capital structue ppt for bba final year s

project management

1. Capital Structure
Theory and Policy

2. Debt-equity Mix and the
Value of the Firm
Capitalstructuretheories:
Netoperatingincome(NOI)approach.
Traditional approach and Net income (NI)
approach.
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal
taxes.
Trade-off theory: costs and benefits of leverage.
2

3. Net Income (NI) Approach
AccordingtoNIapproach
boththecostofdebtandthe
costofequityare
independentofthecapital
structure;theyremain
constantregardlessofhow
muchdebtthefirmuses.As
aresult,theoverallcostof
capitaldeclinesandthefirm
valueincreaseswithdebt.
Thisapproachhasnobasis
inreality;theoptimum
capitalstructurewouldbe
100percentdebtfinancing
underNIapproach.ke
ko
kd
Debt
Cost
kd
ke, ko
3

4. NetOperatingIncome(NOI)Approach
According to NOI
approachthevalueofthe
firmandtheweighted
averagecostofcapitalare
independentofthefirm’s
capitalstructure.Inthe
absenceoftaxes,an
individualholdingallthe
debtandequitysecurities
willreceivethesamecash
flowsregardlessofthe
capitalstructureand
therefore,valueofthe
companyisthesame.ke
ko
kd
Debt
Cost
4

5. Traditional Approach
Thetraditionalapproach
arguesthatmoderatedegree
ofdebtcanlowerthefirm’s
overallcostofcapitaland
thereby,increasethefirm
value.Theinitialincreasein
thecostofequityismorethan
offsetbythelowercostof
debt.Butasdebtincreases,
shareholdersperceivehigher
riskandthecostofequity
risesuntilapointisreachedat
whichtheadvantageoflower
costofdebtismorethanoffset
bymoreexpensiveequity.ke
ko
kd
Debt
Cost
5

6. MM Approach Without Tax:
Proposition I
MM’sPropositionIstates
thatthefirm’svalueis
independentofitscapital
structure.Withpersonal
leverage,shareholderscan
receiveexactlythesame
return,withthesamerisk,
fromaleveredfirmandan
unleveredfirm.Thus,they
willsellsharesoftheover-
pricedfirmandbuyshares
oftheunder-pricedfirm
untilthetwovalues
equate.Thisiscalled
arbitrage.ko
Debt
Cost
MM's Proposition I
6

7. Arbitrage
7Levered Firm ( ):
60,000 50,000 110,000
interest rate 6%; NOI 10,000
shares held by an investor in 10%
Unlevered Firm ( ):
100,000
NOI 10,000
l l l
d
l
uu
L
V S D
kX
L
U
VS
X

    
   




8. Arbitrage
8   
 
Return from Levered Firm:
10 110,000 50 000 10% 60,000 6 000
10% 10,000 6% 50,000 1,000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
   
     


10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less



  
  
  
sh available 11,000 10,000 1,000

9. MM’s Proposition II
Thecostofequityfora
leveredfirmequalsthe
constantoverallcostof
capitalplusariskpremium
thatequalsthespread
betweentheoverallcostof
capitalandthecostofdebt
multipliedbythefirm’s
debt-equity ratio.For
financialleveragetobe
irrelevant,theoverallcostof
capitalmustremainconstant,
regardlessoftheamountof
debtemployed.Thisimplies
thatthecostofequitymust
riseasfinancialrisk
increases.ke
ko
kd
Debt
Cost
MM's Proposition II
9

10. MM Propositions I and II
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 10/
o
o
d
e
e o o d
MM Proposition I :
X
V
k
X
k
V
MM Proposition II :
X k D
k
S
k k (k k )D S




  

11. MM Hypothesis With Corporate
Tax
Undercurrentlawsinmostcountries,debthasanimportant
advantageoverequity:interestpaymentsondebtaretax
deductible,whereasdividendpaymentsandretainedearnings
arenot.Investorsinaleveredfirmreceiveintheaggregatethe
unleveredcashflowplusanamountequaltothetax
deductiononinterest.Capitalisingthefirstcomponentofcash
flowattheall-equityrateandthesecondatthecostofdebt
showsthatthevalueoftheleveredfirmisequaltothevalue
oftheunleveredfirmplustheinteresttaxshieldwhichistax
ratetimesthedebt (iftheshieldisfullyusable).
Itisassumedthatthefirmwillborrowthesameamountof
debtinperpetuityandwillalwaysbeabletousethetax
shield.Also,itignoresbankruptcyandagencycosts.
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 11

12. Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 12LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES
Unlev Lev Unlev Lev
Corp tax 0% 0% 35% 35%
Corp tax on div 0% 0% 10% 10%
Pers tax on div 0% 0% 0% 0%
Pers tax on int 0% 0% 0% 0%
PBIT 2500 25002500 2500
Int 0 700 0 700
PBT 2500 18002500 1800
Corp tax 0 0 875 630
PAT 2500 18001625 1170
Div 2500 18001477 1064
Div tax 0 0 148 106
Tol corp tax 0 01023 736
Div income 2500 18001477 1064
Pers tax on div 0 0 0 0
AT div income 2500 18001477 1064
Int income 0 700 0 700
Pers tax on int 0 0 0 0
AT int income 0 700 0 700
AT total income2500 25001477 1764
Net leverage benifit 0 287

13. MM Hypothesis with Corporate
Tax
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 13After-tax earnings of Unlevered Firm:
(1 )
Value of Unlevered Firm:
(1 )
After-tax earnings of Levered Firm:
( )(1 )
(1 )
Value of Levered Firm:
(1 )
T
u
T
dd
d
d
l
ud
u
u
X X T
XT
V
k
X X k D T k D
X T Tk D
Tk DXT
V
kk
V TD



   
  




14. Miller’s Approach WITH
Corporate and Personal Taxes
Toestablishanoptimumcapitalstructurebothcorporate
andpersonaltaxespaidonoperatingincomeshouldbe
minimised.Thepersonaltaxrateisdifficulttodetermine
becauseofthedifferingtaxstatusofinvestors,andthat
capitalgainsareonlytaxedwhensharesaresold.
MertonmillerproposedthattheoriginalMMproposition
Iholdsinaworldwithbothcorporateandpersonaltaxes
becauseheassumesthepersonaltaxrateonequity
incomeiszero.Companieswillissuedebtuptoapointat
whichthetaxbracketofthemarginalbondholderjust
equalsthecorporatetaxrate.Atthispoint,therewillbe
nonettaxadvantagetocompaniesfromissuing
additionaldebt.
Itisnowwidelyacceptedthattheeffectofpersonaltaxes
istolowertheestimateoftheinteresttaxshield.
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 14

15. LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES
UnlevLevUnlevLevUnlevLevUnlevLevUnlevLev
Corp tax 0% 0%35% 35% 35% 35% 35% 35% 35% 35%
Corp tax on div 0% 0%10% 10% 10% 10% 10% 10% 10% 10%
Pers tax on div 0% 0% 0% 0%20% 20% 20% 20% 20% 20%
Pers tax on int 0% 0% 0% 0% 0% 0%20% 20% 30% 30%
PBIT 2500250025002500250025002500250025002500
Int 0700 0700 0700 0700 0700
PBT 2500180025001800250018002500180025001800
Corp tax 0 0875 630 875 630 875 630 875 630
PAT 2500180016251170162511701625117016251170
Div 2500180014771064147710641477106414071064
Div tax 0 0148 106 148 106 148 106 148 106
Tol corp tax 0 01023 7361023 7361023 7361023 736
Div income 2500180014771064147710641477106414071064
Pers tax on div 0 0 0 0295 213 295 213 281 213
AT div income 25001800147710641182851.21182851.21126851.2
Int income 0700 0700 0700 0700 0700
Pers tax on int 0 0 0 0 0 0 0140 0210
AT int income 0700 0700 0700 0560 0490
AT total income2500250014771764118215511182141111261341
Net leverage benifit 0 287 370 230 216 15
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd.

16. Miller’s Approach with
Corporate and Personal Taxes
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 16After-tax earnings of Unlevered Firm:
(1 )(1 )
Value of Unlevered Firm:
(1 )(1 )
After-tax earnings of Levered Firm:
( )(1 )(1 ) (1 )
(1 )(1 ) (1 ) (1 )(1 )
Va
T
T
d e d d
d d d d e
e
e
e
u
u
X X T T
X T T
V
k
X X k D T T k D T
X T T k D T k D T T
  


     
       
 
lue of Levered Firm:
(1 ) (1 )(1 )(1 )(1 )
(1 ) (1 )
(1 )(1 )
1
(1 )
d d e
l
ud
b
e
eb
e
u
k D T T TX T T
V
k T k T
TT
VD
T
   



  




17. Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd. 17
Demand rate of
interest
Supply rate
of interest
Borrowing
i
s= i
o/(1 –T
c)
i
d= i
o/(1 –T
b)
%

