Capital Structure and Capital Stacking | CMA Inter Syllabus
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Capital Structure -a firm needs funds for long-term requirements and working capital. These funds are collected through different sources both short-term and long term. The long-term funds required by a firm are mobilized through owner’s funds (equity share, preference shares and retained earnings) and long-term debt (debentures and bonds). A mix of various long-term sources of funds employed by a firm
is called capital structure.
According to Gerestenberg, ‘capital structure of a company refers to the composition or make-up of its capitalization and it includes all long-term capital resources, viz, loans, bonds, shares and reserves’. Thus, capital structure is made with debt and equity securities and refers to permanent financing of a firm.
Financial Manager has to plan the appropriate mix of different securities in total capitalization in such a way as to minimize the cost of capital and maximize the earnings per share to the equity shareholders.
There may be four fundamental patterns of capital structure as follows:
Some authors use capital structure and financial structure interchangeably. But both are different concepts. Financial structure refers to the way in which the total assets of a firm are financed. In other words, financial structure refers to the entire liabilities side of the Balance Sheet. But capital structure represents only long-term sources of funds and excludes all short-term debt and current liabilities. Thus, financial structure is a broader one and capital structure is only part of it.
On the other hand, the capital stack is one of the most important concepts for investors interested in evaluating real estate risk and projected rate of return. Understanding the capital stack to assess trade-offs can protect your investment from undue risk, or insufficient gains.
Capital Staking:
In simple terms, the capital stack refers to the layers of capital. The capital stack represents the underlying financial structure of a commercial real estate deal. Often, the capital stack is presented as a graphic that shows the different types of capital in a deal stacked above each other, like a cake with many layers. The capital stack is typically comprised of four sections in the following order: common equity, preferred equity, mezzanine debt, and senior debt. Although common equity is listed first in the stack, it holds the lowest priority, meaning common equity lenders are paid last.
The graphical presentation of capital stack is -
Senior Debt
Senior debt is the bedrock of the capital stack, which typically takes up the most significant portion of the stack. It is also the least risky position, as it’s first in line to get paid back in the event of a default or bankruptcy. As an investor, you should consider a senior debt investment if you want the least amount of risk.
Senior debt is generally secured by a mortgage or deed to the property, which will serve as collateral for the loan. It’s low risk because, in a worst-case scenario of asset underperformance, you can initiate a foreclosure process to recover your full capital investment before any other participant. Its low-risk nature also delivers the lowest potential return to investors, which is a low fixed interest rate.
Mezzanine Debt
Mezzanine debt, sometimes called junior debt, is next in line to get paid out. This debt is often financed by investors rather than a bank. Because this debt is only paid back after all the senior debt has been paid back, it holds more risk than the senior debt. To compensate for this risk, investors earn a higher interest rate than the senior debt, meaning they have a higher potential return.
Mezzanine debt is often critical to the success of a transaction because senior debt holders will typically only lend up to 50% - 60% of a project in some cases, and unless the equity holders can come up with the remaining, then mezzanine debt is necessary. Sometimes mezzanine debt can be called “bridge financing” because it bridges that gap between the senior debt and equity.
Equity Financing
As mentioned before, equity investors buy shares of ownership of the property. These shares will go up and down in value relative to the property valuation. If the property appreciates, the value of the shares will go up. If the property sells at a higher valuation than initially purchased, the investors will profit. But even in the equity stack, not all shares are created equal.
Common Equity
Last in line for payouts are common equity holders. Being a common equity investor means being an owner of the deal. Common equity has the highest return potential, but it’s also the riskiest because holders can only be paid after all debt holders, and preferred equity investors have received their returns.
However, in exchange for being last in line, common equity investors will receive all the profit upon the property sale. In the event of the property appreciates significantly in value, they stand to earn the most substantial return. Unlike the other stacks, there is also no cap on your potential profit or a fixed term for expected returns.
Preffered Equity
After all the debts been paid off, preferred equity shares are next in the payback line. Preferred equity often acts as a hybrid between equity and debt. While technically equity shares, they also often have a payout schedule similar to mezzanine debt (but paid back after the mezzanine debt is paid back in full). Unlike debt, these shares are not backed by any collateral, which means they hold significant risk in the event of a bankruptcy. While investors hold significant risk here, they are rewarded with an even higher interest rate than the mezzanine debt and a preference to be paid back before the common equity.
Features of an Appropriate Capital Structure
A capital structure will be considered to be appropriate if it possesses following features:
Determinants of Capital Structure
The following are the factors influencing the capital structure decisions.
The capital structure of a firm depends on a number of factors and these factors are of different importance.
Generally, the following factors should be considered while determining the capital structure of a company.
a. Trading on Equity and EBIT-EPS Analysis
The use of long-term debt and preference share capital, which are fixed income bearing securities, along with equity share capital is called financial leverage or trading on equity. The use of long-term debt capital increases the earnings per share as long as the return on investment is greater than the cost of debt. Preference share capital will also result in increasing EPS. But the leverage effect is more pronounced in case of debt because of two reasons:
Because of its effects on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase the return on the shareholders equity. The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firms’ capital structure planning. He can analyse the possible fluctuations in EBIT and their impact on EPS under different financing plans.
Under favourable conditions, financial leverage increases EPS, however it can also increase financial risk to shareholders. Therefore, the firm should employ debt to such an extent that financial risk does not spoil the leverage effect.
b. Growth and Stability of Sales
This is another important factor which influences the capital structure of a firm. Stability of sales ensures stable earnings, so that the firm will not face any difficulty in meeting its fixed commitments of interest payment and repayment of debt. So, the firm can raise a higher level of debt. In the same way, the rate of growth in sales also affects the capital structure decision. Usually, greater the rate of growth of sales, greater can be the use of the debt in the financing of a firm. On the other hand, the firm should be very careful in employing debt capital if its sales are highly fluctuating and declining.
c. Cost of capital
Cost of capital is another important factor that should be kept in mind while designing the capital structure of a firm. The capital structure should be designed in such a way that the firm’s overall cost of capital is the minimum. Cost of capital is the minimum return expected by its suppliers. Of all the sources of capital, equity capital is the costliest as the equity shareholders bear the highest risk. On the other hand, debt capital is the cheapest source because the interest is paid on it by the firm whether it makes profits or not. Moreover, interest on debt capital is tax deductible which makes it further cheaper.
Preference share capital is also cheaper than equity capital as the dividends is paid at a fixed rate on preference shares. So, the overall cost of capital depends on the proportion in which the capital is mobilized from different sources of finance. Hence, capital structure should be designed carefully so that overall cost of capital is minimized.
d. Control
Sometimes, the designing of capital structure of a firm is influenced by the desire of the existing management to retain the control over the firm. Whenever additional funds are required, the management of the firm wants to raise the funds without any loss of control over the firm. If equity shares are issued for raising funds, the control of the existing shareholders is diluted. Because of this, they may raise the funds by issuing fixed charge bearing debt and preference share capital, as preference shareholders and debt holders do not have any voting right. The Debt financing is advisable from the point of view of control. But over-dependence on debt capital may result in heavy burden of interest and fixed charges and may lead to liquidation of the company.
e. Flexibility
Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. Capital structure should flexible enough to raise additional funds whenever required, without much delay and cost. The capital structure of the firm must be designed in such a way that it is possible to substitute one form of financing for another to economise the use of funds. Preference shares and debentures offer the highest flexibility in the capital structure, as they can be redeemed at the discretion of the firm.
f. Marketability and Timing
Capital market conditions may change from time to time. Sometimes there may be depression and at over times there may be boom condition in the market. The firm should decide whether to go for equity issue or debt capital by taking market sentiments into consideration. In the case of depressed conditions in the share market, the firm should not issue equity shares but go for debt capital. On the other hand, under boom conditions, it becomes easy for the firm to mobilise funds by issuing equity shares.
The internal conditions of a firm may also determine the marketability of securities. For example, a highly levered firm may find it difficult to raise additional debt. In the same way, a firm may find it very difficult to mobilise funds by issuing any kind of security in the market merely because of its small size.
g. Floatation Costs:
Floatation costs are not a very significant factor in the determination of capital structure. These costs are incurred when the funds are raised externally. They include cost of the issue of prospectus, brokerage, commissions, etc. Generally, the cost of floatation for debt is less than for equity. So, there may be a temptation for debt capital. There will be no floatation cost for retained earnings. As is said earlier, floatation costs are not a significant factor except for small companies. Floatation costs can be an important consideration in deciding the size of the issue of securities, because these costs as a percentage of funds raised will decline with the size of the issue. Hence, greater the size of the issue, more will be the savings in terms of floatation costs. However, a large issue affects the firm’s financial flexibility.
h. Purpose of Financing
The purpose for which funds are raised should also be considered while determining the sources of capital structure. If funds are raised for productive purpose, debt capital is appropriate as the interest can be paid out of profits generated from the investment. But, if it is for unproductive purpose, equity should be preferred.
i. Legal Requirements
The various guidelines issued by the Government from time to time regarding the issue of shares and debentures should be kept in mind while determining the capital structure of a firm. These legal restrictions are very significant as they give a framework within which capital structure decisions should be made.
