Capital Structure Decisions

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1 CAIPCC/Paper3/FinMgt/FinDecisions/CapitalStructure Capital Structure Decisions CA Navin Khandelwal

2 Learning Objectives: u A Capital structure u An optimal capital structure u Value of firm u EBIT-EPS u Break Even or Indifference Analysis u Constructing and interpreting an EBIT-EPS chart u Test learning by illustrative examples

3 Optimum Capital Structure

4 Optimum capital structure u Is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value the firm. u The optimum capital structure minimizes the firms overall cost of capital and maximizes the value of the firm. u Optimum capital structure is also referred as appropriate capital structure

5 Factors determining Capital Structure

6 Theories of capital structure Basic assumptions: There are only two sources of funds used by a firm: perpetual risk less debt and ordinary shares. There are no corporate taxes. This assumption is removed later. The dividend-payout ratio is 100%. that is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings. The total assets are given and do not change. The investment decisions are in other words assumed to be constant. The operating profits (EBIT) are not expected to grow.

7 Factors determining capital structure Factors Internal Cost of capital Risk factor Control factor Objectives Constitution of the company Attitude of the management External Economic conditions Interest rates Policy of lending Tax policies Statutory restrictions

8 Theories of capital structure

9 Theories of capital structure. Contd. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the cost of equity capital. All investors are assumed to have same subjective probability distribution of the future expected EBIT for a given firm. Business risk is constant over time and is assumed to be independent of its capital structure and financial risk. Perpetual life of the firm.

10 Approaches to Capital Structure

11 Approaches to Capital Structure u Net Income NI approach u Net Operating Income NOI approach u Modigliani Miller MM approach u Traditional approach

12 Net Income Approach

13 Net Income Approach u This approach is given by Durand David u Assumptions: this approach is based on three assumptions u There are no taxes u Cost of debt is less than the cost of equity u Use of debt does not change the risk perception of the investor. u According to this approach, the capital structure decision is relevant to the valuation of the firm. u A change in the capital structure causes a overall change in the cost of capital and also in the total value of the firm.

14 Net Income Approach u A higher debt content in the capital structure means a high financial leverage and this results in the decline in the overall weighted average cost of capital and therefore there is increase in the value of the firm. u Thus with the cost of debt and the cost of equity being constant, the increased use of debt (increase in leverage), will magnify the share holders earnings and, thereby, the market value of the ordinary shares. u NI Net Income= EBIT-I or earnings available to equity share holders. u Value of the firm: market value of debt + market value of equity.

15 Net Income Approach Overall cost of capitalization (ko) EBIT/V or (ko) = ki (B/V) + ke (S/V) Ki = cost of debt Ke = cost of equity B = Total market value of DEBT S = Total market value of EQUITY

16 Net Income Approach u Net income approach view of capital structure: Cost of equity Average cost of capital Cost of capital Cost of debt Degree of leverage

17 Net Operating Income NOI approach

18 Net Operating Income Approach u This is another theory suggested by Durand u NOI approach is opposite to NI approach u According to NOI approach value of the firm is independent of its capital structure it means capital structure decision is irrelevant to the valuation of the firm u Any change in leverage will not lead to any change in the total value of the firm and the market price of the shares as well as the overall cost of capital is independent of the degree of leverage

19 Net Operating Income Approach: Assumptions u The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole u The overall cost of capital (ko) of the firm is constant and depends upon the business risk which also is assumed to be unchanged u The cost of debt (kd) is also constant u There is no tax u The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increases in the cost of equity capital (ke)

20 NOI Approach: Propositions NOI approach is based on the following prepositions: Overall cost of capital/ capitalization rate (ko) is constant: NOI approach argues that the overall capitalization rate of the firm remains constant for all degrees of leverage. The value of the firm given the level of EBIT is determined by: V= EBIT/ko EBIT= earnings before interest and tax Ko= overall cost of capital or V=EBIT(1-t) + Bt ke B= value of debt

21 NOI Approach: Prepositions NOI approach is based on the following prepositions: Residual value of equity The value of equity is the residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V) S= value of equity V= value of firm B = value of debt S = V-B

22 NOI Approach: Prepositions Change in cost of equity capital u The cost of equity capital (Ke) increases with the degree of leverage. u The increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders. u To compensate for the increased risk to the ordinary shareholders would expect a higher rate of return on their investment. u The increase in the equity capitalization rate would match in the increase in debt equity ratio.

23 Optimal Capital Structure

24 Optimal Capital Structure u The total value of the firm is unaffected by its capital structure. u No matter what the degree of leverage is the total value of the firm remain constant. u The market price of shares will also not change with the change in debt equity ratio. u There is nothing such as optimum capital structure any capital is optimum according to NOI approach. bhushan

25 Optimal Capital Structure ke Cost of capital ko ki Degree of leverage

26 Modigliani Miller Approach

27 Modigliani Miller (MM) Approach u The M.M thesis relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI approach. u The NOI approach does not provide operational or behavioral justification for the irrelevance of the capital structure. u The significance of M.M approach lies in the fact that it provides behavioral justification for constant overall cost of capital and therefore total value of firm.

