Capital Structure Theories – Detail Explanation

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Capital Structure Theories

Different kinds of capital structure theories have been propounded by different authors to explain the relationship between Capital structure and cost of capital and value of the firm. The important theories are:

  1. Net income approach
  2. Net Operating Income approach
  3. The Traditional approach
  4. Modigliani and Miller approach

Assumptions: In discussing the capital structure theories, the following assumptions have been used:

  1. There are only two sources of finance i.e. equity and debt
  2. There would be no change in the investment decision.
  3. That the firm has a policy of distributing the entire profits among the shareholders implying that there is no retained earnings.
  4. The operating profits of the firm are given and nor expected to grow.
  5. The business risk complexion of the firm is given and is not affected by the financing mix.
  6. There is no corporate and personal tax.

In discussing the theories of capital structure, the following definitions and notations have been used:

E = Total market value of the Equity
D = Total market value of the Debt
V = Total market value of the firm i.e., D + E
I = Total Interest Payment
NOP = Net operating profit i.e. EBIT
NP = Net Profit or profit after Tax
Do = Dividend paid by the company at Time o
D1 = Expected Dividend at the end of the year 1
Po = Current market price of the Share
P1 = Expected Market Price of the share after 1 year.
Kd = After Tax Cost of Debt i.e. I/D
Ke = Cost of Equity i.e. D/Po
Ko = Overall Cost of Capital i.e. WACC

1. Net Income Approach:

According to Durand, this theory states that there is a relationship between capital structure and the value of firm and therefore the firm can affects its value by increasing or decreasing the debt proportion in the overall financing mix. This approach is based on the following assumptions.

  1. The total Capital requirement of the firm is given and remains constant.
  2. The cost of debt is less than cost of Equity.
  3. Both Kd and Ke remain constant and increase in financial leverage i.e. use of more and debt financing in the capital structure does not affect the risk perception of the investors.

The line of argument in favor of Net Income approach is that as the proportion of Debt financing in capital structure increases, the proportion of an expensive source of fund increases. This results in the decrease in overall cost of capital leading to an increase in the firm value. The reason for assuming Kd less than Ke are that interest rates are usually lower than the dividend rates due to the element of risk and the benefit of tax as the interest is a deductible expense. The total market value of the firm on the basis of Net Income approach can be ascertained as below:

V = E + D

Where V = Total market value of the firm
E = Total market value of the Equity

= Earnings available to equity shareholder (NP)
Equity Capitalization rate (Ke)

D = Total market value of the Debt.
Overall cost of Capital can be calculated as below:

Ko = EBIT
       V

2. Net Operating Income Approach:

The NOI approach is opposite to the NI approach. According to NOI approach, the market value of the firm depends upon the net operating profit or EBIT and the overall cost of Capital. The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The NOI approach makes the following assumptions:

  • The Kd is taken as constant.
  • The K0 of the firm is also taken as constant.
  • The firm capitalizes the total earnings of the firm to find the value of the firm as a whole.
  • The use of more and more debt in capital structure increase the risk of the shareholders and thus results in the increase in cost of equity capital i.e. Ke. The increase in Ke is such as to completely offset the benefits of employing cheaper debts.

The value of a firm on the basis of NOI approach can be determined as below:

V = EBIT
     Ko

Where, V = Value of the firm
EBIT = Earning before interest and tax
Ko = Overall cost of Capital

The market value of equity is residual value, calculated as

E = V – D

And the Cost of Equity is,

Ke = EBIT – Interest
V-D

Thus financing Mix is irrelevant and does not affects the value of the firm.. The value of the firm remains for all types of debt – equity mix. Since there will be change in the risk of the shareholders as a result of change in Debt-Equity mix, therefore the Ke will be changing linearly with change in debt proportion.

3. Traditional Approach:

The traditional approach also known as Intermediate approach is a compromise between the two extremes of Net income approach and Net operating income approach. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is the cheaper source if finance then equity. Thus the optimum capital structure can be reached by a proper Debt Equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders.

The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low cost debt. Thus the overall cost of debt decrease up to a certain point, remains more or less unchanged for l\moderate increase in debt thereafter and increases or rises beyond a certain point.

Thus as per the traditional approach, a firm can be benefited from a moderate level of leverage when then advantages of using debt outweighed the disadvantages of increasing Ke. The overall cost of capital is a function of financial leverage. The value of the firm can be affected, by the judicious use of debt and equity in capital structure.

4. Modigliani and Miller Approach:

M&M Model, which was presented in 1958 on the relationship between the leverage, cost of capital and the value of the firm. The model emphasis that under a given set of assumptions the capital structure and its composition has no effect on the value of the firm. There is nothing which may be called the optimal capital structure, the model is based ob the following assumptions:

  1. The capital markets are perfect and the complete information is available to all the investors free of cost.
  2. The securities are infinitely divisible.
  3. Investors are rational and well informed about the risk return of all the securities.
  4. The personal leverage and the corporate leverage are perfect substitute.

On the basis of the above assumptions, the M&M Model derived that:

  1. The total value of the firm is equal to the capitalized value of the operating earnings of the firm.
  2. The total value of the firm is independent of the financial mix.
  3. The cut off rate of the investment decision of the firm depends upon the risk class to which the firm belongs, and thus is not affected by the financing pattern of this investment.

The M&M model argues that if two firms are alike in all respects except that they differ in respect of their financing patter and their market value, then the investors will develop a tendency to sell the shares of the overvalued firm and to buy the shares of the undervalued firm. This, buying and selling pressure will continue till the two firms have same market value Suppose there are two firms, LEV & Co. and ULE & Co.. These are alike and identical in all respect except that the LEV & Co. is a leveraged firm and has 10% debt of Rs. 30, 00,000 in its capital structure

On the other hand, the ULE & Co. is an unleveled firm and has raised funds only by the issue of the equity share capital. Both these firms have an EBIT of Rs. 10, 00,000 and the equity capitalization rate, Ke of 20%. The total value and WACC of both the firms may be ascertained as follows:

m&m approach

Though both the firm has same EBIT still the Levered firm has a lower Ko and higher value as against the Unleveled firm. MM argues that this position cannot exist for a long and there will be equality in the value of the two firms through the Arbitrage process.

The Arbitrage Process: The arbitrage process refers to undertaking by a person of two related actions or steps simultaneously in order to derive the some benefits. E.g. buying by a speculator in one market and selling the same at the same time in some other market. The benefit from the arbitrage process may be in any form: increased income from the same level of investment or same income from lesser investment.

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