Collateral term is very much related and relevant for determining of capital structure as well as capital stacking. The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may take the form of real estate or other kinds of assets, depending on the purpose of the loan. The collateral acts as a form of protection for the lender. That means, if the borrower defaults on their loan payments, the lender can seize the collateral asset and sell it to recoup some or all of its losses.
In legal and financial terminology, a covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out or that certain thresholds will be met. Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.
Covenants are most often represented in terms of financial ratios that must be maintained, such as a maximum debt-to-asset ratio or other such ratios. Covenants can cover everything from minimum dividend payments to levels that must be maintained in working capital to key employees remaining with the firm.
Financial Vs. Non-Financial Covenants
Comparing financial and non-financial covenants in a loan agreement helps us to better understand how agreements are formulated and the way they are executed across various industries. Covenants are a type of promise that exists in contract law and are a part of many borrowing agreements throughout corporate and personal finance.
Financial Covenants
Financial covenants are aspects of an agreement (generally loans) that limit or provide restrictions on how a company or individual operates their finances. A financial covenant can stipulate how much debt a company can take on or even how stringent financial ratios must be maintained as a part of such an agreement. Financial covenants, by their very definition, revolve around the financial aspects of an agreement or contract.
Non-Financial Covenants
Non-financial covenants also serve the purpose of a safety net to the lender. They are usually undertaken by a lender as a measure to prevent the risks related to money-lending activities. Non-financial covenants come with many of the complementary aspects to an agreement that do not discuss finances. They are a critical part of financial agreements that help guide the terms of a contract, as well as provide barriers for one or either party to operate between. It helps to ensure the faithful execution of the contract that occurs in good faith by the two signing parties.
Positive Covenants
A positive covenant is a clause in a loan contract that requires a borrower to perform specific actions. Examples of positive covenants include requirements to maintain adequate levels of insurance, requirements to furnish audited financial statements to the lender, compliance with applicable laws, and maintenance of proper accounting books and credit rating, if applicable. Positive covenant is also known as affirmative covenant.
A violation of a positive covenant ordinarily results in outright default. Certain loan contracts may contain clauses that provide a borrower with a grace period to remedy the violation. If not corrected, creditors are entitled to announce default and demand immediate repayment of principal and any accrued interest.
Negative Covenants
Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a borrower must maintain as of the date of the financial statements. For instance, most loan agreements require a ratio of total debt to a certain measure of earnings not to exceed a maximum amount, which ensures that a company does not burden itself with more debt than it can afford to service.
Another common negative covenant is an interest coverage ratio, which says that Earnings Before Interest and Taxes (EBIT) must be greater in proportion to interest payments by a certain number of times. The ratio puts a check on a borrower to make sure that he generates enough earnings to afford paying interest.
Cross Default
Cross default is a clause added to certain loans or bonds that stipulate that a default event triggered in one instance will carry over to another. Cross default is a provision in a bond indenture or loan agreement that puts a borrower in default if the borrower defaults on another obligation. For example, a cross-default clause in a loan agreement may say that a person automatically defaults on his car loan if he defaults on his mortgage. The cross- default provision exists to protect the interest of lenders, who desire to have equal rights to a borrower’s assets in case of default on one of the loan contracts.
Cross-default is caused by an event of default of a borrower on another loan. Default typically occurs when a borrower fails to pay interest or principal on time, or when he violates one of the negative or affirmative covenants. A negative covenant requires a borrower to refrain from certain activities, such as having indebtedness to profits above certain levels or profits insufficient to cover interest payment. Affirmative covenants obligate the borrower to perform certain actions, such as furnishing audited financial statements on a timely basis or maintaining certain types of business insurance.
If a borrower defaults on one of his loans by violating covenants or not paying principal or interest on time, a cross-default clause in another loan document triggers an event of default as well. Typically, cross-default provisions allow a borrower to remedy or waive the event of default on an unrelated contract before declaring a cross-default.
In simple terms, the capital stack represents the underlying capital structure. When looking at large investments, an important component to review is the ‘capital stack.’ The capital stack is the organization and hierarchy of all the capital contributed to the financing of a deal. Each part of the stack represents a different slice of the investment, and your position in the stack will determine where and when you are entitled to payouts and returns on your investment.
