Capital structure is the ratio of different type of securities issued by the firm to acquire capital. In these type of securities there is a wide range of securities that a company or firm can issue with relevance to its nature condition and requirement. For example issuing common stock, Preferred stock, warrants, bonds, debentures and forwarding contracts etc…
But here a question arises that what should be the capital structure of a firm which will reduce its cost of capital and increase its profitability without taking extra risk. Or what should be the optimal capital structure of a firm. This question has frustrated the theoreticians for decades the early work to make this question easier assumed that both types of costs (cost of equity finance and cost of debt finance) are independent of capital structure until tax is involved. There are many theories regarding the selection of optimal structure, very basic is called traditional view which states that the increase in the debt in capital structure gives the leverage to the profits of the firm and the value as well while the value of equity remains the same
Ks
Ka
Kd
Debt/Equity
Wherw
The capital structure usually splits cash flow in two streams.
Safe and constant stream for debenture and bond holders
Risky and variable stream to the shareholders.
The ultimate goal of capitatal structuring of firm or business to maximise the profitability and the value of the firm either by increasing its income or revenues or decreasing its costs.and cost of capital is the one of the major and most criticle costs of a firm or business
Modigliani-Miller theorem
(MM propostion I,ii) irrelevance of capital structure
Modigliani and miller were professors at the graduate school of industrial administration they formed a theorem to form the basis of modern thinking of capital structure. The basic point of this theorem is that firm's value is independent and irrelevant of to the capital structure of the firm. Whatever the ratio of capital mixture(debt to equity ratio) would be, the value of the firm remains independent and does not simple change with the simple shifting the capital structure from one to another ratio. However this theorem has some strict assumptions which are usually impossible in the real business world.
Proposition ( i):
There is no change in the total value of the firm whether it gets finance by debt or equity and what so ever would the ratio be. Firm's value can be determined by the left hand side of the balance sheet means by real assets but not been affected by the claims against them. To prove their theorem they have assumed some assumptions as follows
Assumptions:
No tax exists (this assumption will be relaxed subsequently)
Every firm within the same industry faces the same level of risk irrespect of its capital structure
All the investors have the complete knowledge of the firm's future cash flows and the returns
No transaction cost prevails
No retained earnings will be kept (all the profits will be distributed as dividend so the earnings will be constant and there will be no growth in the profits)
Avg cost of capital will be constant.
Proposition (II):
The higher debt to equity ratio will lead to a higher required rate of return because of the higher risk involved for equity holders in that firm which have debt
This proposition also has some assumptions
Assumptions
There is no tax exist.
No transaction cost
Individuals and companies can borrow loan at same rate
Explanation:
MM propositions without tax
Proposition 1
The operating income or income before interest and tax(EBIT) is equivalent to its net income of the firm which have to pay out dividends since it is pre-assumed that there is no ta involved
Hence the value of the firm will be
Where
V= value of the firm
EBIT= operating income
Ka = Required rate of return
We also know that value of firm is equalto the sumof its equity and debt
Substituting the equation and solving it for Ka
Where
Ks = cost of equity
Kd = cost of debt
D/E= debt to equity ratio hence Ks has positive relation with debt. As debt increases Ke will also increase. This is also called MM theorem II
1
Illustration
To prove their point they supposed two to firms which are identical to each other. One of them is unlevered so have 100% equity financing, but the other have 5 million debt @ 7.5%.
Both firms are generating operating income of £ 1,000,000 per anum. Investors of both firms have same required rate of return on equity which is 10%, as it is pre-assumed that the cost of will remain constant
Un-levered firm
Levered firm
EBIT
£ 1,000,000
£ 1,000,000
Interest
0
£ 375,000
Net income
£ 1,000,000
£ 625,000
And required rate of equity is 10%
Un-levered firm
Levered firm
Value of equity
1,000,000
0.1
= £ 10,000,000
625,000
0.1
= £6250000
+ value of debt
0
£ 5,000,000
Total value of firm
£ 10,000,000
£ 11,250,000
If these calculations and scenario is true then the person who have 20% of leveraged firm has the income of £ 125000 (625000* 20%) and could sell it for £ 1250000(6250000*20%) and with this he can borrow 1,000,000 @ 7.5% and for this total £2,250,000 (1,250,000 + 1,000,000) he can buy 22.5% share of unleveraged firm now his income would be
EBIT = 225000 (2250000*10%)
INTEREST = 75000 (1000000* 7.5%)
NET INCOME = 150000
Hence the income after buying the unleveraged would be more than the leveraged firm and by borrowing money to finance his investment. Hence when other investors see this opportunity they will also sell the shares of leveraged firm and buy the shares of the un-leveraged firm, so when there is the selling trend in the shares of the leveraged firm its value of shares will be decreased due to selling trend and due to buying trend of unleveraged firm its value will be increased. This phenomena will go on until there is equilibrium established between the leveraged and the un leveraged firm and no arbitrage will be possible.
Consequently the value of the firm will be equal and so avg cost of capital will also be same hence the advantage of using cheap cost of debt finance is set off against the increase in the cost of equity.
With tax
Now in this analysis we will relax the assumption of no tax. It is a fact that GOVT becomes partner in the actual financial world and subsidize if we use debt in our financing.
illustration
we willtake the previous example and assume that there is 35% corporate tax rate. Then the values of the firms will be like this
Un-levered firm
Levered firm
EBIT
£ 1,000,000
£ 1,000,000
Interest
0
£ 375,000
Net income
£ 1,000,000
£ 625,000
Tax(35%)
£ 350000
£ 218750
Income available for share holders
£ 650000
£ 406250
Return on equity=
net income
no of shares
650000
1000000
= £0.65/share
406250
500000
= £ 0.8125/share
So the above examples show that the with the increase in the debt the income available for the shareholders increases so ultimately the value of the firm increases with the increase of debt in financing.
Cost of equity:
Return on equity means that minimum price which a firm have to offer to an investor against his investment.
Traditional views states that cost of equity or required rate of return of equity is independent of the structure of the capital of that firm. But according to the CAPM required rate of return is responsive to the capital structure of the firm and other factors like risk involvement. According to the CAPM the investor will bear the additional risk if he is offered with reasonable additional return or in other words investor will demand more return because of the increase in the risk due to the addition of the debt in the finance.
Conclusion:
