Accounting and Finance for Managers

LESSON

22
CAPITAL STRUCTURE THEORIES
CONTENTS
21.0 22.1 22.2 22.3 22.4 22.5 22.6 22.7 Aims and Objectives Introduction Assumption of the Capital Structure Theories Net Income Approach Net Operating Income Approach ModiglianiMiller Approach Traditional Approach Types of Dividend Policies 22.7.1 Cash Dividend Policy 22.7.2 Bond Dividend Policy 22.7.3 Property Dividend Policy 22.7.4 Stock Dividend Policy 22.8 22.9 Let us Sum up Lesson-end Activity

22.10 Keywords 22.11 Questions for Discussion 22.12 Suggested Readings

22.0 AIMS AND OBJECTIVES

The purpose of this lesson is to identify the optimum capital structure for business fleeces. After studying this lesson you will be able to: (i) describe different theories of capital structure explain aspects of capital structure decision-making (ii) (iii) describe different types of dividend policies

22.1 INTRODUCTION
The capital structure theories are facilitating the business fleeces to identify the optimum capital structure. The optimum capital structure of the organization differs from one approach to another due the assumption which are underlying with reference to many factors of influence. The success of the firm is normally depending upon the rate at which the financial resources are raised, differs from one organisation to another depends upon the needs. The cost of capital is having greater influence on the EBIT level of the
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firm; which directs affects the amount of earnings available to the investors, that finally reflects on the value of the firm. The more earnings available at the end will lead to greater return on investment holdings of the investors, would enhance the value of shares due to greater demand. There are two set of approaches with reference to capital structure; which normally influences the Value of the firm through the cost of overall capital(Ko) is one approach called relevance approach capital structure theories and other do not have any influence on the value of the firm is known as irrelevance approach. The debt finance in the capital structure facilitates the firm to enhance the value of EPS on one side on the another side it is subject to the financial leverage with reference to trading on equity. The application of leverage in the capital structure enhances the value of the firm through the cost of capital.

Capital Structure Theories

The following are the various capital structure theories:

(i) (ii) Net income approach Net operating income approach

(iii) Modigliani and Miller approach (iv) Traditional approach

22.2 ASSUMPTION OF THE CAPITAL STRUCTURE THEORIES

(i) (ii) There are only two resources in the capital structure viz Debt and Equity share capital The dividend pay out ration 100% which means that there is no scope for the retained earnings

(iii) The life of the firm is perpetual (iv) The total assets of the firm do not change (v) The total financing remains constant through balancing taking place in between the debt and share capital

(vi) No corporate taxes; this was removed later

22.3 NET INCOME APPROACH

Algebraically, the relationship between the cost of equity, cost of overall capital and debt-equity ration are explained as follows: Ke=Ko+ (KoKi)B/S Net income approach was developed by Durand, in this he has portrayed the influence of the leverage on the value of the firm, which means that the value of the firm is subject to the application of debt i.e., leverage. In this approach, the cost of debt is identified as cheaper source of financing than equity share capital. The more application of debt in the capital structure brings down the overall capital, more particularly 100% application of debt finance leads to resemble the over all cost of capital as cost of debt. The weighted average cost of capital will come down due to more application of leverage in the capital structure, only with reference to cheaper cost of raising than the equity share capital cost. Ko= Ke(S/V)+Ki(B/V) The value of the firm is more in the case of lesser overall cost of capital due to more application of leverage in the capital structure. The optimum capital structure is that at

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Accounting and Finance for Managers

when the value of the firm is highest and the overall cost of capital is lowest. V=B+S V= EBIT/Ko This approach highlights that the application of leverage influences the overall cost of capital and that affects the value of the firm.

22.4 NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. How the implicit cost of debt will go up? The more application of debt leads to increase the financial risk among the investors, that warranted the equity share holders to bear additional financial risk of the firm. Due to additional financial risk, the share holders are requiring the firm to pay additional dividends over the existing. The increase in the expectations of the shareholders with reference to dividends hiked the cost of equity. Under this approach, no capital structure is found to be a optimum capital structure. The major reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant. It is finally concluded that this approach highlights that application of leverage never makes an attempt to enhance the value of the firm, in other words which is known as unaffected by the application of leverage.

22.5 MODIGLIANIMILLER APPROACH

It is the approach, attempts to explain the application of leverage does not have any influence on the value of the firm through behavioural pattern of the investors. The behavioural pattern of the investors is taken into consideration for explaining the value of the firm which is unaffected by the application of debt/leverage in the capital structure through arbitrage process. The MM approach has three different propositions: (i) The overall capital structure of the firm is unaffected by the cost of capital an degree of leverage

(ii) The cost of equity goes up and offset the increase of leverage in the capital structure (iii) The cut off rate for the investment purposes is totally independent. For discussion, the proposition is only considered for the study of usage of leverage in the capital structure, which do not have any impact in the value of the firm.

