Capital structure theories - NI Approach, NOI approach & MM Approach

Capital structure theories - NI Approach, NOI approach & MM Approach. Meaning of capital structure , Features of An Appropriate Capital Structure, Determinants of Capital Structure, Planning the Capital Structure Important Considerations,

1. Financial management Unit 04 Capital structure theories

2. Content Traditional view vs MM hypothesis, MM position I &II, Capital structure designing in practice – EBIT- EPS analysis, the pecking order theory. Factors impacting leverage decision 

3. Meaning of capital structure

4. Features of An Appropriate Capital Structure Optimal capital structure - is that capital structure at that level of debt – equity proportion where the market value per share is maximum and the cost of capital is minimum.

5. Determinants of Capital Structure

6. Planning the Capital Structure Important Considerations

7. INTRODUCTION TO THE THEORY Can a company affect its total valuation and its required return by changing its financing mix? In this unit, we are going to find out what happens to the total valuation of the firm and to its cost of capital when the ratio of debt to equity, or degree of leverage, is varied. We use a capital market equilibrium approach because it allows us to abstract from factors other than leverage that affect valuation.

8. Assumptions and Definitions

9. Contd …. 4. Investors are rational-The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. 5. The operating earnings of the firm are not expected to grow. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.

10. Capital structure theories

11. Net Income Approach (NI) 

12. Net Operating Income Assumptions – WACC is always constant, and it depends on the business risk which remains constant. Value of the firm is calculated using the overall cost of capital i.e. the WACC only. Thus the split between debt and equity is not important. The cost of debt ( Kd ) is constant. Corporate income taxes do not exist.

13. Net Operating Income Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Thus there is no Optimal Capital Structure. NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity ( Ke ) A higher cost of equity ( Ke ) nullifies the advantages gained due to cheaper cost of debt ( Kd ). In other words, the finance mix is irrelevant and does not affect the value of the firm.

14. Pecking order theory The “PECKING ORDER THEORY” is based on the assertion that managers have more information about their firms than investors. This disparity of information referred to as asymmetric information. Managers will issue debts when they are positive about their firms future prospects and will issue equity when they are unsure. A commitment to pay to fixed amount of interest and principal to debt-holders implies that the company expects steady cash flows. On the other hand, an equity issue would indicate that the current share price is overvalued. This implies that firms always use internal finance and choose debt over new issue of equity when external financing is required.

15. Contd … Hence Myers has called it the ‘ Pecking order’ theory . Since there is not well defined debt-equity target. There are two kinds of equity, internal and external. Debt is cheaper than internal and external equity because of interest deductibility. Internal equity is cheaper and easier to use than external equity because No taxes paid on retained earnings. No transaction costs