Theories of capital structure

Q.2 Explain the theories of capital structure in brief?

Ans. Net Income (NI) theory:-

This theory was propounded by David Durand. According to this theory a firm can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum possible extent.

As debt is cheaper source of finance, it results in a decrease in overall cost of capital leading to an increase in the value of the firm as well as market value of equity shares.

Assumptions:

1.The cost of debt is cheaper than the cost of equity

2.Income tax has been igored

3.The cost of debt capital and cost of equity capital remains constant i.e. with the increase in debt capital the risk perception of creditors and equity investors does not change ]

4. Total value of firm = Market value of Equity + market value of debt. Or V = S +D

2. Market Value of share (S);

S = F Or EBIT-I

Ke Ke

Where;

E = Earnings available for equity shareholders

EBIT = Earnings before interest and Tax

Ke = Cost of Equity Capital.

3. The overall cost of capital or capitalization ratio:

Ko = EBIT

V

Ko = Overall cost of capital

V = Value of the firm. For More Detail: - http://www.gurukpo.com

Net Operating Income (NOI) Theory

This theory has also been propounded by David Durand. This theory is just opposite that of Net Income Theory. According to this theory, the total market value of the firm (v) is not affected by the change in the capital structure and the overall cost of capital (Ko) remains fixed irrespective of the debt-equity mix. According to this theory there is nothing like optimum capital structure.

Assumptions:-

1. The split of total capitalization between debt and equity is not essential or irrelevant.

2. At every level of capital structure business risk is constant; therefore, the rate of capitalization also remains constant.

3. The rate of debt capitalization remains constant.

4. There are no corporate taxes.

5. With the use of debt funds which are cheaper, the risk of shareholders increases, which in turn results to increase in the equity capitalization rate. Hence debt capitalization rate remains constant.

Computation:-

1.Value of the firm = EBIT

Ko

Or V = S + D

Or S = V – D

2.Cost of Equity Capital:-

Ke = EBIT - I

S

I = Interest on debt

Modigliani – miller theory:-

This theory was propounded by Franco Modigliani and Merton Miller (generally referred to as M-M) who are Nobel Prize winners in financial economies. They have discussed their theory in two situations:

(i) When there are no corporate taxes, and

(ii) When there are corporate taxes.

(i) In the Absence of Corporate taxes:-

As per Modigliani – Miller if there are no corporate taxes than the changes in the capital structure of any firm do not bring any chage in the overall cost of capital and total value of firm. The reason is that though the debt is cheaper to equity with increased use of debt as a source of finance, the cost of equity increases and the advantage of low-cost debt is offset equally by the increased cost of equity. For More Detail: - http://www.gurukpo.com

According to this theory, two identical firms in all respect, except their capital structure, cannot have different market value or cost of capital due to arbitrage processes.

For example, suppose the capital structure of company comprises of equity share capital of Rs 10, 00, 00 and 6% debentures of Rs 20, 00, 00. If the average rate of return on total capital employed is 10%, the company will earn a profit of Rs. 30,000 (10% on 30, 00, 00). Out of this profit, the company will have to pay leaving a balance of (1800/10,0,0x100) Which is the company succeeds in paying more dividend on equity shares capital with the use of borrowed capital such a situation in any business is known as ‘trading on equity’.

Assumptions:-

1. The capital market is perfect.

2. There is no transaction cost.

3. All the firms can be divided in hom0geneous risk classes.

4. There is no corporate tax.

5. All the profits of the firm are distributed.

6. Individual investors can easily get loans on the same terms and conditions on which any firm gets.

(ii) When Corporate Taxes Exist:-

The basic theory of Modigliani- Miller that the changes in the capital structure do not affect the total value of the firm and overall cost of capital is not true in the presence of corporate taxes.

Corporate taxes are reality; therefore, they changed their basic theory in the year 1963.

They accepted this fact that for corporate tax determination of interest is a deductible expenditure than the cost of debt is low. Therefore if any firm uses debt in its capital structure it leads to reduction in the overall cost of capital and increase in the value of the firm. They accepted that the total value of a leveraged firm is high than the non-leveraged firm.

Computation:-

1. Value of Unleveled firm (Vu)

Vu = Earning after tax but before Interest

After tax equity capitalization Rate

Vu = EBIT (1 – T)

Ke

2. Value of levered firm (Vt)

Vt = Vu + DT or EBIT (1-t) + DT

Ke For More Detail: - http://www.gurukpo.com

Where D = Amount of Debt

T = Tax Rate

Traditional Theory:-

The traditional theory is a mid-path between Net Income theory and Net Operating Income theory. According to this theory the cost of debt capital is lower than the cost of equity capital, therefore a firm by increasing the proportion of debt capital in its capital structure to a certain limit can reduce its overall cost of capital and can raise the total value of the firm. But after a certain limit the increase in debt capital leads to rise in overall cost of capital and fall in the total value of the firm. A rational or appropriate mix of debt and equity minimizes overall cost of capital and manimises value of the firm. Thus this theory accepts the idea of existence of optimum capital structure. Ezra soloman has enplained the effects of changes in capital structure on the overall cost of capital (Ko) and the total value of firm (V) in the following stages :

First Stage : In the beginning the use of debt capital in the capital structure of the firm results in fall of over all cost of capital and increases the total value of the firm because in the first stage cost of equity remains fixed rises slightly and use of debt is favourably treated in capital market.

Second State : In this stage beyond a particular limit of debt in the capital structure , the additional of debt capital will have insignificant or negligible effect on the value of the firm and the overall cost of capita. It is because the increase in cost of equity capital, due to increase in financial risk, offsets the advantage of using low cost of debt. Therefore during this second stage the firm can reach to a point where overall cost of capital is minimum and the total value is maximum.

Third Stage: - If the proportion of debt capital in the capital structure of the firm increases beyond an accepted limit this dead to increase in the over all cost of capital and fall in the total value of the firm because the financial risk rises rapidly which results into higher cost of equity capital which cannot be offset led by low debt capital cost. Hence, the total value of the firm will decrease and the overall cost of capital will increase.