Assumptions of the MM approach:

This approach is discussed under the perfect market conditions (i) Securities are divisible infinitely. Investors are allowed to buy and sell securities (ii) (iii) Investors are rational to access the information (iv) No transaction costs involved in the process of the buying and selling of securities Arbitrage process: It is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. With the help of arbitrage process, the investors are permitted to shift holding of the Levered firm to the unlevered firm which is known as undervalued. These two firms are identical in business risk except in the application of debt finance in the levered firm. In order to maintain the similar amount of the financial risk of the firm, the investor is required to undergo for personal leverage or home made leverage to maintain the same

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proportion of investment in the unlevered firm. During this process, the investor could save something and this continuous arbitrage process will level the value of the both firms. It means that the value of the firm is unaffected by the application of leverage which is explained through the arbitrage process, nothing but behavioural pattern of the investors. The same thing could be applied in the case of reverse arbitrage process in between the Unlevered and levered. This also another kind of process in which the investor could gain through the transfer of the holdings from the unlevered firm to levered firm. The value of the firm is unaffected by the application of the leverage in the capital structure.

Capital Structure Theories

22.6 TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium. The risk premium which is expected by the investors will enhance the overall cost of capital. The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity.

22.7 TYPES OF DIVIDEND POLICIES

The dividend policy is the policy that facilitates the firm to decide how much should be declared as a dividend. The declaration of dividend is normally to be taken with reference to the future prospects of the firm. The dividends are normally decided by the board of directors during the board meeting which may affect other important decisions of the firm. Most of the companies never think off about the future prospects before the declaration of the dividends to the shareholders. As a finance manager should emphasize the importance of declaring or non declaring the dividends which are having greater influence on the futuristic decisions of the enterprise. Types of dividend policies: (i) Cash dividend

(ii) Bond dividend (iii) Property dividend (iv) Stock dividend

22.7.1 Cash Dividend Policy

The dividends are paid in terms of cash. This type of dividend normally leads to cash outflow which has greater influence on the cash position of the firm. At the moment of declaring the cash dividend, future cash needs should be predetermined and dividends declared to the share holders.

22.7.2 Bond Dividend Policy

Instead of paying dividend in terms of cash, some companies are issuing bond dividends, which facilitate them to postpone the immediate cash outflows. Immediately after the
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issuance of bonds, the bond holders are receiving the interest on their holdings besides the bond values to be paid on the due date. This method is not popular in India.

22.7.3 Property Dividend Policy

Instead of paying dividends in cash, some assets are given to the shareholders as dividend payments. This is also not existing in India.

22.7.4 Stock Dividend Policy

Instead of making the payment of cash dividend, the stock are issued to the existing shareholders. The company shares are issued to existing share holder which is known other words as stock dividends.
Check Your Progress 1. 2. Write a note on the ModiglianiMiller approach. Explain the various types of dividend policies.

22.8 LET US SUM UP

The capital structure theories are facilitating the business fleeces to identify the optimum capital structure. The optimum capital structure of the organization differs from one approach to another. The cost of capital is having greater influence on the EBIT level of the firm; which directs affects the amount of earnings available to the investors, that finally reflects on the value of the firm. Net income approach, the cost of debt is identified as cheaper source of financing than equity share capital. Net Operating income approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. Under this approach, no capital structure is found to be a optimum capital structure. Arbitrage process is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. The traditional approach is known as intermediate approach in between the Net income approach and NOI approach.

22.9 LESSON-END ACTIVITY

Assuming the condition of the original M & M (Miller-Modigliani) approach, state whether the following statement is true or false: In a world of perfect capital market, an increase in financial leverage will increase the market value of the firm. Provide an intuitive explanation of your answer.

22.10 KEYWORDS
Arbitrage process Dividend Policies Cash dividend policy

22.11 QUESTIONS FOR DISCUSSION

1. Write the various assumption of the capital structure theories.
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2.

Explain the Net income approach.

Elucidate the Net operating approach. Explain briefly about the traditional approach. What is meant by the dividend policy?

Capital Structure Theories

22.12 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

The Criticism Of The Modigliani And Miller Hypothesis Finance Essay

Capital structure has a major implication to the ability of firms to meet the various needs of stakeholders. There were various studies carried out on capital structure and major development on new theories for optimal debt to equity ratio. The first milestone on the issue was set by Modigliani and Miller(1958) through which they presented in their seminal work two important propositions that shaped the economic theory behind capital structure and its effect on firm value. The Modigliani and Miller hypothesis is identical with the net operating income approach. At its heart, the theorem is an irrelevance proposition, but the Modigliani-Miller Theorem provides conditions under which a firms financial decisions do not affect its value. They argue that in the

absence of taxes, a firms market value and the cost of capital remain invariant to the capital structure changes. In their 1958 articles, they provide analytically and logically consistent behavioural justification in favour of their hypothesis and reject any other capital structure theory as incorrect. The ModiglianiMiller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a companys value is unaffected by how it is financed, regardless of whether the companys capital consists of equities or debt, or a combination of these, or what the dividend policy is. Miller (1991) explains the intuition for the Theorem with a simple analogy. Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring. He continues, The Modigliani-Miller proposition says that if there were no costs of separation, (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk. The main content of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) and selling off safe cash flows to debtholders leaves the firm with more lower valued equity,thus keeping the total value of the firm unchanged. Furthermore, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity.