A simple way to imagine a capital stack is to think of it as a pyramid. This pyramid (as given in previous section) represents all the amounts invested into a deal. As we know, imagine that this pyramid is broken down into levels, and each level is a different source of capital used to finance the project - both debt and equity.
Capital stack may be used as an instrument to mitigate the risk in investment. There are two key considerations with any investment: risk and return. In terms of risk, investors always need to consider what the outcome will be if things do not go according to the plan. Capital stack will help investors in this situation. However, understanding where you fall in the capital stack is essential toward recognizing the full risk and reward potential of an investment. There will always be a trade-off in return potential in exchange for getting paid back sooner. Investing is all about risk mitigation. Understanding the risk tolerance and the time horizon for earning returns will help to determine whether or not a specific opportunity is a right fit for your portfolio. The capital stack helps in this matter to investors.
The capital stack generally tells the order of priority of payout with respect to other positions within the capital stack. Starting at the bottom of the capital stack, the senior debt will be paid out first, then the mezzanine debt, then the preferred equity and finally the common equity. If the real estate investment doesn’t perform as projected, there may not be enough money to repay all money invested along with returns. The bottom layers will be repaid first, and the top layers will incur losses before anyone else.
Thus, your position in the capital stack directly relates to your risk. If you happen to be towards the top of a capital stack, you will inherently have more risk than the lower layers. If you are in the bottom of the capital stack, your investment will be safer relative to the other higher positions in the capital stack.
Debt management is a way to get debt under control through financial planning and budgeting. The goal of a debt management plan is to use these strategies to help you lower your current debt and move toward eliminating it completely. The main objective of debt management is to ensure that the organisation’s financing needs and its payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk.
However, senior debt and junior debt (subordinated debt or mezzanine debt), both are long-term liabilities or non- current liabilities of the company. They are an important source of finance in debt financing. There are times when the Cost of Equity exceeds the cost of debt, in such a situation preference shifts from equity to debt. Senior Debt and Junior Debt is important tool for debt financing. They help the company in both, in the short as well as long term. Though their ultimate objective to gather resources are almost the same, they have different characteristics altogether. They both act as a source of finance for the issuing company, but they both carry different levels of risk, interest rate, repayment priority, and may attract different kinds of investors or lenders, etc.
Senior debt is often secured. Secured debt is debt secured by the assets or other collateral of a company and can include liens and claims on certain assets. When a company files for bankruptcy, the issuers of senior debt, typically bondholders or banks are having the best chance of being repaid. Next in line are junior debt holders, preferred stockholders, and common stockholders. In some cases, these parties are paid by selling collateral that has been held for debt repayment.
Senior debt and subordinated debt are long-term sources of debt finance serving different purposes. It would be absolutely wrong to say, one debt is more important than the other. So, both kinds of debt are equally important and should be managed properly for any organisation.
The existence of an optimum capital structure is not accepted by all. There are two extreme views or schools of thought regarding the existence of an optimum capital structure. As per one view, capital structure influences the value of the firm and cost of capital and hence there exists an optimum relevance and hence there exists an optimum capital structure. On the other hand, the other school of thought advocates that capital structure has no relevance and it does not influence the value of the firm and cost of capital. Reflecting these views, different theories of capital structure have been developed. The main contributors to the theories are David Durand, Ezra Solomon, Modigliani and Miller.
The important theories of capital structure are:
Assumption underlying the theories:
In order to have a clear understanding of these theories and the relationship between capital structure and value
of the firm or cost of capital, the following assumptions are made:
| In analysing the capital structure theories, the following basic definitions are used: |
| S = Market value of common shares |
| D = Market value of debt |
| V = Market value of the firm = S + D |
| NOI = X = Expected net operating income, i.e., Earnings Before Interest and Taxes (EBIT) |
| NI = NOI - Interest = Net Income or shareholder’s earnings. |
1. Net Income Approach
This approach was identified by David Durand. According to this approach, capital structure has relevance, and a firm can increase the value of the firm and minimise the overall cost of capital by
employing debt capital in its capital structure. According to this theory, greater the debt capital employed, lower shall be the overall cost of capital and more shall be the value of the firm.
This theory is subject to the following assumptions:
According to the above assumptions, cost of debt is cheaper than cost of equity and they remain constant irrespective of the degree of leverage. If more debt capital is used because of its relative cheapness, the overall cost of capital declines and the value of the firm increases.