18. Financial Distress
Financialdistressariseswhenafirmisnotableto
meetitsobligationstodebt-holders.
Foragivenlevelofdebt,financialdistressoccurs
becauseofthebusiness(operating)risk.withhigher
businessrisk,theprobabilityoffinancialdistress
becomesgreater.Determinantsofbusinessriskare:
Operating leverage (fixed and variable costs)
Cyclical variations
Intensity of competition
Price fluctuations
Firm size and diversification
Stages in the industry life cycle
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19. Consequences of Financial
Distress
Bankruptcy costs
Specificbankruptcycostsincludelegaland
administrativecostsalongwiththesaleofassetsat
“distress”pricestomeetcreditorclaims.Lenders
buildintotheirrequiredinterestratetheexpected
costsofbankruptcywhichreducesthemarketvalue
ofequitybyacorrespondingamount.
Indirect costs
Investing in risky projects.
Reluctance to undertake profitable projects.
Premature liquidation.
Short-term orientation.
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20. Debt Policy and Shareholders Conflicts
Shareholder—manager conflicts
Managers have a tendency to consume some of the firm’s
resources in the form of various perquisites.
Managershaveatendencytobecomeundulyriskaverse
andshirktheirresponsibilitiesastheyhavenoequity
interestorwhentheirequityinterestfalls.Theymaybe
passingupprofitableopportunities.
Shareholder—bondholder conflicts
Shareholdervalueiscreatedeitherbyincreasingthevalue
ofthefirmorbyreducingthethevalueofitsbonds.
Increasingtheriskofthefirmorissuingsubstantialnew
debtarewaystoredistributewealthfrombondholdersto
shareholders.Shareholdersdonotlikeexcessivedebt.
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21. Monitoring
Outside investors will discount the prices they are
willing to pay for the firm’s securities realising that
managers may not operate in their best interests.
Firms agree for monitoring and restrictive covenants to
assure the suppliers of capital that they will not operate
contrary to their interests.
Agency Costs
Agency costs are the costs of the monitoring and control
mechanisms.
Agencycostsofdebtincludetherecognitionofthe
possibilityofwealthexpropriationbyshareholders.
Agencycostsofequityincludetheincentivethat
managementhastoexpandthefirmbeyondthepointat
whichshareholderwealthismaximised.
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22. Financial Distress
Financial Management, Ninth Edition © I M
Pandey
Vikas Publishing House Pvt. Ltd.
Debt
Market Value of The Firm
Value of
unlevered
firm
PV of interest
tax shields
Costs of
financial distress
Value of levered firm
Optimal amount
of debt
Maximum value of firm

23. Optimum Capital Structure:
Trade-off Theory
The optimum capital structure is a function of:
Agency costs associated with debt
The costs of financial distress
Interest tax shield
The value of a levered firm is:
Valueofunleveredfirm
+PVoftaxshield
–PVoffinancialdistress
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24. Pecking Order Theory
The announcement of a share issue reduces the share price
because investors believe managers are more likely to issue
when shares are overpriced.
Firms prefer internal finance since funds can be raised without
sending adverse signals.
If external finance is required, firms issue debt first and equity as
a last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.
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Pandey
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25. Pecking Order Theory
Implications:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better.
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26. Features of an Appropriate
Capital Structure
Return
Risk
Flexibility
Capacity
Control
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27. Approaches to Establish Appropriate
Capital Structure
EBIT—EPS approachfor analyzing the impact of
debt on EPS.
Valuation approachfor determining the impact
of debt on the shareholders’ value.
Cash flow approachfor analyzing the firm’s
ability to service debt.
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28. CashFlowApproachtoTargetCapital
Structure
Cash adequacy and solvency
Indeterminingafirm’stargetcapitalstructure,akeyissue
isthefirm’sabilitytoserviceitsdebt.Thefocusofthis
analysisisalsoontheriskofcashinsolvency—the
probabilityofrunningoutofthecash—givenaparticular
amountofdebtinthecapitalstructure.Thisanalysisis
basedonathoroughcashflowanalysisandnotonrulesof
thumbbasedonvariouscoverageratios.
Components of cash flow analysis
Operating cash flows
Non-operating cash flows
Financial cash flows
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29. Reserve financial capacity
Reductioninoperatingandfinancialflexibilityiscostly
tofirmscompetinginchargingproductandfactor
markets.Thusfirmsneedtomaintainreservefinancial
resourcesintheformofunuseddebtcapacity,large
quantitiesofliquidassets,excesslinesofcredit,accessto
abroadrangeoffundsources.
Focus of cash flow analysis
Focus on liquidity and solvency
Identifies discretionary cash flows
Lists reserve financial flows
Goes beyond financial statement analysis
Relates debt policy to the firm value
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30. Cash Flow Analysis Versus EBIT–EPS
Analysis
The cash flow analysis has the following advantages
over EBIT–EPS analysis:
It focuses on the liquidityand solvencyof the firm over a long-
period of time, even encompassing adverse circumstances.
Thus, it evaluates the firm’s ability to meet fixed obligations.
It goes beyond the analysisof profit and loss statement and also
considers changes in the balance sheet items.
It identifies discretionary cash flows.The firm can thus prepare
an action plan to face adverse situations.
It provides a list of potential financial flowswhich can be
utilized under emergency.
It is a long-term dynamic analysisand does not remain
confined to a single period analysis.
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31. Practical Considerations in Determining
Capital Structure
Control
Widely-held Companies
Closely-held Companies
Flexibility
Loan Covenants
Early Repay ability
Reserve Capacity
Marketability
Market Conditions
Flotation Costs
Capacity of Raising Funds
Agency Costs
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