Wednesday, December 4, 2013

Assignment on 'Capital Structure Theories'

Capital Structure Theories


Different theories of capital structure:

 The following theories of capital structure have been developed in the literature of finance :-
1)      Net Income approach.
2)      Net Operating Income Approach.
3)      Traditional Theory.
4)      Modigliani and Miller Theory.
5)      The Tradeoff Theory.
6)      The Pecking Order Theory. and
7)      Signaling Theory.

The following sub-sections explain each of the theories of capital structure.

Net Income Approach:

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. A firm can choose a degree of capital structure in which debt is more than equity share capital.  According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

Assumptions of NI approach:

  1. There are no taxes
  2. The cost of debt is less than the cost of equity.
  3. The use of debt does not change the risk perception of the investors
  4. The final and the main thing is that the cost of debt and equity are expected to be independent.

A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%

Net Operating Income Approach

Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:
At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:  Value of Equity = Total value of the firm - Value of debt 
Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remain constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

Traditional theory:

The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases.
 Let us consider an example where a company has 20% debt and 80% equity in its capital structure. The cost of debt for the company is 9% and the cost of equity is 14%.
           So, WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity)                                    
                        (20% x 9%) + (80% x 14%) 1.8 + 11.2 13%
 If the company wants to raise the debt portion in the capital structure to be 50%, the cost of debt as well as equity would increase due to the increased risk of the company. Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost of capital would be:
                    WACC = (50% x 10%) + (50% x 15%) 5 + 7.5 12.5%
In the above case, although the debt-equity ratio has increased, as well as their respective costs, the overall cost of capital has not increased, but has decreased. The reason is that debt involves lower cost and is a cheaper source of finance when compared to equity. The increase in specific costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a cheaper source, namely debt.
Now, let us assume that the company raises its debt percentage to 70%, thereby pushing down the equity portion to 30%. Due to the increased and over debt content in the capital structure, the firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be:
      WACC = (70% x 15%) + (30% x 20%) 10.5 + 6 16.5%
This decision has increased the company's overall cost of capital to 16.5%. The above example illustrates that using the cheaper source of funds, namely debt, does not always lower the overall cost of capital. It provides advantages to some extent and beyond that reasonable level, it increases the company's risk as well the overall cost of capital. These factors must be considered by the company before raising finance via debt.

Modigliani and Miller Theory:

MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital.

Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure. Here the market value of the firm depends on, net operating income and risk involved in it interest on the firm financing.

The Trade Off Theory:

 The tradeoff theory of capital structure suggests that target debt ratio may vary from to firm. While firms with safe tangible assets and enough taxable income to shield ought to have high target ratios, the unprofitable firms with risky intangible assets ought to rely on equity financing. In the absence of the cost of adjustment, each firm should be at its debt target ratio. The trade off avoids extreme-predictions and rationales moderate debt ratio.

The pecking order theory:

The pecking order theory is based on: (a) preference for internal funds , (b) sticky dividend policy ,and (c) aversion to issuing equity .
In pecking order theory, there exists no predetermined debt-equity mix, because there are two kinds of equity: internal and external, one at the top of the packing –and the other at the bottom. The packing order explains why profitable firms generally borrowless – not because they have low target debt ratios, but because they do not require external fund.

Signaling theory:

According to this theory, the use of stock is a negative signal, while using debt is a positive or at least neutral signal. Therefore, companies try to maintain a reserves borrowing capacity; and this means using less debt in normal times than the MM trade off theory would suggest.

 Some common questions from Capital Structure Theories:

·         What are the assumptions of Modigliani and Miller (M-M) Theory of capital structure?

Ans : M-M  approach is based on the following assumption :
a)      Inventors can borrow or lend at the same market rate of interest .
b)      There is absence of bankruptcy costs.
c)       The capital markets are efficient , so the information flows freely to the investors and there exists no transaction cost.
d)      The capital market is highly competitive.
e)      There is absence of tax.
f)       Investors are indifferent between dividend and retained earnings.
g)      There is co-incidence of expectation among investors.

·         What are the criticisms of M-M approach of capital structure?

     Ans :- The M-M approach has been criticized on the following main grounds:-
a)      In practice , there is the absence of perfect markets and rational investors . As a result, the investors may not have the requisite information.
b)      By avoiding taxes and transaction cost ,the model becomes too simplified to reflect the actual condition  in the security market.
c)       The  assumes that firms and individual can  borrow  and lend at the same interest rate does not hold in will in real situation.
d)      The proof of proposition -1 assumes that investors are willing to pledge their stock as collateral to borrow money . But in really , investors may be willing to accept such a personal risk .
e)      The existence of transaction costs also interferes with working of arbitrage.
f)       Institutional restrictions also impede the working of arbitrage .
g)      It is incorrect to assume that personal home made leverage is a perfect substitute for corporate leverage.

·         What are the factors that affect capital structure decisions?

Ans :  factors affecting capital stricture decisions are given below:-
 (A) Quantitative factors/Financial factors:     
              a) Profitability aspect
                        b) Growth rate

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