According to this approach:
V = S + D
S = Market Value of Equity = NI / Ke
D = Market Value of Debt
ko = Overall Cost of Capital = EBIT/ V
It is evident from the above diagram that when degree of leverage is zero (i.e., no debt capital employed), overall cost of capital is equal to cost of equity (ko = Ke). If debt capital is employed further and further which is relatively cheap when compared to cost of equity, the overall cost of capital declines, and it becomes equal to cost of debt (kd) when leverage is one (i.e., the firm is fully debt financed). Thus, according to this theory, the firm’s capital structure will be optimum, when degree of leverage is one.
2. Net Operating Income Approach
This net operating income (NOI) approach is also suggested by David Durand. This represents another extreme view that capital structure and value of the firm are irrelevant. This capital structure of the firm does not influence cost of capital and value of the firm. The value of the firm (V) is determined as follows:
V = S + D = NOI / ko
ko The overall cost of capital and depends on the business risk of the firm. It is not affected by financing mix.
The critical assumptions of this theory are:
According to this theory, the use of less costly debt increases the risk to equity shareholders. This causes the equity capitalisation rate (Ke) to increase. As a result, the low cost advantage of debt is exactly offset by the increase in the equity capitalisation rate. Thus, the overall capitalisation rate (ko) remains constant and consequently the value of the firm does not change.
The above diagram shows that ko and kd are constant and ke increases with leverage continuously. The increase in cost of equity (Ke) exactly offsets the advantage of low-cost debt, so that overall cost of capital (ko) remains constant, at every degree of leverage. It implies that every capital structure is optimum and there is no unique optimum capital structure.
3. The Traditional Approach
This approach, which is also known as intermediate approach, has been popularised by Ezra Solomon. It is a compromise between the two extremes of Net Income Approach and Net Operating Income Approach. According to this approach, cost of capital can be reduced or the value of the firm can be increased with a judicious mix of debt and equity. This theory says that cost of capital declines with increase in debt capital up to a reasonable level, and later it increases with a further rise in debt capital. The way in which the overall cost of capital reacts to changes in capital structure can be divided into three stages under traditional position.
Stage I
In this stage, the cost of equity (Ke) and the cost of debt (kd) are constant and cost of debt is less than cost of equity. The employment of debt capital up to a reasonable level will cause the overall cost of capital to decline due to the low-cost advantage of debt.
Stage II
Once the firm has reached a reasonable level of leverage, a further increase in debt will have no effect on the value of the firm and the cost of capital. This is because of the fact that a further rise in debt. Capital increases the risk to equity shareholders which leads to a rise in equity capitalisation rate (Ke).
This rise in cost of equity exactly offsets the low–cost advantage of debt capital so that the overall cost of capital remains constant.
Stage III
If the firm increases debt capital further and further beyond reasonable level, it will cause an increase in risk to both equity shareholders and debt holders, because of which both cost of equity and cost of debt start rising in this stage. This will in turn to cause an increase in overall cost of capital. If the overall effect of all the three stages is taken, it is evident that cost of capital declines and the value of the firm increases with a rise in debt capital up to a certain reasonable level. If debt capital is further increased beyond this level, the overall cost of capital (ko) tends to rise and as a result the value of the firm will decline.
It is seen from above graph that the overall cost of capital declines with an increase in leverage up to point L and it increases with rise in the leverage after point L1. Hence, the optimum capital structure lies in between L and L1.
4. Modigliani – Miller (M-M) Hypothesis
The Modigliani – Miller hypothesis is identical with the Net Operating Income Approach. Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by the changes in capital structure. In other words, capital structure decisions are irrelevant and value of the firm is independent of debt–mix.
Basic Propositions:
M-M Hypothesis can be explained in terms of two propositions of Modigliani and Miller. They are:
a. The overall cost of capital (ko) and the value of the firm are independent of the capital structure.
The total market value of the firm is given by capitalising the expected net operating income by the rate appropriate for that risk class.
b. The financial risk increases with more debt content in the capital structure. As a result cost of equity (Ke) increases in a manner to offset exactly the low – cost advantage of debt. Hence, overall cost of capital remains the same.
Assumptions of the M-M Approach:
Proposition I
According to Modigliani–Miller, for the firms in the same risk class, the total market value is independent of capital structure and is determined by capitalising net operating income by the rate appropriate to that risk class. Proposition I can be expressed as follows:
V = S + D = X / Ke = NOI / ko
Where, V = The market value of the firm
S = The market value of equity
D = The market value of debt
According the Proposition I the average cost of capital is not affected by degree of leverage and is determined as follows:
k = X/ V
According to M –M, the average cost of capital is constant as shown in the following figure.
