Capital structure c apital s tructure theory capital

“Capital Structure Decisions”
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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.
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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,
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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