Capital Structure C APITAL S TRUCTURE THEORY Capital structure

Capital structure c apital s tructure theory capital

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“Capital Structure Decisions” 16
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3.6 C APITAL S TRUCTURE THEORY Capital structure theory provides some insights into the value of debt versus equity financing. Modern capital structure theory began in 1958, when Modigliani and Miller proved, under a very restrictive set of assumptions, that a firm’s value is unaffected by its capital structure. There are 4 theories: NI approach (net income approach) NOI approach (net operating income approach) MM approach (Modigliani-Millar Approach) Traditional approach NI APPROACH (N ET I NCOME A PPROACH ) When you raise debt, leverage will increase. The overall values of the firm will increase. Debt will have lower cost, so overall cost of capital will reduce (it is better if the cost of capital reduces). V = S+ D Where, V = value of the firm, S = equity, D = debt An increase in leverage will increase the value of the firm, it will raise EPS, it will raise the market price of the shares and it will reduce weighted average cost of capital, thus leverage is always beneficial. “Capital Structure Decisions” 17
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NOI APPROACH (N ET O PERATING I NCOME A PPROACH ) Capital structure decision is irrelevant. If you raise debt, the cost of equity will increase. The overall cost of capital will remain constant in spite of leverage. Thus there is no advantage of raising debt. As we raise the debt, the cost of equity increases in the same proportion. The market discounts the firm, which is leveraged. Thus capital structure decision has no relevance. According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same. MM A PPROACH WITHOUT T AX The firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an un-levered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage. The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, “Capital Structure Decisions” 18
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regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases. MM APPROACH WITH T AX Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the un-levered cash flow plus an amount equal to the tax deduction on interest. Capitalizing the first component of cash flow at the
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