28 MM Approach: Assumptions u u u u u u Perfect capital market Securities are infinitely divisible Investors are free to buy/ sell securities Investors can borrow without restrictions on the same terms and conditions as the firm can There are no transactions costs Information is perfect, that is each investor has same information which is readily available to him without cost; & Investors are rational and behave accordingly.

29 MM Approach: Assumptions.. Contd... u Given the assumption of perfect information and rationality all investors have the same expectations of firm net operating income (EBIT) with which to evaluate the value of a firm u Business risk is equal among all the firm within similar operating environment, that means all the firms can be divided into equivalent risk class. u The term equivalent/homogeneous risk class means that the expected earnings have identical risk characteristics and firm within an industry are assumed to have same risk characteristics u The dividend payout ratio 100% u There are no taxes. (This assumption is removed later)

30 MM Approach: Propositions There are three basic proposition of M.M approach. Preposition One The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure, the ko and V are constant for all degrees of leverages. the total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. V=EBIT ko V is determined by the assets in which the company has invested and not how those assets are financed

31 MM Approach: Proposition 1 V Ko % Degree of leverage (B/V)

32 MM Approach: Propositions Proposition 2 The second proposition of M.M approach is that the ke is equal to the capitalization rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalization rate (ke) and (ki) times the ratio of debt to equity. In other words ke increases in the manner to offset exactly the use of a less expensive source of funds represented by debt or The rate of return required by the shareholders increases linearly as the debt/equity ratio is Increased. Ke(L) = Ke(u)+[(ke(u)-ki)*D/E]

33 MM Approach: Propositions Proposition Three The cut-off rate for the investment purpose is completely independent of the way in which an investment is financed. The cut off rate for investment will be in all cases the WACC.

34 Criticism of MM approach urisk perception uconvenience ucost uinstitutional restrictions udouble leverage utransaction cost utaxes

35 Traditional Approach

36 Traditional approach : WHY? u The net income approach (NI) as well as net operating income approach(noi) represent two extremes as regards the theoretical relationship b/w: Capital Structure Weighted Average Cost of Capital Value of the firm u NI Approach: Use of debt in the capital structure will always affect the overall cost of capital and the total valuation NOI approach: argues- capital structure is totally irrelevant u The MM Approach supports the NOI approach. But the assumptions of MM approach are of doubtful validity.

37 Traditional approach : WHY? u The traditional approach is the midway between the NI and NOI approaches. u It partakes of some features of both these approaches. Thus also known as Intermediate approach u It resembles or agrees with the NI approach in arguing that cost of capital and total value of the firm are not independent of the capital structure. But it dose not agree with the view that the value of firm will necessarily increase at all degrees of leverage.

38 Traditional approach : WHY? u It shares a feature with NOI approach also that beyond a certain degree of leverage, the overall cost increases leading to decrease in the total value of the firm. And it differs with NOI approach in that it dose not argue that the weighted average cost of capital is constant for all degrees of leverage. u The crux of traditional view relating to leverage and valuation is that through judicious use of debt-equity proportions, a firm can increase its total value and there by reduce its over all cost of capital. u The rationale behind this view is that debt is relatively cheaper source of funds as compared to ordinary shares.

39 Traditional approach : WHY? u With a change in the leverage, that is, using more debt in place of equity, a relatively cheaper source of fund replaces a source of fund which has relatively higher cost. This obviously causes a decline in the over all cost of capital. u If the debt-equity ratio is raised further, the firm would become financially more risky to the investors who will penalize the firm by demanding a higher equity capitalization rate (ke). But the increase in ke may not be so high to neutralize the benefit of using cheaper debt.

40 Traditional approach : WHY? If, however, the debt is increased further two things are likely to happen: owing to increased financial risk ke will record a substantial rise (ii) the firm would become very risky to creditors who also would be compensated by a higher return such that ki will rise

41 Traditional approach : WHY? u The use of debt beyond a certain point will, therefore, have the effect of raising the weighted average cost of capital and conversely reducing the total value of the firm. u Thus up to a point the use of debt will favorably affect the value of the firm; beyond that point use of debt will adversely affect the value of the firm. At that level of debt-equity ratio, the capital structure is an optimal capital structure.

42 Over all cost of capital and optimum leverage Cost of equity Ke Cost of capital WACC Cost of debt Ki Degree of leverage Optimum level of capital

43 Overall Cost of Capital & Value of Firm Market value Value of firm Value of equity Value of debt Optimum level of capital Degree of leverage

44 EBIT-EPS analysis u EBIT-EPS analysis should be considered logically as the first step in the direction of designing a firm s capital structure. u EBIT-EPS analysis shows the impact of various financing alternatives on EPS at various levels of EBIT. This analysis is useful for two reasons u The EPS is the measure of firms performance given the P/E ratio, the larger the EPS the larger would be the value of the firm u The EBIT-EPS analysis information can be extremely useful to finance manager in arriving at an appropriate financing decision.

