Capital Structure Approach/Theories

1. Net Income Approach (NI)/Relevant Theory:

Net income approach and net operating income approach were proposed by David Durand. According to NI approach, there exists positive relationship between capital structure and valuation of firm and change in the pattern of capitalisation brings about corresponding change in the overall cost of capital and total value of the firm.Thus, with an increase in the ratio of debt to equity overall cost of capital will decline and market price of equity stock as well as value of the firm will rise. The converse will hold true if ratio of debt to equity tends to decline.

This approach is based on three following assumptions:

(1) There are no taxes;

(2) Cost of debt is less than cost of equity;

(3) The use of debt does not change the risk perception of investors. This implies that there will be no change in cost of debt and cost of equity even if degree of financial leverages changes.

On the basis of the above assumptions, it has been held in the NI approach that increased use of debt will magnify the shareholders’ earnings (because cost of debt and cost of equity will remain constant) and thereby result in rise in share values of equity and so also value of the firm.

Excellent Manufacturing Company expects to earn net operating income of Rs. 1, 50,000 annually. The Company has Rs. 6.00,000 8% debentures. The cost of equity capital of the Company is 10%. What would be the value of Company? Also calculate overall cost of capital.

Solution:

Calculation of Value of Excellent Manufacturing Company

Net operating Income(NOI)                                   Rs. 1,50,000

Less: Interest on 8% debentures (I)                     Rs. 48,000

Earnings available to equity shareholders (NI)    Rs. 1,02,000        

Equity Capitalisation rate (ke)                     Rs. 0.10

Market Value of Equity: (S) = NI/Ke                      Rs. 10,20,000

Total Value of Debt (B)                                          Rs. 6,00,000

Total Value of firm (S+B) = V                                Rs. 16,20,000

 Overall cost of capital = Ko = EBIT/V = 1,50,000/16,20,000    * 100 = 9.3%

  Now assume that the management raises the amount of debt from Rs. 6,00,000 to Rs. 12,00,000 and uses the proceeds so obtained to repurchase stock.

Presuming that the cost of debt remains constant, value of the company will be as shown below:

  Net operating Income(NOI)                                   Rs. 1,50,000

Less: Interest on 8% debentures (I)                     Rs. 96,000

Earnings available to equity shareholders (NI)    Rs. 54,000 

Equity Capitalisation rate (ke)                     Rs. 0.10

Market Value of Equity: (S) = NI/Ke                      Rs. 5,40,000

Total Value of Debt (B)                                          Rs. 12,00,000

Total Value of firm (S+B) = V                                Rs. 17,40,000

 Overall cost of capital = Ko = EBIT/V = 1,50,000/17,40,000    * 100 = 8.6%

It is to be noted from the above that with decrease in debt from Rs. 1,50,000 to Rs. 75,000, overall cost of capital rises from 9.3% to 9.6% and total value of firm declines from Rs. 16,20,000 to Rs. 15,60,000. In sum, as per NI approach increase in ratio of debt to total capitalisation brings about corresponding increase in total value of firm and decline in cost of capital.

On the contrary, decrease in the ratio of debt to total capitalisation causes decline in total value of firm and increase in cost of capital.

2. Net Operating Income Approach (NOI)/Irrelevant Theory:

According to Net Operating Income Approach which is just opposite to NI approach, the overall cost of capital and value of firm are independent of capital structure decision and change in degree of financial leverage does not bring about any change in value of firm and cost of capital.

The market value of the firm is determined by the following formula:

Value of Firm = EBIT/K₀ (%)

The crucial assumptions of the NOI approach are:

(1) The firm is evaluated as a whole by the market. Accordingly, overall capitalisation rate is used to calculate the value of the firm. The split of capitalisation between debt and equity is not significant.

(2) Overall capitalisation rate remains constant regardless of any change in degree of financial leverage.

(3) Use of debt as cheaper source of funds would increase the financial risk to shareholders who demand higher cost on their funds to compensate for the additional risk. Thus, the benefits of lower cost of debt are offset by the higher cost of equity.

(4) The cost of debt would stay constant.

(5) The firm does not pay income taxes.

Thus, under the NOI approach the total value of the firm as stated above is determined by dividing the net operating income (EBIT) by the overall capitalisation rate and market value of equity (S) can be found out by subtracting the market value of debt (B) from the overall value of the firm (V).

  S = V – B

Example:

 Canon Manufacturing Company has annual net operating income of Rs. 150000. The Company has Rs. 6,00,000 8% debentures. The overall cost of capital of the Company is 10%. What would be the value of the Company?