Arbitage Process
According to Modigliani–Miller Hypothesis, two firms identical in all respects except their capital structure, cannot have different market values or different cost of capital. In case, these firms have different market values, the arbitrage will take place and equilibrium in market values is restored in no time. Arbitrage process refers to switching of investment from one firm to another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. The use of debt by the investors is known as personal leverage or homemade leverage.
Because of this arbitrage process, the market price of securities in higher valued market will come down and the market price of securities in the lower valued market will go up, and this switching process is continued until the equilibrium is established in the market values. So, Modigliani–Miller, argue that there is no possibility of different market values for identical firms.
Reverse Working of Arbitrage Process
Arbitrage process also works in the reverse direction. Leverage has neither advantage nor disadvantage.
If an unlevered firm (with no debt capital) has higher market value than a levered firm (with debt capital) arbitrage process works in reverse direction. Investors will try to switch their investments from unlevered firm to levered firm so that equilibrium is established in no time.
Thus, Modigliani–Miller proved in terms of their proposition I that the value of the firm is not affected by debt-equity mix.
Proposition II
Modigliani–Miller’s proposition II defines cost of equity. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital (ko) plus a premium for the financial risk, which is equal to debt – equity ratio times the spread between average cost and cost of debt.
Thus, cost of equity is:
Ke = ko+ (ko – kd) × D/S
Where, Ke = Cost of equity; ko = Average cost of capital
D/S = Debt – Equity ratio; kd= Cost of debt
Modigliani–Miller argue that ko will not increase with the increase in the leverage, because the low – cost advantage of debt capital will be exactly offset by the increase in the cost of equity as caused by increased risk to equity shareholders. The crucial part of the Modigliani–Miller Thesis is that an excessive use of leverage will increase the risk to the debt holders which results in an increase in cost of debt (kd). However, this will not lead to a rise in ko. Modigliani–Miller maintain that in such a case ke will increase at a decreasing rate or even it may decline. This is because of the reason that at an increased leverage, the increased risk will be shared by the debt holders. Hence ko remain constant. This is illustrated in the figure given below:
Criticism on M–M Hypothesis
The arbitrage process is the behavioural and operational foundation for M–M Hypothesis. But this process fails the desired equilibrium because of the following limitations.
M – M Hypothesis Corporate Taxes
Modigliani and Miller (M–M) later recognised the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximising debt component in the capital structure.
According to this approach, value of a firm can be calculated as follows:
Value of Unlevered firm (Vu) = EBIT x (1-t) / Ke
Where, EBIT = Earnings Before Interest and Taxes
ko= Overall cost of capital
D = Value of debt capital
t = Tax rate
Value of levered firm (Vl) = Value of Unlevered firm + Debt (tax rate)
5. Trade-off Theory
When a firm is unable to meet its obligations, it results in financial distress that can lead to bankruptcy. When a firm experiences financial distress several things can happen such as:
A major contributor to financial distress is debt. The greater the level of debt and the larger the debt servicing burden associated with it, the higher the probability of financial distress.
The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The trade-off theory of capital structure postulates that managers attempt to balance the benefits of interest tax shields against the present value of the possible costs of financial distress.
According to the trade-off theory, every firm has an optimal debt-equity ratio that maximises its value. The optimal debt-equity ratio of a profitable firm that has stable, tangible assets would be higher than the optimal debt-equity ratio of an unprofitable firm with risky, intangible assets. A profitable firm can avail of tax shield associated with debt fully. Further, when assets are stable and tangible, financial distress costs and agency costs tend to be lower.
How well does the trade-off theory explain corporate financing behaviour? It explains reasonably well some industry differences in capital structures. For example, power companies and refineries use more debt as their assets are tangible and safe. Software companies, on the other hand, borrow less because their assets are mostly intangible and somewhat risky. The trade-off theory, however, cannot explain why some profitable companies depend so little on debt. Some companies having highly profitable, use very little debt. They pay large amounts by way of income tax which they can possibly save to some extent by using debt without causing any concern about their solvency.