Assumptions:
The ModiglianiMiller theorem can be best explained in terms of their proposition 1 and proposition 2. However their proposition are base on certain assumption and particularly relate to the behaviour of investors, capital market, the actions of the firm and the tax environment. According to I.M Pandey(1999) the assumptions of the Modigliani - Miller theorem is based on: Perfect capital markets These are securities (shares and debt instruments)which are traded in the perfect capital market situation and complete information is available to all investors with no cost to be paid. This also means that an investor is free to buy or sell securities, he can borrow without restriction at the same terms as the firm do and he behave rationally. It also implies that the transaction cost(cost of buying and selling securities) do not exist. Homogeneous risk classes Firms can be group into homogeneous risk classes. Firms would be considered to belong to a homogeneous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogeneous class. Risk The risk of the investors is defined in terms of the variability of the net operating income(NOI). The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate. No taxes In the original formulation of their hypothesis, M-M assume that no corporate income taxes and personal tax exist. That is, they are both perfect substitute. Full payout Firms distribute all net earnings to the shareholders, which means a 100% payout.

Proposition 1: the market value of any firms is independent of its capital structure.
M-M(Modigliani and miller) argue that for firms in the same risk class the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the rate appropriate to that risk class. This is their proposition 1 and can be expressed as follows:

Value of firm= Market value of equity + Market value of debt

=
V= (S + D) = = Where V = the market value of the firm S = the market value of the firms ordinary equity D = the market value of debt = the expected net operating income on the assets of the firm = the capitalization rate appropriate to the risk class of the firm. Also, M-M extended proposition 1 by arguing that there is a linear relationship between cost the cost of equity and the financial leverage. Financial leverage is measured by the Debt to Equity ratio(D/E).The cost of equity capital can be denoted by the following relationship: = + ( - ) DE Where denotes cost of equity capital; denotes overall cost of capital and denotes cost of debts of the firm L . Based on the assumption that there is no corporate tax then is equal to the rate of interest on financial leverage employed by the firm.

Arbitrage process:
Arbitrage process is base on the principle that Proposition 1 is based on the assumption that 2 firms are identical except for their capital structure which cannot command different market value and have different cost of capital. Modigliani and Miller do not accept the net income approach on the fact that two identical firms except for the degree of leverage, have different market values. Arbitrage process will take place to enable investors to engage in personal leverage to offset the corporate leverage and thus restoring equilibrium in the market.

Criticism of the Modigliani and Miller hypothesis:

On the basis of the arbitrage process, M-M conclude that the market value of firms are not affected by leverage but due to the existence of imperfections in the capital market, arbitrage may fail to work and may give rise to differences between the market values of levered and unlevered firms. The arbitrage process may fail to bring equilibrium in the capital market for the following reasons: Lending and borrowing rates differences: Based on the assumption that firms and individuals can borrow and lend at the same rate of interest does not hold good in practice. This is so because firms which hold a substantial amount of fixed assets will have a higher credit standing, thus they will be able to borrow at a lower rate of interest than individuals. Non-substitutability of personal and corporate leverages: It is incorrect to say that personal leverage and corporate leverage are perfect substitute because of the existence of limited liability a firms hold compare to the unlimited liability of individuals hold. For examples, if a levered firm goes bankrupt, all investors will lose the amount of the purchase price of the shares. But if an investor creates personal leverage, in the event of a unlevered firms insolvency, he would lose not only his principal in the shares but also be liable to return the amount of his personal loan. Transaction costs: Transaction cost interfere with the working of the arbitrage. Due to the cost involved in the buying and selling of securities, it is necessary to invest a larger amount in order to earn the same return. As a result , the levered firm will have a higher market value.

Institutional restrictions: Personal leverage are not feasible as a number of investors would not be able to substitute personal leverage for corporate leverage and thus affecting the work of arbitrage process.
3. Corporate taxation and personal taxation: 5. 6.

M-M theory is also criticize for the reason that it ignores the corporate taxation and personal taxation. Retained earnings: It also ignores personal aspect of financing through retained earnings. In real world , corporate will not pay out the entire earnings in the form of dividends. Investors willingness: Investors will not show much interest in purchasing low rated issued by highly geared firms.

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