Solution:

Value of Canon Company has been computed as below:

Net operating Income (NOI)                                            Rs. 1,50,000

Overall Capitalisation rate (ko)                                       Rs. 0.10

Total market value of the company (V)                          Rs. 15,00,000

Total Value of Debt (B)                                                    Rs. 6,00,000

Total Market Value of Equity (S)                                    Rs. 9,00,000

Equity Capitalisation Rate (Ke)  = EBIT – I/V-B

                                                     = 1,50,000 – 45,000/9,00,000   *  100 = 11.33%      

The overall cost of capital  (K0) = Ki (B/V)   + Ke (S/V)  = 10%

Now assume in order to assess the effect of leverage on value of firm that the Company increases the amount of debt from Rs. 6,00,000 to Rs. 12,00,000. The value of the firm and cost of equity capital will be as shown above. It may be noted from the above that increase in amount of debt from Rs. 6,00,000 to Rs. 12,00,000 has not brought about any change in the total value of the Company but cost of equity capital has shot up from 11.33% to 18%.

Net operating Income (NOI)                                            Rs. 1,50,000

Overall Capitalisation rate (ke)                                       Rs. 0.10

Total market value of the company (V)                          Rs. 15,00,000

Total Value of Debt (B)                                                    Rs. 12,00,000

Total Market Value of Equity (S)                           Rs. 3,00,000

Equity Capitalisation Rate (Ke)  = 1,50,000 – 96,000/3,00,000  * 100 = 18%

What would happen under NOI approach if the amount of debt declines from Rs. 6,00,000 to Rs. 3,00,000 ? The value of the company in that case will be, as shown below. A perusal of the table will show that as the amount of debt decreases from Rs. 6,00,000 to Rs. 3,00,000 while value of the firm remains at Rs. 15,00,000 as it was earlier cost of equity capital has declined from 11.33% to 10.5%.

Calculation of Value of Cannon company:

Net operating Income                                            Rs. 1,50,000

Overall Capitalisation rate (ke)                             Rs. 0.10

Total market value of the company (V)                Rs. 15,00,000

Total Value of Debt (B)                                          Rs. 3,00,000

Total Market Value of Equity (S)                           Rs. 12,00,000

Equity Capitalisation Rate (Ke)         = 1,50,000 – 24,000/12,00,000 = 10.5%

3. Traditional Approach:

While the above two approaches represent extreme views about the impact of financial leverage on value of firm and cost of capital, traditional approach offers an intermediate view which is a compromise between the NOI and NI approaches.

This approach resembles the NI approach when it argues that the value of the firm can be increased and cost of capital can be reduced by the judicious mix of debt and equity share capital but it does not subscribe to the view of NI approach that the value of the firm will increase and cost of capital will decrease for all the degrees of financial leverage.

Further, the traditional approach differs from the NOI approach because it does not hold the view that the overall cost of capital will remain constant whatever be the degree of financial leverage. Traditional theorists believe that up to certain point a firm can by increasing proportion of debt in its capital structure reduce cost of capital and raise market value of the stock.

 Beyond the point further induction of debt will lead the cost of capital to rise and market value of the stock to fall. Thus, through a judicious mix of debt and equity a firm can minimise overall cost of capital to maximise value of stock. They opine that optimal point in capital structure is one where overall cost of capital begins to rise faster than the increase in earnings per share as a result of application of additional debt.

4. Modigliani-Miller (M-M) Approach:

 Modigliani and Miller presented rigorous challenge to the traditional view. This approach closely resembles with NOI approach. According to this approach, cost of capital and so also value of the firm remain unaffected by leverage employed by the firm.

Modigliani and Miller argued that any rational choice of debt and equity results in the same cost of capital under their assumptions and that there is no optimal mix of debt and equity financing.

 The independence of cost of capital argument is based on the hypotheses that regardless of the effect of leverage on interest rates the equity capitalisation rate will rise by an amount sufficient to offset any possible savings from the use of low-cost debt.

 They contend that cost of capital is equal to the capitalisation rate of a pure equity stream of income and the market value is ascertained by capitalizing its expected income at the appropriate discount rate for its risk class.

 So long as the business risk remains the same, the capitalisation rate (cost of capital) will remain constant. Hence as the firm increases the amount of leverage in its capital structure the cost of debt capital remaining constant the capitalisation rate (cost of equity capital) will rise just enough to offset the gains resulting from applications of low-cost debt.

 Thus, the essence of the M-M approach is that for firms in the same risk class the total value of the firm and the overall cost of capital are not dependent upon degree of financial leverage. The K and V remain constant for all degrees of financial leverage and value of the firm is found out by capitalizing the expected flow of operating income at a discount rate appropriate for its risk class.

The value of the levered firm can be found with the help of the following formula:

VI = Vu+ Bt ………

VI = Value of levered firm

Vu = Value of unlevered firm

B = Amount of borrowing

T = tax rate