6. Pecking Order Theory
The pecking order theory has emerged as alternative theory to the trade-off theory. Rather than introducing corporate taxes and financial distress into the M-M framework. The pecking order theory states that internal financing is preferred over external financing, and if external finance is required, firms should issue debt first and equity as a last resort. Moreover, the pecking order seems to explain why profitable firms have low debt ratios: This happens not because they have low target debt ratios, but because they do not need to obtain external financing. Thus, unlike the trade-off theory the pecking order theory is capable of explaining differences in capital structures within industries.
This leads to the following pecking order in the financing decision:
The significant implications of the pecking-order theory are as follows:
Illustration 1
The expected annual net operating income of a company (EBIT) is ₹50,000. The company has ₹2,00,000, 10% debentures. The equity capitalisation rate (Ke ) of the company is 12.5%. Find the value of the firm and overall cost of capital under Net Income approach.
Solution:
Illustration 2
Assuming no taxes and given the Earnings Before Interest and Taxes (EBIT), interest (I) at 10% and equity capitalisation rate (Ke ) below, calculate the total market value of each firm under Net Income approach:
| Firms | EBIT | I | Ke |
| (₹) | (₹) | ||
| X | 2,00,000 | 20,000 | 12.0% |
| Y | 3,00,000 | 60,000 | 16.0% |
| Z | 5,00,000 | 2,00,000 | 15.0% |
| W | 6,00,000 | 2,40,000 | 18.0% |
Also determine the Weight Average Cost of Capital (WACC) for each firm.
Solution:
Illustration 3
The existing capital structure of XYZ Ltd. is as under: (₹)
| Equity Shares of ₹100 each | 40,00,000 |
| Retained Earnings (₹) | 10,00,000 |
| 9% Preference Shares (₹) | 25,00,000 |
| 7% Debentures (₹) | 25,00,000 |
The existing rate of return on the company’s capital is 12% and the income-tax rate is 50%.
The company requires a sum ₹ 25,00,000 to finance an expansion programme for which it is considering the following alternatives:
It is estimated that the P/E ratios in the cases of equity preference and debenture financing would be 20,17 and 16 respectively.
Which of the above alternatives would you consider to be the best?
Solution:
Illustration 4
XL Limited provides you with following figures:
| Particulars | Amount (₹) |
| Profit | 2,60,000 |
| Less: Interest on Debentures@12% | 60,000 |
| 2,00,000 | |
| Income tax @50% | 1,00,000 |
| Profit After Tax (PAT) | 1,00,000 |
| Number of Equity shares (of ₹ 10 each) | 40,000 |
| EPS (Earning per Share) | 2.50 |
| Ruling Price in Market | 25 |
| P/E Ratio (i.e. Price/EPS) | 10 |
The company has undistributed reserves of ₹6,00,000. The company needs ₹2,00,000 for expansion. This amount will earn at the same rate as funds already employed. You are informed that a debt equity ratio more than 35% will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14%. You are required to ascertain the probable price of the share.
Solution:
Illustration 5
From the following data find out the value of each firm and value of each equity share as per the Modigliani-Miller approach:
| X (₹ ) | Y (₹ ) | Z (₹ ) | |
| EBIT (₹) | 13,00,000 | 13,00,000 | 13,00,000 |
| No. of shares | 3,00,000 | 2,50,000 | 2,00,000 |
| 12% debentures (₹) | 9,00,000 | 10,00,000 |
Solution:
Illustration 6
Z Co. has a capital structure of 30% debt and 70% equity. The company is considering various investment proposals costing less than ₹ 30 lakh. The company does not want to disturb its present capital structure.
The cost of raising the debt and equity are as follows:
| Project Cost | Cost of Debt | Cost of Equity |
| Above ₹ 5 lakh | 9% | 13% |
| Above ₹ 5 lakh and up to ₹ 20 lakh | 10% | 14% |
| Above ₹ 20 lakh and up to ₹ 40 lakh | 11% | 15% |
| Above ₹ 40 lakh and up to ₹ 1 crore | 12% | 15.55% |
Assuming the tax rate is 50%, compute the cost of two projects A and B, whose fund requirements are ₹ 8 lakh and ₹ 22 lakh respectively. If the projects are expected to yield after tax return of 11%, determine under what conditions if would be acceptable.
Solution:
Illustration 7
Company X and Company Y are in the same risk class, and are identical in every fashion except that Company X uses debt while Company Y does not. The levered firm has 9,00,000 debentures, carrying 10% rate of interest. Both the firms earn 20% before interest and taxes on their total assets of ₹15 lakh.
Assume perfect capital markets, rational investors and so on; a tax rate of 50% and capitalisation rate of 15% for an all equity company.
