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Approaches to Capital Structure (MM Approach and Traditional Approach)

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Kunal Madaan

on 26 March 2014

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Transcript of Approaches to Capital Structure (MM Approach and Traditional Approach)

Traditional
Approach

So, to conclude...
Approaches to
Capital Structure

MM
Approach

Capital Structure
Modigliani-Miller Approach
Thank you
Financial leverage increases the financial risk. Given the objective of the firm to maximize the value of equity shares, the firm should select a capital structure/financial leverage which will help in achieving the objective of financial management.

Capital structure refers to the mix of different sources of finance (debt & equity) to total capitalization. An optimum capital structure maximizes the shareholders’ wealth or minimizes its overall cost of capital.

Capital Structure
Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital (k0) and valuation (V). The four important theories are :-

i) Net income approach
ii) Net operating income approach
iii) Modigliani and Miller (MM) approach
iv) Traditional approach


Capital Structure Theories
There are only two sources of funds used by a firm: perpetual risk less debt & ordinary shares.
There are no corporate taxes.
The dividend-pay-out ratio is 100.
The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant.
The firm can change its capital structure either by selling shares and use the proceeds to retire debentures or vice versa.
The EBIT are not expected to grow.
Business risk is constant over time and is assumed to be independent of its capital structure and financial risk.
Perpetual life of the firm.
Assumptions related to capital structure theories
S= total market value of equity

B= total market value of debt

I= total interest payments

V= total market value of the firm (V=S+B)

NI= net income available to equity holders

Cost of debt (ki) = I/B

Cost of Equity capital (ke) = (D1 or E1)/P0

Overall cost of capital, K0 = EBIT/V

Ke = k0 + (k0 – ki) B/S
Definitions & Symbols
It concurs that an increase in the proportion of debt in the capital structure would lead to an increase in the financial risk of the equity holders & provides a behavioral justification for the irrelevance of capital structure. They maintain that the weighted average cost of capital does not change with a change in the leverage.

The basic proposition of the MM approach is that the overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class. Our focus is in exploring the relationship between leverage and valuation.
Modigliani-Miller Approach
Perfect capital markets – implications are that securities are infinitely divisible, investors are free to buy/sell securities, investors can borrow without restrictions, perfect information and investors are rational.
Investors have same expectation of firm’s EBIT with which to evaluate the value of the firm.
Business risk is equal among all firms within similar operating environment.
The dividend payout ratio is 100%.
There are no taxes.
Assumptions
The MM approach illustrates the arbitrage process with reference to valuation in terms of two similar firms except leverage so that one of them has debt and the other does not. The investors of the firm whose value is higher will sell their shares and instead buy the shares of the firm whose value is lower. The behavior of the investors will have the effect of increasing the share prices of firm whose shares are being bought & lowering the share prices of firm whose shares are being sold.

