of capital is dependant on the capital structure, and there is an optimal capital structure which minimises the cost of capital. At this optimal capital structure, the real marginal cost of debt and equity is the same. Before this point is reached, the real marginal cost of debt is less than the real marginal cost of equity. After this point, the real marginal cost of debt is more than the real marginal cost of equity.

Miller and Modigliani approach

Miller and Modigliani criticise traditional approach that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in NOI approach.

The assumptions regarding Miller and Modigliani (MM) approach: perfect capital markets, rational behaviour, homogeneity, taxes, and dividend payout.

Perfect capital markets – Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, and availability of all required information at all times.

Investors behave rationally – They choose the combination of risk and return which is most advantageous to them.

Homogeneity of investor’s risk perception – All investors have the same perception of business risk and returns.

Taxes – There is no corporate or personal income tax.

Dividend payout is 100% – The firms do not retain earnings for future activities.

Basic propositions

Three propositions can be derived based on the assumptions made on MM approach:

Proposition I: The total market value of the firm, which is equal to the total market value of equity and total market value of debt, is independent of the degree of leverage. Therefore, the market value of the firm can be expressed as:

Expected NOI/discount rate appropriate to its risk class

i.e., expected overall capitalisation rate

V = (S+B)

which is equal to O/k0 which is equal to NOI/k0

V = (S+B) = O/k0 = NOI/k0

Where V is the market value of the firm,

S is the market value of the firm’s equity,

B is the market value of the debt, O is the net operating income,

k0 is the capitalisation rate of the risk class of the firm, i.e., the discount rate applicable. depicts the graphical representation of proposition

The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism.

Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. This is a balancing act.

Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return, buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk. The MM hypothesis thus states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation.

Such behaviours are expected to increase the share prices whose shares are being purchased and lowering the share prices of those share which are being sold. This switching operation will continue till the market prices of identical firms become equal or identical. Thus, the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

Proposition II: The expected yield on equity (ke) is equal to the discount rate (capitalisation rate) applicable (k0) plus a premium. This premium is equal to the debt-equity ratio times the difference between k0 and the yield on debt, r.

This can be represented as below:

ke = k0 + [ (k0 – r) (B/S)]

Proposition III: This proposition states the implication of the earlier propositions for investment decision making.

It states that the average cost of capital is not affected by the financing decisions as investment and financing decisions are independent.

Criticisms of MM proposition

There were many criticisms, on various grounds, over MM propositions.

Risk perception

The assumption that risks are similar is wrong. The risk perceptions of investors/personal leverage and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of individuals puts firms and investors on a different footing.

All investors lose if a leveraged firm becomes bankrupt, but an investor loses not only his or her shares in a company but would also be liable to repay the money he or she borrowed.

Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered firm than investing in levered firms.

Convenience

Investors find personal leverage inconvenient. This is so because it is the firm’s responsibility to observe corporate formalities and procedures whereas it is the investor’s responsibility to take care of personal leverage.

Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is subjected to question.

Transaction costs

Another cost that interferes in the system of balancing with arbitrage process is the presence of transaction costs. Due to the presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the same amount of return.

Taxes

When personal taxes are considered along with corporate taxes, the MM approach fails to explain the financing decision and the firm’s value.

Agency costs

A firm requiring loan approaches creditors and creditors may sometimes impose protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans, appointment of key persons, restriction on dividend payouts, limiting further issue of capital, limiting new investments or expansion schemes, etc.

Taxation and other imperfections cast a shadow on the leverage irrelevance theorem of MM and imply that the cost of capital is affected by financial leverage. The effect of taxation is to reduce the cost of capital as financial leverage increases. Alternatively, it implies that the value of the firm increases with financial leverage.

Bankruptcy and agency costs, however, tend to increase the cost of capital as financial leverage increases. In other words, these imperfections detract from the value of the firm as financial leverage increases.