Solution:
Illustration 8
A Company’s current operating income is ₹ 4 lakh. The firm has ₹ 10 lakh of 10% debt outstanding. Its cost of equity capital is estimated to be 15%.
Solution:
A. Theoritical Questions
1. Indifference Level of EBIT is one at which:
Answer: d. None of these
2. Financial Break-even level of EBIT is one at which:
Answer: b. EPS is zero
3. Relationship between change in Sales and d Operating Profit is known as:
Answer: b. Operating Leverage
4. If a firm has no Preference share capital, Financial Breakeven level is defined as equal to –
Answer: b. ineterest liability
5. At Indifference level of EBIT, different capital have-
Answer: b. Same EPS
6. Which of the following is not a relevant factor m EPS Analysis of capital structure?
Answer: d. Dividend paid last year
7. For a constant EBIT, if the debt level is further increased then
Answer: b. EPS may increase
8. Between two capital plans, if expected EBIT is more than indifference level of EBIT, then
Answer: c. One is better than other
9. Financial break-even level of EBIT is:
Answer: b. Intercept at X-axis
10. What is the value of a levered firm L if it has the same EBIT as an unlevered firm U Ltd., (with value of ₹ 700 lakh), has a debt of ₹ 200 lakh, tax rate is 35 % under M-M approach?
Answer: a. ₹ 770 lakh
B. Numerical Questions:
1. Premier Ltd's capital structure consists of the following:
| Particulars | Amount (in ₹ lakh) |
| Equity shares of ₹ 100 each | 20 |
| Retained earnings | 10 |
| 9% Preference shares | 12 |
| 7% Debentures | 8 |
| TOTAL | 50 |
The company’s EBIT is at the rate of 12% on its capital employed which is likely to remain unchanged after expansion. The expansion involves additional finances aggregating ₹ 25 lakh for which the following alternatives are available to it:
It is estimated that the P/E ratio in case of equity shares, preference shares and debentures financing would be 15, 12, and 10 respectively.
Which of the financing alternatives would you recommend and why? The corporate tax rate is 35%.
Answer:
2. Key information pertaining to the proposed new financing plans of Hypothetical Ltd. is given below:
| Sources of Funds | Financing Plans | |
| 1 | 2 | |
| Equity | 15,000 shares of ₹ 100 each | 30,000 shares of ₹ 100 each |
| Prefernce shares | 12%, 25,000 shares of ₹ 100 each | -- |
| Debentures | ₹ 5,00,000 at a coupon rate of 0.10 | 15,00,000, coupon rate of 0.11 |
Assuming 35% tax rate,
Answer:
3. Hypothetical is in need of ₹ 1,00,000 to finance its increased net working capital requirements. The finance manager of the company believes that its various financial costs and share price will be unaffected by the selection of a particular plan, since a small sum is involved. Debentures will cost 10%, preference shares 11%, and equity shares can be sold for ₹ 25 per share. The tax rate is 35%.
| Sources of Funds | Financial plans (per cent) | ||
| 1 | 2 | 3 | |
| Equity | 100 | 30 | 50 |
| Prefernce shares | 0 | 10 | 20 |
| Debentures | 0 | 60 | 30 |
Answer:
1. The two companies, X Ltd. and Y Ltd., belong to an equivalent risk class. These two firms are identical in every respect except that X Ltd. is unlevered while Company Y Ltd. has 10 % debentures of ₹ 30 lakh. The other relevant information regarding their valuation and capitalisation rates are as follows:
| Particulars | X Ltd. | Y Ltd. |
| Net operating income (EBIT) (₹) | 7,50,000 | 7,50,000 |
| Interest on debt (I) (₹) | 3,00,000 | |
| Earnings to equity holders (NI) (₹) | 7,50,000 | 4,50,000 |
| Equity-capitalisation rate ( ke) | 0.15 | 0.20 |
| Market value of equity (S) (₹) | 50,00,000 | 22,50,000 |
| Market value of debt (B) (₹) | 30,00,000 | |
| Total value of fi rm (S + B) = V (₹) | 50,00,000 | 52,50,000 |
| Implied overall capitalisation rate ( Ko) | 0.15 | 0.143 |
| Debt-equity ratio (B/S) | 0 | 1.33 |
Answer:
2. VE has EBIT of ₹ 2 million and tax rate is 40%. The return on equity without debt is 14%. Determine the value of the company according to M-M hypothesis when,
Answer:
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