Arbitrage process
1) Risk perception – of personal & corporate leverage are different. If they are perfect substitutes, the risk to which an investor is exposed must be identical irrespective of whether the firm has borrowed or borrows proportionately.
2) Investors would find the personal leverage inconvenient.
3) Relatively high cost of borrowing with personal leverage.
4) MM contend that with Corporate taxes, debt has a definite advantage as interest paid on debt is tax-deductible and leverage will lower the overall cost of capital. The value of levered firm (V1) would exceed the value of the unlevered firm (Vu) by an amount equal to levered firm’s debt multiplied by tax rate.
Limitations
The Traditional Approach is midway between NI and NOI approaches. The crux this approach is that through a judicious combination of debt and equity, a firm can increase its value (V) and reduce its cost of capital ( ) upto a point. However, beyond that point , the use of additional debt will increase the financial risk of the investors as well as of the lenders and as a result will cause a rise in the . At such a point, the capital structure is optimum. In other words, at the optimum capital structure, the marginal real cost of debt (both implicit and explicit) will be equal to the real cost of equity.
Traditional Approach
Other things being equal, the market value of a company's securities will rise as the amount of leverage in its financial structure is increased from zero to some point determined by the capital market's evaluation of the level of business uncertainty involved. Beyond this point and up to a second point, changes in leverage have very little effect, that is, within this range of leverage the total market value of the company is unchanged as leverage changes. Beyond this range of acceptable leverage the total market value of securities will decline with further increase in the amount of leverage.
The effect of increase in leverage from zero, on cost of capital and valuation of firm, can be thought to involve three distinct phase.
The Traditional approach suggests that:
During the first phase, increasing leverage increases the total valuation of the firm and lowers the overall cost of capital. As the proportion of debt in the capital structure increases, the cost of equity ( ) begins to rise as the reflection of the increased financial risk. but it does not rise fast enough to off set the advantage of using the cheaper source of debt capital. Likewise, for the most of the range of this phase, the cost of debt ( ) either remains constant or rises to a very small extent because the proportion of debt by the lender is considered to be within safe limits. Therefore, they are prepared to lend the firm at almost same rate of interest. Since debt is typically a cheaper source of capital than equity, the combined effort is that the overall cost of capital begins to fall with the increasing use of debt.
Increased Valuation and
Decreased Overall Cost of Capital
After a certain degree of leverage is reached, further moderate increases in leverage have little or no effect on total market value. During the middle range, the changes brought in equity- capitalization rate and debt-capitalization rate balance each other. As a result, the values of (V) and ( ) remain almost constant.
Constant Valuation and
Constant Overall Cost of Capital
Beyond a certain critical point, further increases in debt proportions are not considered desirable. They increase financial risk so much that both cost of equity and cost of debt start rising rapidly causing ( ) to rise and (V) to fall.
Decreased Valuation and
Increased Overall Cost of Capital
Leverage and Cost of Capital
Leverage and Cost of Capital
The traditional view on leverage is commonly referred to as one of 'U' shaped cost of capital curve. In such a situation, the degree of leverage is optimum at a point at which the rising marginal cost of borrowing is equal to the average overall cost of capital. For this purpose, marginal cost of a unit of debt capital consists of 2 parts:
(i) the increase in total interest payable on debt
(ii) the amount of extra net earnings required to restore the value of equity component to what it would have been under the pre-existing capitalization rate before the debt is increased.
According to traditional approach, the cost of capital of a firm as also its valuation is dependent upon the capital structure of the firm and there is an optimum capital structure in which the firm's cost of capital is minimum and its value is maximum.
Let us suppose that the firm has 20% debt and 80% equity in its capital structure. The cost of debt and the cost of equity are assumed to be 10% and 15% respectively. What is the overall cost of capital, according to the traditional approach?
Example
Solution
The overall cost of capital ( ) = i.e. 0.15 (20/100) + i.e. 0.15 (80/100)
=14 %
Further, suppose, the firm wants to increase the percentage of debt to 50. Due to increased financial risk, the cost of debt and cost of equity will presumably rise. Assuming, they are 11% & 16%, the cost of capital would be = 0.11 (50/100) + 0.16 (50/100) = 13.5%
It can, thus be seen that with a rise in debt-equity ratio, cost of equity and cost of debt increase but cost of capital has declined presumably because these increases have not fully offset the advantages of the cheapness of debt.
Assume further, the level of debt is raise to 70% of the capital structure of the firm. There would consequently be a sharp rise in risk to the investors as well as creditors. The would be, say, 20% and the 14%. The = 0.14 (70/100) + 0.20 (30/100) = 15.8%
Further, suppose, the firm wants to increase the percentage of debt to 50. Due to increased financial risk, the cost of debt and cost of equity will presumably rise. Assuming, they are 11% & 16%, the cost of capital would be = 0.11 (50/100) + 0.16 (50/100) = 13.5%
It can, thus be seen that with a rise in debt-equity ratio, cost of equity and cost of debt increase but cost of capital has declined presumably because these increases have not fully offset the advantages of the cheapness of debt.
Assume further, the level of debt is raise to 70% of the capital structure of the firm. There would consequently be a sharp rise in risk to the investors as well as creditors. The would be, say, 20% and the 14%. The = 0.14 (70/100) + 0.20 (30/100) = 15.8%
The overall cost of capital has actually risen when the firm tries to employ more of what appeared, at the previous debt equity ratio, to be the least costly source of funds, that is, debt. Therefore, the firm should take into account the consequences of raising the percentage of debt to 70% on the cost of both equity and debt.
The example demonstrates that the excessive use of debt greatly increases financial risk and completely offsets the advantage of using the lower cost debt. Therefore, the firm should consider the two off-setting effects of increasing the proportion of debt in the capital structure: the rise in cost of debt and equity and the decrease or increase in cost of capital and the total value generated by using a greater proportion of debt.
Assume there are two firms, L and U, which are identical in all respects except that firm L has 10% Rs. 5,00,000 debentures. The EBIT of both the firms are equal (Rs. 1,00,000). The equity capitalization rate of firm L is higher (16%) than that of firm U (12.5%)

Example
Solution
Effect of Arbitrage
5) Bankruptcy costs arise due to a firm’s inability to meet the promised payments of interest and principal. Sometimes, these costs may lead to its liquidation.
Bankruptcy costs are of 2 types:
i) Direct bankruptcy costs are legal and administrative costs associated with bankruptcy proceedings of the firm.
ii) Indirect bankruptcy costs are costs of avoiding a threat of bankruptcy.
Bankruptcy costs can be exorbitant and a disincentive to use excessive levels of debt as use of debt beyond safe limits offsets the tax advantage of using debt. It depresses the value of levered firm.
MM suggest Vl = Vu + Bt (bankruptcy costs)

According to MM hypothesis, since debt financing has no advantage, it has no disadvantage either. In other words, just as the total value of the levered firm can not be more than that of an unlevered firm, the value of an unlevered firm can not be greater than the value of a levered firm. This is because the arbitrage process will set in and depress the value of the unlevered firm and increase the market price and , thereby, the total value of the levered firm. The arbitrage would thus operate in the opposite direction.
Assume that in previous example, the equity capitalisation rate is 20% in the case of levered firm, instead of 16%.
Arbitrage process: Reverse Direction
Solution
Effect of Reverse Arbitrage Process
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