Capital Structure Theories Practical Application

Capital Structure Theories Practical Application

1. Capital Structure Theories
(Session 02)
By
Gayan Abeyrathna
(M.Acc.,BBM.(Hons.)sp. In Acc. & Fin., DICA-SL)

Net operating income (NOI) approach.
Traditional approach and Net income (NI) approach.
MM hypothesis with and without corporate tax.
Miller’s hypothesis with corporate and personal taxes.

2. Capital Structure Theories:
–Net operating income (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.

3. Net Income (NI) Approach
•According to NI approach both the cost of debt and the cost of equity are independent of
the capital structure; they remain constant regardless of how much debt the firm uses.

• As a result, the overall cost of capital declines and the firm value increases with debt. This
approach has no basis in reality; the optimum capital structure would be 100 per cent debt
financing under NI approach.
3
We Wd KO
1 0 0.10
0.75 0.25 0.09
0.5 0.5 0.08
0.25 0.75 0.06
0 1
Ke=10% Kd=5%

4. Example
Net Operating Income: Rs:1000
Interest: Rs:300
Ke=9.33%
Kd=6%

Calculate the Value of the firm
using NI approach

5. TOTAL VALUE OF THE FIRM (NI APPROACH)

6. Net Operating Income (NOI) Approach
•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.
.
6

7. Example
NOI= Rs:1000
Debt (B)= Rs:5000
Calculate,
Value of the Firm (V)
Value of Equity (E)

8. TOTAL VALUE OF THE FIRM (NOI APPROACH)

9. Traditional Approach
•The traditional approach has emerged as a
compromise to the extreme position taken by
the NI approach. Like the NI approach it does
not assume constant Ke with financial leverage
and continues declining in WACC.

•The traditional approach argues that moderate
degree of debt can lower the firm’s overall cost
of capital and thereby, increase the firm value. A
judicious mix of debt and equity can increase
the value of the firm

•The initial increase in the cost of equity is more
than offset by the lower cost of debt. But as debt
increases, shareholders perceive higher risk and
the cost of equity rises until a point is reached at
which the advantage of lower cost of debt is
more than offset by more expensive equity.
9
Ke Kd We Wd KO
8 2 1 0 8.000
9 3 0.75 0.25 7.500
10 3.2 0.5 0.5 6.600
18 3.3 0.25 0.75 6.975

10. MM Approach
(Modigliani,H. and M.H.Miller),1958
•MM’s approach is a net operating income approach
•Provides a behavioral justification for constant cost of capital &
Value of the firm
•The value of the firm depends on the earnings and risks of its
assets rather than the way of financed the assets

11. MM Approach Without Tax:
Proposition I
•MM’s Proposition I is that, the total
market value is independent of the
debt-equity mix and is given by
capitalizing the expected net operating
income by the capitalization rate (i.e.,
the opportunity cost of capital)
appropriate to that risk class.
11

12. MM’s Proposition I: Key Assumptions
•Perfect capital markets
•Homogeneous risk classes
•Risk
•No taxes
•Full payout
12

13. Arbitrage Process
•Suppose two identical firms, except for their capital structures, have different market values.
In this situation, arbitrage (or switching) will take place to enable investors to engage in the
personal or homemade leverage as against the corporate leverage, to restore equilibrium
in the market.

•On the basis of the arbitrage process, MM conclude that the market value of a firm is not
affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does
not help in creating any wealth for shareholders. Hence one capital structure is as much
desirable (or undesirable) as the other.

14. Arbitrage Process Example

15. MM’s Proposition II
•Financial leverage causes two opposing effects: it increases the shareholders’
return but it also increases their financial risk. Shareholders will increase the
required rate of return (i.e., the cost of equity) on their investment to
compensate for the financial risk. The higher the financial risk, the higher the
shareholders’ required rate of return or the cost of equity.
•The cost of equity for a levered firm should be higher than the opportunity cost
of capital, k
a; that is, the levered firm’s k
e > k
a. It should be equal to constant k
a,
plus a financial risk premium.
15

16. Cont…
•To determine the levered
firm's cost of equity, k
e:
16
Cost of equity under the MM

17. PRACTICE QUESTIONS

18. Q1
Alfa Ltd with Net Operating Earnings of Rs:300,000 is attempting
to evaluate a number of possible capital structures given below.
Which Capital Structure will you recommend & why?
Capital Structure Debt in Capital
Structure
Cost of Debt % Cost of equity%
1 300,000 10 12
2 400,000 10 12.5
3 500,000 11 13.5
4 600,000 12 15
5 700,000 14 18

20. Q2
The Hypothetical Ltd’s current earnings before interest & tax are
Rs:400,000. It currently has outstanding debts of Rs:1500000 at
an average cost of 10%. Its cost of equity capital is estimated to
be 16%.
1> Determine the value of the firm using traditional approach.
2> Determine the overall capitalization rate.

22. Q3
From the following selected data, determine the value of firms, P
& Q belonging to the homogeneous risk class under
1.NI approach
2.NOI approach
P Q
EBIT 225,000 225,000
Int. (0.15) 75,000 -
Ke 0.2
Tax rate .35

25. Q4.
Moon Lanka Ltd has financed its
total assets from equity & its cost
of capital is 15% (Ka). Company is
expecting to have 80% from equity
& 20% from debts in the future. If
the cost of debt is 10% (Kd),
Calculate the cost of equity (Ke)
using Modigliani & Miller (MM)
theory.
4Marks
(HNDA 4203, 2
nd
sem 2015, Q2.iii)

26. Q5
•Assume that EBIT (i.e., Net Operating Income) is Rs. 100,000.
The amount of debt employed by firm Rs. 700,000; the cost of
debt 6%; and the rate of return expected by equity
shareholders 10%. ko = 8%.

•Calculate value of the firm using NI & NOI approaches