45 EBIT -EPS Analysis u In general, the relationship between EBIT and EPS is as follows EPS= (EBIT-I) (1-t) N Where EPS= earning per share EBIT= earnings before interest and tax I= interest t= tax N= number of equity shares

46 Break even EBIT level or Indifference point u The breakeven EBIT for two alternative financing plans is the level of EBIT for which the EPS is the same under both the financing plans. (EBIT-I) (1-t) = (EBIT-I) (1-t) N N

47 Financial breakeven u It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. interest and preference dividends. It denotes the level of EBIT for which the firms EPS just equals to zero. u If EBIT is less than financial break even point, then EPS will be negative u But if the expected level of EBIT exceeds than that of break even point more fixed costs financing instruments can be inducted in the capital structure otherwise the use of equity will be preferred.

48 Choices for CAPITAL STRUCTURE DEBT EQUITY PREFERENCE DEBT PREFERENCE DEBT EQUITY EQUITY PREFERENCE DEBT+EQUITY+PREFERENCE

49 Illustrative Examples Total Capital Required Rs. 10,00,000 EBIT Rs. 500,000 Assume Corporate Tax 50% Case 1 Only Debt Case 2 Only Equity Case 3 Only Preference Case 4 Debt + Equity Case 5 Equity + Preference Case - 6 Debt+Preference Case 7 Debt+Equity+Preference

50 Illustrative Examples- Case 1- Only Debt EBIT Rs. 500,000 (-) 10% Rs. 100,000 PBT(Profit Before Tax) Rs. 400,000 (-) 50% Rs. 200,000 PAT(Profit After Tax) Rs. 200,000

51 Illustrative Examples- Case 2- Only Equity EBIT Rs. 500,000 (-) 10% Nil PBT(Profit Before Tax) Rs. 500,000 (-) 50% Rs. 250,000 PAT(Profit After Tax) Rs. 250,000 No. of Eq. Shareholders 100,000 EPS (Earning/Share) Rs. 2.50/Share

52 Illustrative Examples- Case 3- Only Preference EBIT Rs. 500,000 (-) 10% Nil PBT(Profit Before Tax) Rs. 500,000 (-) 50% Rs. 250,000 PAT(Profit After Tax) Rs. 250,000 (-) Pref. 10% Rs. 100,000 NPAT (Net PAT) Rs. 150,000

53 Illustrative Examples- Case 4- Debt + Equity EBIT Rs. 500,000 (-) 10% Rs. 50,000 PBT(Profit Before Tax) Rs. 450,000 (-) 50% Rs. 225,000 PAT(Profit After Tax) Rs. 225,000 No. of Eq. Shareholders 50,000 EPS (Earning/Share) Rs. 4.50/Share

54 Illustrative Ex.- Case 5- Equity + Preference EBIT Rs. 500,000 (-) 10% NIL EBT(Earning Before Tax) Rs. 500,000 (-) 50% Rs. 250,000 EAT(Earning After Tax) Rs. 250,000 (-)Preference dividend Rs. 50,000 NPAT Rs. 200,000 /No. of Equity share 50,000 EPS Rs. 4

55 Illustrative Ex.- Case 6- Debt + Preference EBIT Rs. 500,000 (-) 10% Rs. 50,000 EBT(Earning Before Tax) Rs. 450,000 (-) 50% Rs. 225,000 EAT(Earning After Tax) Rs. 225,000 (-)Preference dividend Rs. 50,000 NPAT Rs. 175,000

56 Illus. Ex.- Case 7- Debt + Equity +Preference EBIT Rs. 500,000 (-) 10% Rs. 20,000 EBT(Earning Before Tax) Rs. 480,000 (-) 50% Rs. 240,000 EAT(Earning After Tax) Rs. 240,000 (-)Preference dividend Rs. 30,000 NPAT Rs. 210,000 No. of Equity Share 50,000 EPS Rs. 4.20/Share

57 Comparison of Results CASE PAT EPS Only Debt Rs. 400,000 N.A. Only Equity Rs. 250,000 Rs. 2.50/Share Only Preference Rs. 250,000 N.A. Debt + Equity Rs. 225,000 Rs. 4.50/Share Equity + Preference Rs. 250,000 Rs. 4.00/Share Debt+Preference Rs. 225,000 N.A. Debt+Equity+ Preference Rs. 240,000 Rs. 4.20/Share

58 Questions asked in Exams 2 (May 2003) Calculate the level of EBIT at which EPS indifference point b/w following financing alternatives will occur. 1. Equity Share capital of Rs. 600,000; 12% debentures of Rs. 400, Equity Share capital of Rs. 400,000; 14% preference shares of Rs. 200,000 and 12% debentures of Rs. 400,000. Assume the company is in 35% tax bracket and par value of equity share is Rs. 10 in each case.

INTRODUCTION Meaning of Capital Structure Definition of Capital Structure Gerestenbeg, James C. Van Horne, Presana Chandra,

INTRODUCTION Meaning of Capital Structure Definition of Capital Structure Gerestenbeg, James C. Van Horne, Presana Chandra, INTRODUCTION Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If